Why Government Borrowing Impedes Corporate Earnings

Published: June 20, 2016 at 4:35 pm

Last Updated on

We all understand the importance of living within our means and strive to implement it on a day-to-day basis.  If the Indian government manages to do the same over a financial year, it would grab headlines!

When I heard about the term fiscal deficit (expenditure > revenue) for the first time, I was shocked to learn how the government routinely spends more than it earns and finances the deficit via borrowing from market participants (which includes us, AMCs, banks etc.).

Politicians routinely make bombastic promises and relief to win elections and are forced to implement them in part/full to save face. This has resulted in high government borrowing.

The trouble is, the government is competing with private players in the bond market and gobbles up most of the money available for borrowing. Demand increases interest rates and the private players are crowded out!

Borrowing is a key driver of corporate earnings which in turn positively impacts the stock market. Therefore, the lack of depth in the corporate market could well impede corporate earnings.

The corporate bond market is less than half the size of the government bond market. By definition, a corporate bond offers a risk premium when compared to a government. This risk spread varies when the gov bond yields change, due to supply and demand of the corp. bond and due to change in credit worthiness of the bond.

Read more about these ideas:

Understanding Interest Rate Risk in Debt Mutual Funds

Understanding Credit Rating Risk in Debt Mutual Funds

Credit downgrades are quite common. However, since the market does not have depth, it is very difficult for a bulk buyers like AMCs, banks and other institutions to sell these bonds – pointed out by FT MD and Fixed Income CIO, Santhosh Kamat in a Cafemutual conference.

Due to recent trouble with credit rating downgrades, retail investor participation in corporate bonds have come dramatically. illiquidity due to small market size is the reason for this.

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While many worry about low retail participation in the equity markets, the corresponding participation in the corporate bond market is probably lower and more fragile!

In a working paper titled, Corporate Bond Markets in India: A Study and Policy Recommendations, RBI chair professor Charan Singh and his IIM Bangalore students identify the issues with

three pillars of corporate debt markets – institution and regulators, market participants, and instruments

They list “inadequate infrastructure, illiquidity, regulatory gaps, limited investor and issuer base, and absence of benchmark yield curve across maturities” as the main reasons.

They recommend (not exhaustive)

  • tax breaks to RIs and NRIs to encourage the purchase of corporate bonds.
  • Allow credit enhancement. That is, allow third-parties to offer collateral to the corporate borrower.
  • Make it possible for insurers and pension funds to invest more in corporate bonds.
  • Create corporate bond indices. We still do not have a pure corporate bond index.

Reducing fiscal deficit will naturally increase corporate borrowings.

Doing this will involve short-term pain, petitions to roll back and failure to do so would mean losing elections.

Pain due to

  • removal of all subsidies -petrol, LPG, fertilisers etc.
  • making small savings schemes which are marked to market.
  • Restrictions on how much state governments can borrow from the centre to dole out freebies.
  • closure of all tax loops holes.

oh dear! This is depressing. I can see a messy vicious circle forming!

Chris Vick
Photo credit: Chris Vick

Note: I am a student of the subject and these are my learnings. Feel free to share your thoughts on the subject.

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