A Cash Buildup and Business Investment
As the economic recovery continues at a slow pace, some observers point to the vast cash reserves sitting on corporate balance sheets as one reason for a lack of more robust job creation. The thinking is that if firms would simply begin investing this cash in new plants, equipment, and employees, the pace of the recovery would pick up and bring unemployment down. However, many company executives are waiting until the slow pace of the recovery quickens before putting additional cash at risk.
Nonfarm, nonfinancial corporations continue to build their holdings of cash and other liquid assets. By the end of the third quarter 2010, these assets totaled more than $1.93 trillion, an increase of 14.4 percent over the prior year’s level and a rise of 4.7 percent since the end of June 2010. Nationally, cash and checking deposits held by corporate businesses rose by just over 200 percent, or almost $300 billion, from the beginning of the recession in December 2007 to September 2010. Some of this increase may reflect a reduction in dividend payments (at least through 2009) and the increased proceeds from bond issuance in a low-interest-rate environment. Cash holdings and other liquid assets as a share of total corporate assets also saw a sharp increase, rising around 2 percentage points since the start of the recession. That share is the highest it’s been since the mid-1950s (7.4 percent as of September 2010).
Discussions with business leaders across the Fourth District point to three reasons for the buildup of cash reserves. First, for many corporations, demand uncertainty remains the fundamental issue. As a result, managers are reluctant to put capital at risk. For them, it is difficult to identify projects that make sense at this point in the recovery. Rising exports help some, but they are not seen as a fundamental driver of investment. Second, because of demand uncertainty, companies are very conservative in ordering, which puts additional financial pressure on suppliers, especially those that are small. Banks in turn are reluctant to work with the suppliers, which forces these businesses to build cash reserves in the event that they cannot obtain credit to cover operating costs. Finally, as long as consumption is moderate, business investment will be moderate. Although recent increases in retail sales are encouraging, many consumers remain wary of committing to big-ticket purchases. This trend is expected to continue until households deleverage and the unemployment rate declines.
The relatively subdued levels of spending by all businesses began to show a modest recovery during the past few quarters. Still, in the third quarter of 2010, spending remained 15 percent below pre-recession levels. Estimated spending in the third quarter was more than $1.43 trillion (seasonally adjusted annualized rate). This spending is commonly known as business fixed investment (BFI) and includes information processing equipment and software, capital equipment, and structures as its major components.
To gain a better understanding of the near-term investment plans of businesses nationwide, the 12 Federal Reserve Banks were asked by the System’s Board of Governors to solicit information from contacts across their Districts in January and July of 2010. Industry sectors included in the Fourth District’s inquiries were manufacturing, energy, and freight transportation. The most notable finding that emerged when we compared the District’s July results to those from January was a substantial drop among the share of respondents who said that they were planning to increase capital spending.
Our inquiries revealed that during the recession, many District companies cut back or froze capital budgets. As the recovery showed early signs of taking hold late in 2009, managers began to loosen the tight grip they had on spending, and set in motion some projects that had been postponed. By mid-2010, firms felt comfortable with their level of investment, even though it remained substantially below pre-recession levels, and they were determined not to raise it until they felt that a sustainable recovery was under way. Two other possible explanations for the reluctance to raise capital spending as of mid-2010 are suggested by a closer examination of the results of our inquiries.
One explanation is that beginning late in 2009 and continuing through at least the first quarter of 2010, inventory adjustments became a primary driver of the recovery. In fact, rising inventories accounted for 2.8 percentage points of the 5 percent GDP growth (annualized rate) during the fourth quarter of 2009. To meet this rising demand, many District manufacturers reported a need to replace aging machinery or other equipment. In our January inquiry, the need to purchase capital equipment was the most frequently reported reason for increasing capital outlays (29 percent of respondents cited it). By July, only 10 percent of our contacts saw equipment purchases as important.
The other possible explanation for the decline in planned capital spending is uncertainty about the economic recovery. In the Fourth District’s July 2010 inquiry, over 30 percent of respondents cited a heightened level of uncertainty as their primary reason for not increasing current or near-term capital spending. According to our contacts, uncertainty was being driven in part by the policy environment, lingering concerns over the European debt crisis, and sluggish consumer spending. Until more clarity arrives, business owners said that they were likely to postpone decisions on costly investments.
Business Owners’ Reasons for Increasing or Decreasing Capital Expenditures
|Major factors for increasing|
|Expect high sales growth||8||19|
|Need to purchase IT equipment||18||12|
|Need to purchase capital equipment||29||10|
|Improved financial position||16||17|
|Major factors for not increasing|
|Expect low sales growth||25||16|
|Capacity utilization is low||21||14|
|High level of uncertainty||21||31|
|Limited need to purchase capital equipment||0||16|
Source: Federal Reserve Bank of Cleveland, capital expenditure inquiries—Fourth District business contacts.
Taking a closer look at national BFI data, we see that business investment declined (21.6 percent) for six straight quarters during the 2007-2009 recession and into the very early stages of the recovery. Since the recovery began, businesses have invested a disproportionate amount of their capital budgets on information processing equipment and software. The average share of BFI used for information processing equipment and software from July 2009 through September 2010 was 42 percent, while capital equipment and structures each garnered about a 29 percent share.
Over the past eight years, business investment in information processing equipment and software rose 45 percent, topping out at $595.5 billion (nominal) in the third quarter of 2010. With the exception of dips following the dot-com bust and the 2001 and 2007-2009 recessions, spending on information processing equipment and software has shown a strong upward trend. Many business contacts in the Fourth District reported that they never froze capital outlays for technology during the recession, of which information processing equipment and software is an integral part. Even when demand was at its lowest, the need to contain costs and improve efficiency was ever present. One result of the improved efficiencies they achieved is that as demand picks up, producers feel less of a need to hire new, permanent employees.
When comparing the change in spending for information processing equipment and software during the 2007-2009 recession to the change in investment for capital equipment and structures, three major differences were observed. First, the time between peak spending and a bottoming out was only nine months for information processing equipment and software, while it was more than two years for capital equipment. As for spending on structures, a possible flattening out of the decline was seen toward the end of 2010. Second, the pullback in investment for information processing equipment and software was only 9 percent, while there was a 35 percent drop in outlays for both capital equipment and structures. Finally, the amount of time needed to reach the previous spending peak was much quicker for information processing equipment and software. From the time it bottomed out in the first quarter of 2009, spending on information processing equipment and software reached its previous peak in just over nine months. In contrast, after one year, outlays for capital equipment remain 20 percent below their previous peak. One possible explanation for this large difference in investment is that businesses are not increasing capacity. Data provided by the Federal Reserve show that total industrial capacity leveled out during 2008 and has been relatively flat ever since, although utilization rates are climbing.
Where is business investment expected to head in 2011? Blue Chip consensus forecasts project an increase of 8.7 percent on a year-over-year basis in 2011, which is 3 percentage points more than the year-over-year change that was expected in 2010. Prospects for a rise in BFI would be enhanced if consumer spending continues its upward trend.
Blue Chip Economic Indicators. Randell E. Moore, Executive Editor. Vol. 35, No. 12, December 10, 2010.