Both Stephen Gordon and I have tried to debunk the myth that corporate Canada is sitting on a pile of cash rather than investing in workers and equipment. Cash on hand is a poor proxy for investment when companies have alternative avenues for financing investments.
Corporations are holding onto more cash, but this is unrelated to investment spending. Companies are simply financing their investments using debt rather than cash. This seems counterintuitive at first (why pay interest expenses when you could simply pay in cash?) but from a corporate strategy perspective this makes a great deal of sense.
A large company like Suncor Energy could pay for an investment, in part or whole, with cash on hand. Alternatively, it could issue a bond which matures in 2018, which, given current market rates, would have a yield of less than 3 per cent a year.
Paying 3 per cent a year in interest is certainly an expense greater than zero, but cash on hand (and close cash substitutes) is likely to be far more valuable. If the world economy slides back into recession, credit markets may dry up, making the decision to hold cash look quite prescient. This cash has a very clear insurance value. The cash also has value if the world economy improves, as nominal interest rates would also rise. Suncor can then take its cash, put it back into the bond market and purchase securities that have higher yields than the ones they issued in 2012. This difference in interest rates is essentially free profit.
If anyone in Canada understands this basic Finance 101 argument, it is Bank of Canada Governor Mark Carney. So how can we explain Mr. Carney’s recent comments?
Economist Livio Di Matteo has given the best explanation I’ve seen so far. He suggests there is a difference of opinion between the Bank and corporate Canada on the state of the global recovery. I think we can take his arguments even further. If the Bank of Canada thinks a return to recession is less likely than Bay Street believes, then there will be a disagreement about the insurance value of this cash. The Bank of Canada would see the insurance value as being far less valuable than Bay Street believes. Take away the insurance value of cash and the benefits of debt financing are less clear.
More importantly, self-fulfilling prophecies are quite common in economics. If companies believe the economy is likely to get worse, they may slow their investments, as we saw briefly in late 2011. The reduction in spending will, in fact, reduce economic activity. Mr. Carney’s comments should be interpreted as reassuring corporate Canada credit that markets will not dry up in the short-to-medium term. While I have recently disagreed with Mr. Carney, if this is, in fact, the argument he is making, I would likely take his side.
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