Financialization and the World Economy - Dissertation Example

Financialization and the World Economy Introduction The modern economy of the world has undergone a massive change with the globalization of the economy. With the globalization and the liberalization of the economy, the influence of the Government on the economy diminished. The market dynamics influenced the values of the companies. With the lessening of the influence of the Government, the shareholders of the company became important. It was the prime concern for the management for the management to give values to the shareholders. Providing values to the shareholders would mean that the value of the company in the market would increase. In the last few years there has been pressure on the management of the companies to deliver values to the shareholders. There are no specific definitions of the term of Financialization. It can be loosely defined as the process to increase the value of the shareholders. The trend has been prevalent from the days of the globalization. It has gained momentum as the value of the stakeholders is important for the organizations. It has been a much developed process from the days of the protectionism. However, there have been reservations about the process because in the case of the financialization the majority of the money is distributed to the shareholders. As most of the funds are used for increasing the value of the shareholders, the management is not left with enough money. The amount of money is too small for the growth of the company and the financing of the assets. With the rise of the financialization process, the importance of the capital markets increased. There was a rise in the leveraging of assets; trading in the capital market with the help of derivatives and the securitization of the assets. This was done to increase the income of the firms. However, the recession in 2008-09 changed the perception of the industry. The financial market submerged under the pressure from the real estate industry and the companies suffered huge losses. It was because of the over dependence on the financial markets. (Epstein,2005 : 3-5; Stockhammer, 2004; Foster, April, 2007; Morgan et al, 2010: 330) In this paper, a research will be done on the financialization process in general. The paper will take the example of GE in the case of the topic to some extent. The paper will deal in the process and the relationship between the management and the shareholders. Financialization As mentioned in the earlier section, the process of financialization has been one of the most prominent in the case of the modern economy. The shareholders are the most prominent investors of the company. The market has become liberalized and money from the capital market is the one of the prime methods of financing of the company. Therefore, it has become important for the companies to project the values to attract the shareholders. The shareholders perceive the value of he companies with the help of the EPS of the companies. The EPS of the companies increase if there is a distribution of the money. Therefore, it has been important for the companies to take part in the financialization process. The EPS of the company also increases with the cash investments or the acquisitions of the company. There has been a trend of the investments of the companies all over the world. It has increased the importance of the financial markets of the world. The investments of the companies have been rising as a result and the accumulation of goods has been decreasing. There has been a reduction in the desired growth rate of the companies. Financialization can be comprehensively defined as follows: “Financialization refers to the increasing importance of financial markets, financial motives, financial institutions, and financial elites in the operation of the economy and its governing institutions, both at the national and international level.” There has been an intrusion of the capital markets from the companies from the start of the globalization process. The essence has been on the increase of the value of the shareholders. There has been a general trend by the management to follow the requirements of the stakeholders. This has resulted in various scams like that of Enron. The shareholders of the company have been involved in reaping more benefits out of the activities of the company and the management has been following it. In many cases, the company has suffered a dip in its reputation. This has been the reason that the Corporate Social Responsibility has gained in importance in the present scenario. (Froud et al, 2006: 8). The process of financialization has widespread impact on the economy. As the process of financialization involves the increase of the value of the company in terms of investments and share value it has an impact on the capital market of the country. The effects of financialization on the economy of the country can be listed as follows: The importance of the financial sector becomes relative to the importance of the real estate sector. As the two sectors are related it helps in the transfer of money from the real estate sector and to the financial sector. This influences the inequality of the income and the economy is susceptible to shocks like the recent case of the downturn of the economy. With the importance of the financialization process, the economy is no longer stable. The increased levels of debt both in the case of the households and the companies are sure to have an effect on the economy. The debts are unstable source of funding and this may eventually cause concerns for the companies and the households. However, these concerns have not decreased the growth of the process of financialization. The theories in the field of finance also support the growth of the financialization process. The Agency theory that underlines the importance of the shareholders value by staying in the purview of the law has helped in the growth of the financialization. The economic theories state the importance of the increase of the scope of the financial markets as that will increase the efficiency of the economy. The importance of the financial sector in the economy increased and the process of financialization developed the economy. The process started in 1979 in the developed countries of the world. With the liberalization of most of the economies of the world, the process gained further momentum. (Andersson et al, 2007) The process of financialization helped in the development of the financial sector. However, on the other way round, it increased the debt portion in the society – in the households and the companies. There are two components of the income in the country. The income of the country increases with the development of the companies and the organizations. The owners manage the companies and they get the profit share. The workers get a limited source of income. With the financialization process, the income of the shareholders has been increasing while that of the workers has been decreasing. There has been a disparity of income that gets reflected in the income of the country. From 1979, the income of most of the countries of the world has been decreasing. However, in the case of the companies and the shareholders, the financialization process has been good. With the financialization process, the value of the shareholders has increased. This has helped the economy to a large extent with the inflow of the investments in the economy. The matter can be analyzed with the help of the case of GE. GE has been one of the major companies of the world based in the USA. Like all the other companies of the world, GE has been influenced by the financialization process and has been doing its bit to increase the value of the shareholders. The paper will look in the comparison of the performance of the company in the case of the buyback of the shares and the investments made by the company to the present day to look into the effects of the financialization process. (Palley, 2007; Pike & Pollard, n.d.; Dore, 2008; Dumenil, & Levy, 2004; 110-112) General Electric Financialization has been evident in the case of all the major companies of the world. GE is one of the topmost companies of the world. GE has a rich heritage of innovation and growth in the case of the electronics goods category. It was originated by Thomas Alva Edison in the USA and has been growing since then. It is one of the most recognized brands of the world. The growth and the stature of the company have been maintained through the continuous importance to innovation. The company till this day has a dedicated cell of innovation. Every year the management makes it a point to introduce new products in the market. The management of the company has moved into the other sectors of the market. The GE has made its presence felt in all the major markets of the world. The innovation has been the reason for the growth of the GE all over the world. Like in the case of the other companies, the financialization process has affected the management of the GE. The management of the GE has been dedicated to provide values to its shareholders. (GE, n.d.) In this paper the case of the AGEA has been taken to underline the importance of the financialization process. Before dwelling on any further the motive of the financialization process should be reviewed. The motive of the financialization process is the increase of the value of the shareholders. How the value of the shareholder increases? The shareholder value is created because of these underlying steps: Source: Fernandez, 2001:3 The process will be discussed with the help of the case of the GE. Equity Market Value: The equity market value of the company is the value of the shares of the company. The shares are traded in the market and the prices of the shares are dependent on the market movements. The price of the shares multiplied by the number of the outstanding shares of the company is the value of the equity of the company. Increase of the equity market value: As the prices of the shares of the company are dependent on the market reactions, the prices can change. The increase of the market shares of the company may reflect the increased values of the company. The value of the shares is calculated as in the case of the equity market value. The increase of the value is calculated by deducting from the value of the shares in the year 2, the value of the shares in year 1. Shareholder value added: The shareholder value added concept is the difference between the wealth of the shareholders in the year 2 and that of the year 1. Though the shareholder vale added and the increase of the equity market value are quite similar there are key differences in the concepts. In some cases the equity market value of shares changes but the shareholder value does not. An example in this case is when the company pays money in the form of dividends or bonuses. In this case, the value of the shareholder does not change but the equity market value changes. The shareholder value added of a firm can be calculated as follows: Shareholder value added =Change of equity market value + Dividends paid in the year- capital increases + payments to shareholders (for example: discounts, share buy-backs....) - Conversion in the case of convertible debentures. In the case of GE, the shareholder value added of the firm has to be calculated by taking into consideration all these components. Shareholder return: The next step of the process is the calculation of the shareholder return of the company. It is the process of calculating the return the shareholders get from the shares of the company. It is calculated by dividing the value added of the shareholders by the value of the equity at the start of the year. It is one of the most comprehensive processes in the case of the measurements of the profits of the shareholders. The formula of the process is as follows: Shareholder return = shareholder value added / equity market value Required return to equity: This concept is the perceived value of the shareholders. In other words, the return the shareholders expect from the company is the required rate of return. This is the minimum rate that the shareholders expect from the company and this can be earned at free of risk. The risk free rate is determined the rate of interest on the Government bonds and papers. The investor will demand a minimum of that rate from the company. However, the rate of interest will be more in the case of the companies as there is a risk associated with the investment. The required rate of return of the company can be calculated as follows: Required rate of return = Risk free rate + risk premium The risk free rate in the industry may be as low as 8%. In some case, the investors may demand 20% from the investments in the company. The difference between the 8% and the 20% is the risk premium for the company. The risk premium varies with the stature of the companies. If the company is a reputed one, the risk premium will be lower. It depends on the mentality of the investors. The general investors are risk adverse and they will only take the risk of investment if they get a substantial amount of return. This is why the required rate of return in the case of the companies is high. Created Shareholder Value: In this case the value for the shareholders is created. It has to be noted that it is possible only when the actual value of the shares are greater than that of the perceived value of the shareholders. The company creates the value for the shareholders. This is a vital concept in the case of the financialization process because the main essence of the process is the creation of the value for the shareholders. The created shareholder value of the company can be described with the help of this formula: Created shareholder value = Equity market value x (Shareholder return - Ke) Here Ke is denoted as the required return of the equity. The created shareholder value is the last step in the process of financialization. (Fernandez, 27th April, 2001) Examples of financialization As is evident, the financialization process has been a core concept of all the business organizations of the world. In the case of GE also, the financialization process has been present. It was in 2007, that the management of the company decided to buy back shares from the market. The share value of GE has been decreasing over the years. However, contrary to the decrease in the value of the shares, the company has been growing with the help of the acquisitions and the takeovers. The problem was that the investments were expensive and the return was not high enough. This decreased the value of the shares of the company. This made the shareholders move away from GE. The need was an immediate action from the management to increase the value of the shares. The management decided to buy back the shares from the market. The total buy back of the shares of the company amounted to $8 billion in 2007. This made the earnings per share of the company increase. In the 2nd quarter of the year, GE earned 5.2 cents per share. It was expected to earn $2.23 per share at the end of the year. The earnings of the shares increased due to the buybacks and the good performance of the past investments. This can be summed in the words of J.R. Immelt, the chairman of GE, “We’re tough-minded and investor friendly, and we’re delivering a solid, low-risk 2007”. (Hinton, 13th July 2007). The policy of the buybacks benefited the company to a large extent as found out by the words of Mr. Dray of Goldman Sachs. He said “Investors always prefer the immediate certainty of buybacks to a risky, challenging acquisition.” (Hinton, 13th July 2007). The performance of GE was all the more affected because of the mortgage crisis in the USA. The mortgage crisis meant that the financialization process suffered as the money from the real estate would not come in. In fact the real estate sector suffered the most in the case of the mortgage crisis and to show the performance like that of the GE in the troubled times increased the confidence of the investors. (Deutsch, 14th July, 2007; GE to buy back $15 billion in stock; ups dividend, 10th December, 2004) Implications to shareholders The created shareholder value is a strong reference point in the case of the shareholders. The managers of the organizations highlight the figure of the created value in the financial reports of the company. This coupled with the narratives help to attract the shareholders to invest in the company. The shareholders value is created when the prices of the shares in the market increases. The prices of the shares in the market increase when the shareholders are provided with dividends or other financial leverages. The shares also increase when the company has a hand in the other activities that increase the reputation of the company. Often the activities of the company deal in the immediate effects like the increase of the sales or entering into a contract. The management of the companies also deals in the investment of the financial assets which can increase the value of the shares in a short period of time. However, does this involve the real increase in the value of the shareholders? The disadvantages of the capital markets have been seen in the case of the recent case of recession. The capital market collapsed and the value of the shares decreased. The managers project this increase in the value of the shares in the annual reports and the various advertisements to attract the shareholders. This however, is not the real increase in the value of the shareholders. The research by Andersson et al shows that in the case of the top performing firms, the value did not increase. The real value of the firms did not increase with the dearth of investments in the assets of the firm. Most of the investments were made in the case of the financial markets. This shows that money is being distributed to the shareholders more against the real investments. The performance of the firms is generally disappointing and they suffered during the recession due to this cause. (Andersson et al, 2007) Conclusion The performance of GE over the years proves the importance of the financialization process for the companies over the world. The value of the shareholders was decreasing and it resulted in taking away the shareholders from the company. The management of the company understood the situation and they looked to increase the value of the shareholders. The Buyback of the shares did this and it helped in restoring confidence of the shareholders on the company. This proves the validity of the financialization process in the modern context. The financialization process looks to increase the value of the shareholders. This is important in keeping the shareholders to the company, as that would be helpful in getting investments. The shareholders, in general, are attracted to the firms when they see a strong financial performance. In a bid to project a stronger financial performance, the management invests in the financial assets which offer good return. This has been done as opposed to the more traditional form of assets which would be beneficial for the company in the longer run. The traditional form of assets would not provide the returns immediately and will result in the eradication of the cash from the books of the company. Thus the values of the shareholders would decrease. The management reverts to the easier form of increasing the value of the shareholders. This has resulted in the dip in the actual performance of the company. There has been a gap between the needs of the shareholders and the supply of the management. The shareholders want a secure place to invest their money and the management projects them as the more profitable ones. This has led the companies in trouble as seen in the case of the recent recession. References: 1. Epstein, G. (2006). Financialization and the world economy. Edward Elgar Publishing. USA. 2. Stockhammer, E. (2004). Financialisation and the slowdown of accumulation. Cambridge Journal of Economics. Vol 28 No. 5. Available at: http://cje.oxfordjournals.org/cgi/content/short/28/5/719 (Accessed on 12th June, 2010) 3. 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