The Velocity of Money

Since Japan adopted Corporate Governance and Stewardship Codes in 2014, companies are finally beginning to understand that their obsession with cash has to end. The Corporate Governance Code (“CGC”) compels managers to focus their attention on performance measures like return on equity (“ROE”), a concept unknown to most of them before 2014.

For many corporations even achieving the not so lofty ROE goal of 8 percent, as suggested by the so-called Ito Review, released in August 2014, will be a challenge given the excessive amount of cash weighing down their balance sheets. At present, Japanese-listed companies are awash in liquid assets; about $2.2 trillion. How these funds will be used is of paramount interest to shareholders.

Japanese companies weren't always so conservative with their cash reserves. Beginning with the bursting of the asset bubble in 1992, and the ensuing series of global financial crises, Japanese corporations became increasingly stingy with their cash payouts. They had little choice but to “over-save” for a rainy day simply because banks, which previously served as a sort of corporate safety net, were no longer able to lend unrestrictedly. A paper from the IMF shows that for every year since the 1990s (the infamous “Lost Decade” of Japan), corporate net lending has trended upwards, with as much as a six to eight point gap of savings over investment.

Evidence shows that the turmoil of the 1990s may be to blame for this stark gap. Prior to the “Lost Decade,” investment actually outpaced savings by an order of magnitude, with savings accounting for a negative percent of GDP. Apparently, this trauma seems to linger in the institutional memory of many Japanese corporations: in 2014, the cash holdings of Japanese companies came to over 40 percent of GDP. By comparison, corporate cash holdings in the United States accounted for only about 10 percent of GDP.

The consequences of hoarding cash are quite serious, not just for shareholders but for employees as well. Looking at worker salaries, we see that despite unemployment being at a record low of 2.4 percent (a number not seen since the boom of the 1970s), wages have only grown slowly, or even gone backwards. In 2018, salaries grew only about 0.9 percent from one year ago; with bonuses, the number rose to 1.3 percent, still an unthinkably low rate for an economy that is at close to full employment.

But beyond that, the consequences for shareholders are also quite severe. According to a recent Goldman Sachs report, the ROE for firms listed on the Tokyo Stock Exchange reached a record high of 10.5 percent. Yet in contrast to other regions, it was still low; the United States saw 17.8 percent, while Europe saw 14.3 percent. Even with the new pressure to return cash to shareholders, Japan still has the highest ratio of cash-rich companies (58.5 percent), especially when compared to the United States (14.6 percent).

Perhaps part of the reason has to do with time, as managers are slowly growing to understand the objectives of these new reforms. More of them now realize that maintaining excessive amounts of cash reserves are not necessarily an optimal way to manage their balance sheets. While it may help weather a recession and avoid dreaded layoffs, too much cash sitting idly in the bank can lead to a host of other problems, among them lower ROE and ultimately, a lack of growth due to insufficient investment. Now, it also makes corporations vulnerable to increasingly disgruntled shareholders, both foreign and domestic.

Much of the problem stems from a more fundamental weakness; Japanese corporations struggle with their capital allocation policy. Indeed this is the main focus of the recent corporate governance code reforms. Unfortunately, undefined capital allocation policies have led to excessive savings, and not, as one might expect, unbridled spending.

One can argue that as a result of these weak capital allocation policies, equities have languished. Japanese pension funds get famously low returns, even posting negative returns in 2015. Compounding the issue is the all-encompassing drag Japan’s rapidly aging population and low birthrates,put on pension fund assets. This is forcing the government to take drastic steps; there is even a plan to raise the retirement age to 70 or higher.

Unfortunately, as the Goldman Sachs report makes clear, the status quo remains strong. Some 60 percent of Japanese companies remain “cash rich,” having more cash holdings than their interest-bearing debt. This is approximately four times higher than the United States, and more than three times higher in Europe. By far, it seems that IT services has the highest proportion of companies (approximately half) with a cash ratio of 30 percent or more. The lowest seems to be electric power and gas, where the average cash ratio seems to hover at around 6 percent.

Yet these problems are not insurmountable. Over the past few years Japanese companies have been using increasing amounts of their cash reserves to buy back shares. Companies like beverage giant Kirin and telecommunications provider NTT Docomo bought back large chunks of its stock, with a total of ¥4.47 trillion of buybacks from January to March 2018. In Kirin’s case, these buybacks increased their share value by 8 percent.

While significant progress has been made, Japanese companies still have too much cash sitting idle: one estimate is as high as $2.4 trillion in corporate balance sheets. They need to do much more with the vast resources at their disposal, whether it is investment, M&A, wage hikes, or improving total shareholder returns. If re-elected in September, Abe will certainly further push even harder for Japanese corporations to implement these changes. If Japan is to ever get its engines going at full steam this problem has to be addressed--and soon.