INSTITUTIONAL SECTOR AND ITS INFLUENCE ON THE DEVELOPMENT OF SELECTED INDICATOR Michaela ROUBÍČKOVÁ Silesian University in Opava, Karvina, Czech Republic, EU, roubickova@opf.slu.cz Abstract This article aims to analyze and evaluate the potential impact of inflows of foreign capital and membership in the institutional sector in the development of profitabil.ity and corporate debt in the construction industry. The development of enterprises with foreign owners and domestic companies from early 2007 until mid-2011 is compared. This period was chosen because of efforts to maintain continuity and comparabil.ity of data (the data is analyzed according to the methodology of classification CZ- NACE) in order to capture the development of the financial situation of enterprises in the selected sector before and during the crisis period. The selected industry was the construction industry for two reasons. First, clearly this is a sector with higher degree of cyclical developments, second it has an impact on a number of important macroeconomic indicators. Data of the industry is then compared with the data representing GDP in order to assess whether some foreign-controlled sector corresponds to the development of stronger business cycle or, conversely, whether there are any sensitive companies that have domestic owners. Keywords: Institutional sector, foreign investor, foreign direct investment, profitabil.ity, indebtedness. 1. INTRODUCTION The article objective was to analyze and assess potential impact of the institutional sector on profitabil.ity development and corporate debt in the building industry that is in the Czech Republic, as in other EU countries, among key industries of the national economy. At the moment (2012) it creates approximately 7 % of gross value added and employs around 9 % of the persons working in the civil sector. The construction industry is a significant consumer of energy, materials and products. The construction industry was analyzed partly because it is generally regarded as the industry with higher rate of cyclical development as noted by Czasaný and Macháčková [1], and also due to its impact on a number of macroeconomic indicators. At the beginning of 2010, building industry share in GDP creation was roughly 6.5 % and it employed approximately 450 thousand workers. Each million Czech crowns invested in the industry generate the need of 3.2 to 3.5 jobs. The analyses carried out by Deloitte show that 100 mil. CZK invested in construction generate the contribution to public budgets of around 55.5 mil. CZK. And conversely, reducing investments in the building industry has adverse effects on employment rate and related indicators of the national economy. The loss of one job in the building industry brings about the job loss of 2.2 2.5 workers in associated branches. The decrease of construction investments by 10 bil. CZK can mean the reduction of contribution to public finance by as much as 5.55 bil. CZK [10]. As part of the analysis described in this paper the affiliation of building industry companies to a given institutional sector was assessed. The institutional sector represents a set of institutional units that are characterized by simil.ar focus and objectives and are designed to analyze income creation and distribution. The sectors are further broken down into subsectors. In case of non-financial corporations that this paper deals with, this split is made depending on the entity that controls and manages them. Thus there are state-controlled corporations, private corporations under domestic control and private corporations under foreign control. Although the split into individual subsectors cannot be fully
accurate as the subsectors overlap in some cases and part of the corporations in national public and private sectors can be owned by a foreign owner, but it still provides relatively significant information. Whereas this article focuses on comparing the economic parameters of private companies under domestic control and private companies under foreign control (state-controlled enterprises are completely excluded from the analysis), there is a clear link with foreign direct investments (FDI). As stated by the Economic Survey of Europe [3], FDI are often regarded as a significant lever of the transformation of economies in transition. A foreign direct investment can be defined as the investment where a foreign investor owns 10 or more percent of stock (shares) or voting rights. In addition to a holding in the share capital, also reinvested profit and other capital including credit relations with the foreign investor is regarded as part of the foreign direct investment. Unless this share exceeds 50 %, the corporations with foreign interest are included in the public or private national sector [7]. So foreign control is defined as direct or indirect (through interconnected entities) control of more than a half of shareholders voting rights or more than a half of shares. The controlling country is defined according to the domicile of the ultimate controlling institutional unit. This unit is the company that is not any further controlled by other institutional unit [5]. 2. ISSUE DEFINITION The effect of a foreign owner on selected economic indicators has been discussed in a number of studies. However, most of them focus on market, not bank oriented economies (particularly the USA) and one of the monitored parameters is share market price or the amount of paid out dividends. Yet there are studies that discussed the influence of foreign direct investments on company profitabil.ity. For instance Wheeler [11] or Dworin [2] showed that the subsidiaries in the USA owned by foreign entities had reported lower profitabil.ity than domestic companies. Grubert, Goodspeed and Swenson [4] published the data showing that in 1987 the profitabil.ity of 37% of all non-financial foreign corporations had been within the interval -2.5% to +2.5% while out of domestic ones only 27% had fallen into this interval. Szanyi [8] shows that the companies with foreign owners doing business in Hungary reported, mainly during the first years after the investment was made, worse financial results than domestic companies. On the other hand however, Thomas [9] states that subsidiaries operating in a higher risk region that still has growth potential can record higher profitabil.ity than parent companies. However, the aim of this paper is not to compare profitabil.ity of a parent corporation and subsidiaries but in general that of non-financial companies with foreign and domestic owners operating in the building industry in the territory of the Czech Republic. The nature of the building industry is national and regional to a large extent and the industry is considered as largely self-sufficient on a national level and substantially diversified as a branch. In spite of that, foreign direct investments have been flowing to this industry in recent years and enterprises with foreign majority owners have been established in the country. In general, foreign direct investments are made partly of foreign investor contribution in the share capital (SC, ZK) of domestic companies, partly of the reinvested earnings (RE, RZ) earned by the companies (or their parts) and reinvested back to the business in domestic territory, and last but not least of inter-company loans between the foreign (parent) corporation and the domestic company (subsidiary). The reinvested earnings are, in contrast to the other two remaining components of foreign direct investments, specific in the fact that it does not mean the real inflow of foreign capital to foreign exchange market. So the reinvested earnings of foreign companies is the figure included in the balance of payment but which does not have any effect on the foreign exchange market and consequently the Czech crown exchange rate. Most of the data in the balance of payment shows transactions between country residents and foreign entities within which domestic currency is
exchanged for foreign currencies. Such transactions reflect in the changes of demand and supply on the foreign exchange market. Earnings of foreign companies can either be repatriated back to parent companies as dividends or reinvested in domestic country and thus the original foreign investment in the share capital can be increased. In both cases such a transaction is recorded as an expense in the current account income balance, however just dividends have a real effect on country s external imbalance because they increase demand for the currency of the foreign investor on the foreign exchange market. Reinvested earnings remain in domestic economy and due to the double-entry principle of booking the items of balance of payment they are booked as the inflow of foreign direct investments to the country. 3. ISSUE ANALYSIS The inflow of direct investments to the Czech economy as a whole in 1999-2002 grew each year, on average, by about one tenth (even at relatively high base values from the previous year) while the average annual inflow over this period was 225.9 bil. CZK. Such figures indicated the first place in the world of the Czech Republic as to the volume of incoming investments per capita. Reinvested earnings over this period grew each year, on average, by 41 %. However, in 2003 foreign direct investments dropped significantly by 74 % year to year, while the decline of the amount of reinvested earnings was just 1.7 %. In 2003, foreign direct investments reached the volume of 72.9 bil. CZK. In 2005, the highest ever inflow of foreign direct investments in the Czech economy was recorded with the net balance of 279.2 bil. CZK out of that capital stake and reinvested earnings reached 262.5 bil. CZK and the rest were other investments. In 2006, foreign direct investments in the Czech Republic were lower by 144.5 bil. CZK (i.e. by 52 %) year over year. Equity stakes in Czech companies declined by 148.8 bil. CZK. However, foreign investors reinvested the earnings in the amount of 82.1 bil. CZK back to the business on the territory of the Czech Republic which was by 4 bil. CZK more than in 2005. Fig. 1 shows data in 2001 2011 whereas foreign direct investments (FDI, PZI) in the Czech Republic and FDI in building industry companies are indicated. Fig.1 Foreign direct investments in the Czech Rep. and construction industry in 2001 2011, in mil. CZK The correlation coefficient of values in individual years is almost equal to 0 which means that there was no significant positive or negative relation between the foreign direct investments in total and those in the construction industry. From the long-term point of view, 2011 is a specific year when the FDI share in the construction industry was nearly 12 % while in previous years 1 2 %. Foreign direct investments in construction were fluctuating considerably. While in 2007 they reached altogether 716
mil. CZK, the figure in 2008 was -930 mil. and in 2011 over 10 bil. CZK. Fig. 2 shows individual components of foreign direct investments in 2007 2011. Fig. 2 Foreign direct investments in construction industry in 2007 2011, in mil. CZK Fig. 3 indicates the gross domestic product generated in construction as well as foreign direct investments in this branch. Mutual relation of these two quantities in the shown period does not confirm the notion that the inflow of foreign direct investments should bring the increase of GDP. Even though the correlation coefficient of -0.4 means medium correlation but in this case the negative one. The monitored period is relatively short, however for instance in 2011 when FDI peaked and increased more than three times compared to 2011, GDP declined by almost 6 %. Fig. 3 Foreign direct investments and GDP in construction industry in 2007 2011 In the building sector in 2007 2011, foreign investors reinvested substantially earned profits instead of their repatriation back to owners countries. Fig. 4 shows the fact that only in 2011 the total FDI exceeded significantly reinvested earnings (it constituted less than 50 % of total FDI), while that was not the case of previous years and in 2008, reinvested earnings were the only positive item. All other FDI components were negative.
Fig. 4 Foreign direct investments and reinvested earnings in construction industry in 2007 2011, in mil. CZK 4. DISCUSSION Based on the above data two hypotheses were formulated as follows: HYPOTHESIS I: Return on equity (ROE) of private foreign-controlled companies will be higher, in the long term, than the one of private companies under domestic control. HYPOTHESIS II: The share of equity to total assets will be lower, in the long term, than the one of companies under foreign control. Hypothesis I is based on the assumption that when foreign companies reinvest their earnings in construction companies in the Czech Republic despite GDP in this industry declines, they will seek higher return on equity. The higher return can be reached by contributing of lower cost of capital that is generally associated with the higher share of foreign capital. That is the base on which hypothesis II was formulated. Fig. 5 shows the development of return on equity (ROE) for both sectors, i.e. private domesticcontrolled companies (domestic) and private foreign-controlled companies (foreign). Authors agree (stated for example by Růčková [6]) that in the field of profitabil.ity the most interesting is, in connection with capital market, the return on equity indicator that draws the attention especially of shareholders, partners as well as potential investors. Fig. 5 shows that only in 2009 and 2011 the ROE of foreign companies exceeds the ROE of the domestic ones. Although these are the years when the largest reinvestments of earnings were made but when we compare the mutual relation between ROE and FDI of foreign companies, there is medium negative correlation (-0.65) which indicates that increased reinvestment of earnings does not bring to foreign entities proportionate higher return on equity.
Fig. 5 ROE of companies under domestic and foreign control in 2007 2011, in % So it follows from the arguments set out above that hypothesis I was not confirmed. Private foreigncontrolled companies do not have, in the long term, higher return that private domestic-controlled companies. How efficient are these companies for their owners can be documented, besides ROE, also by the spread indicator. This indicator defines the difference between ROE and required (assumed) return on equity. The higher the spread value the companies achieve, the higher the value add create for their owners. Fig. 6 Spread of companies under domestic and foreign control in 2007 2011, in % Fig. 6 makes apparent that not even this indicator is very favorable for the companies under foreign control. Just in 2009 they brought significantly higher value add for their owners, however in 2010 ROE did not even reach the required return rate and in 2011 it exceeded it just slightly. While hypothesis I was not confirmed, Fig. 7 suggests that hypothesis II was definitely confirmed. Fig. 7 shows the share of equity (E) in company total assets (A), i.e. by how many percents the investor covers company needs through own equity. The higher this share is, the more expensive resources the company employs in general. Foreign-controlled companies employ in the construction industry, in the long term, less of their own resources than domestic-controlled companies.
Fig. 7 E/A of companies under domestic and foreign control in 2007 2011, in % The fact that foreign-controlled companies employ cheaper resources is proved by lower weighted average cost of capital (WACC). The cost of capital of domestic companies is constantly by at least 1.5 % higher. Mutual relation between employing equity and WACC is shown at Fig. 8. Fig. 7 E/A and WACC of companies under domestic and foreign control in 2007 2011, in % The figure indicates that there is a direct correlation between weighted average cost of capital and the amount of employed equity. Whereas the correlation coefficient in that period was 0.92, we can see very high correlation. 5. CONCLUSION The objective of the paper was to assess the impact of belonging to an institutional subsector on the development of profitabil.ity and debt ratio of building companies. Therefore the development of indicators of companies with foreign and domestic owners since the beginning of 2007 till the middle of 2011 was analyzed and compared. Based on theoretical assumptions two hypotheses were determined. HYPOTHESIS I that supposed that ROE of private foreign-controlled companies would be higher, in the long term, than ROE of private domestic-controlled companies was not confirmed. It was not even proved that those companies would bring higher value add to their owners. On the other hand HYPOTHESIS II that defined the assumption that the ratio of equity to total assets would be in foreign-controlled companies lower, in the long term, was clearly confirmed. In the long term, these companies use cheaper financial resources. However, lower pricing of financial resources does not
clearly lead to higher profitabil.ity. The relation between debt ratio and ROE represents very low (in fact useless) negative correlation (the correlation coefficient is equal to -0.13). LITERATURE [1] CZESANÝ, S., MACHÁČKOVÁ, L. Ekonomický vývoj z pohledu konjunkturálních a kvantitativních indikátorů [online] (Economic development from the viewpoint of short-term and quantitative indicators), Praha, 2005. [Quoted 2012-03-23]. Available at URL: http://panda.hyperlink.cz/cestapdf/pdf07c5/ czesanymachackova.pdf [2] Dworin, L. Transfer pricing issues, National Tax Journal, no. 43, 1990, s. 285-291. ISSN 0028-0283. [3] Economic Survey of Europe, no. 1, Chapter 5, 2001. ISSN 0070-8712. [4] Grubert, H., Goodspeed T., Swenson, D. Explaining the low taxable income of foreign-controlled companies in the United States. In Studies in international taxation. Chicago: University of Chicago Press 1993, s. 237-275. ISBN 0-226-29701-2. [5] Foreign direct investments in 2009 [online], Praha, 2010. [Quoted 2012-03-23]. Available at URL: http://www.cnb.cz/miranda2/export/sites/ www.cnb.cz/ cs/statistika/ platebni_bil.anc stat/publikace_pb/pzi/pzi_2009_ CZ.pdf [6] RŮČKOVÁ, P. Profitabil.ity as Basic Criterion of Efficient Management in Context of Crisis Development. Proceedings of the 13th International Conference on Finance and Banking. Karvina: School of Business Administration, 2011, pp. 313 320. ISBN 978-80-7248-753-0. [7] SPĚVÁČEK, V. Sektorová analýza vývoje české ekonomiky [online] (Sector analysis of development of the Czech economy), Praha, 2010. [Quoted 2012-03-23]. Available at URL: https://is.muni.cz/ do/econ/soubory/oddeleni/ centrum/papers/16spevacek.pdf [8] Szanyi, M. Foreign Direct Investments in Small Business in Transition Economies. Warsaw: Central European University, 1998, 35 s. ISSN 1506-1639. [9] Thomas, W. Firm Characteristics and the Pricing of Foreign Earnings of US Multinational Firms. Journal of International Financial Management and Accounting, vol. 15, 2004, s. 145-173. ISSN 0954-1314. [10] Development of construction industry until 2012 [online], Praha, 2012. [Quoted 2012-03-23]. Available at URL: http://www.deloitte.com/assets/dcom-czechrepublic/local% 20Assets/Documents/Real%20Estate/vyvojstavebnictvi_do_roku_2012_101021.pdf [11] Wheeler, J.E. An academic look at transfer pricing in a global economy. Tax Notes, (July 1988), 87-96. ISSN 0270-5494