While working in Korea during the 1997 Asian financial crisis, I saw many corporations battle for survival after they had borrowed too much for acquisitions and investments. Yet there was a sense that if they could just get through the crisis, growth was bound to come back.
This time around, the mood is different. The main worry for corporate leaders isn’t survival— companies in North America boast healthy balance sheets—but how soon growth will return. We live in unusual economic times. As countries and as individuals, we have never been more in debt. Corporations, on the other hand, are flush with cash. Worried about volatility, they’re hoarding money—and holding back the very growth they’re anxious to see return. What’s more, their fl awed way of evaluating risk is causing them to miss out on potentially lucrative opportunities.
The sums are staggering. In the European Union and North America, excess cash—over and above what a company needs to operate—amounts to over US$2 trillion. That’s more than double the 2002 levels. In Canada, cash levels outside the financial sector have risen by 60% since 2008. Globally, companies are sitting on more than US$5 trillion.
There are a number of reasons why businesses have built up such large reserves. First, they’re enjoying a period of relatively high profitability. Earnings at large non-financial companies in the U.S. are at 5.5% of GDP— more than 50% above the average of the past 25 years. We see a similar picture in Canada and Europe. But instead of distributing these profits back to shareholders in the form of dividends and share buybacks, many have chosen to retain sizable cash cushions to ensure future access to capital amid a shaky global banking system. Similar concerns have also lowered spending on mergers and acquisitions— historically one of the top uses for corporate cash— and led businesses to cut back on investing in R&D and expansion. Among the S&P 500 companies, for instance, such investment over the past three years is 6% below the levels of the previous three.
Are companies right to be so thrifty? They are clearly nervous about the global economic outlook and high household and government debt. This is understandable. My colleagues at the McKinsey Global Institute, our firm’s business and economics research arm, have analyzed previous downturns and found that when individuals and governments focus on paying down debt, these efforts curb economic growth for three to five years. The global impact of the current deleveraging could be even more severe because many countries are doing it simultaneously.
Nevertheless, I would argue that business leaders need to adjust how they think about risk. There are flaws in the decision making processes around investments within corporations and on their boards. Our research shows that investment budgets are too often based simply on levels in previous years, and too many investment projects are turned down by junior managers, preventing top leaders from even looking at all the available opportunities.
Moreover, the “hurdle rates” that define the minimum acceptable return on an investment remain higher than they should be—in many cases because thinking remains coloured by an earlier world of higher inflation and interest rates. When nominal interest rates were 8%, a 15% hurdle rate perhaps made sense. With interest rates now at 3%, 10% would seem more appropriate.
Policy-makers could help get corporate leaders spending again by decisively focusing on deficit and debt reduction. But the companies themselves have every incentive to overcome these barriers. Doing so would oil the global recovery to everyone’s benefit. If North American and European corporations were to spend just 10% of their cash each year, they could create up to five million jobs. And history tells us it is the companies that have invested ahead of a recovery that reap the biggest benefits.
Dominic Barton is the Global Managing Director of McKinsey & Co.