Why Government Borrowing Impedes Corporate Earnings

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.

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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6 thoughts on “Why Government Borrowing Impedes Corporate Earnings

  1. Austin

    Every government borrows some do more than the others and Indian debt is still manageable infact its decreased to below 40 % of GDP i.e Public Debt. Many Western nation has debt above 100 % or close to 100 % of GDP. Japan has Debt of 240 % of GDP.

    The main factor that affect corporate borrowing are Interest Rates , Lower the interest rate better is for corporate to borrow else they tend to borrow from Western Banks where Interest rates are near Zero , but near zero interest rates wipes out the saving class and negitive interest rates confiscates wealth.

    According to Allan Greenspan throught out the period of history spanning many centuries interest rates of 4-5 % has been good for borrower and saving class

    In the end discipline is needed , Spending and Borrowing should be managed with near zero deficit and low debt , there is no short cut there.

    Reply
    1. freefincal

      Interest rate also depends on money supply. Which is the key reason for the lack of dept in the corporate bond market.

      Reply
  2. S Srinivasan

    The answer is NOT a clear YES or a NO, like most things in life.
    Let me look at the positive side of it first. When corporates are reluctant to invest, if the government borrows and invests in building assets it can improve in many ways.
    1. It gives confidence to the corporates. So they would come to the market - It is not often the extra percentage interest that makes a difference but the confidence that there is opportunity to make money that creates the difference.
    2. This borrowing when it creates asset - creates more job opportunities (let us not get stuck with the efficiency of the government!). So it creates more consumption and the corporate earnings can be positively affected.
    3. Some of the corporates themselves could get the projects that the government invests in - so that helps them to further their earnings.

    On the negative side:
    1. If the money is spent in a profligate manner - it is a concern, because that increases the debt of the government with no assets created. This will potentially lead to a higher interest rate even for the government.
    2. If the sovereign rate goes up, naturally all the corporate rates will go up, so thereby further impeding the ability to leverage and invest by the corporates.

    Reply
  3. sundararajan

    removal of all subsidies -petrol, LPG, fertilisers etc. - Why ? especially on farm subsidiary. US spends billions every year on farm subsdiary (manily to export at lesser price) but preaches or forces other countries not to do the same. It is sad that most if not all farm subsidary benefits rich farmers in India, but at least some percentage of small farmers still benefits. We don't need to follow exactly what west says, they alway have hidden agenda.

    Reply
  4. Karthik

    Corporate bonds offering 9.5 % are being oversubscribed 20 times( recent DHFL bonds ) where as it would cost them 12-14 % to borrow from bank..what does this indicate?

    Reply

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