I recently got into an argument about Chilean education reform. For those who don’t know, there have been massive protests in Chile demanding better -and free- tertiary education. While that’s a fascinating issue from a humane perspective, and certainly an issue in this year’s election, there an actuarial problem that gets ignored in the fray. (And, let’s be honest, accounting isn’t exactly the prom queen of political debate.)
The issue is copper. Copper is a popular topic in education debates, because Chile is the world’s largest producer and exporter of copper. With commodity prices through the roof, money is in the air and people want it. I mean, they want it to finance education reform of course. Since a lot of the copper is being mined by foreign companies, the idea is that if the mines were nationalized, the money that these companies are making and taking overseas would instead stay in the country, and could be used for something useful. Like education.
On the surface, it makes sense. You know, a company invests in a country to make a profit, and naturally is going to take that profit out of the country to spend it on… dividends and fancy quarterly reports? Except, no. Multinational corporations don’t do that, and it’s having an interesting effect on their home countries.
There are a host of financial, monetary and banking issues that create the phenomenon; but like Einstein said, “if you don’t know how to explain something simply, you don’t understand it well enough”. Well, let’s see how well I understand this:
Corporations are under no obligations to “cash in” their profits; they pay a certain amount of their profits in dividends, which is decided by the board of directors. However, just because they are making money, it doesn’t mean that they are taking it out of the company and spending it on rich people stuff. Consequently, multinational corporations (like mining companies) are free to withdraw profits from their company and it’s subsidiaries as it suits them.
The first issue is taxation. Most corporations pay a lower tax rate to encourage them to reinvest in the company, as opposed to taking the money out of the business through dividends, where they pay a higher tax rate. A subsidiary in a foreign country is a corporation by itself; which means that withdrawing money from it counts as taking a dividend by the host country, and therefore must pay a higher tax rate. Unless there is a double taxation treaty between the countries (and there are precious few of those), then when that dividend comes back to the corporation’s headquarters, it is considered “profit” by the government and taxed again.
That might be enough by itself to encourage multinational corporations not to “take home” their profits in other countries unless they absolutely have to. But there are other incentives as well: interest rates. Many multinational corporations have businesses in developing countries where interest rates are a lot higher (0.5% in the EU vs. 5% in Chile, for example). Capital costs in a foreign country are a lot higher than they are at home, which makes it a lot more profitable to have money in that market. Consequently, multi-national corporations are encouraged to pay dividends with the profits from their home country, and leave foreign profits in the host countries.
However, this goes a step further. Profits from a foreign subsidiary can be used to invest in the local capital markets with a much higher rate of return. Foreign bonds can be used as collateral to fund cheaper loans in the corporation’s home country. This has two major implications:
- Companies who wish to expand operations can use bonds issued in foreign companies to obtain capital in their host country,
- Companies who wish to expand operations in the same foreign country are better off buying local bonds, using them as collateral to obtain loans in their home country, and then send that money to their subsidiary. This increases foreign investment in that country.
Both of these scenarios implicate money leaving low-interest home countries in favor of high-interest developing countries. In other words, carry trade.
Central banks in Europe, Japan and the US are trying to stimulate their respective economies by reducing interest rates. But a lot of these funds are being channeled into carry trades, and actually stimulating developing countries with increased foreign investment.
This is why an increase in corporate profits at foreign companies doesn’t have a direct impact on the exchange rate; foreign companies are not interested in withdrawing their profits from the country. At least, this is the case in Chile right now. Situations change, and interest rates will move in the future. However, extended low interest rates have a negative impact on capital growth, savings and people living in retirement.
The interesting point is the irony: Foreign companies are not exploiting underdeveloped countries; in fact they are exploiting their own developed countries in favor of the underdeveloped. So…yay globalization?