Should companies be taking greater advantage of record low interest rates?

To borrow or not to borrow?

Business is currently resisting the temptation to binge on cheap debt thanks to low interest rates, but should companies be borrowing more?

NICKI HUTLEY

Director and chief economist at Urbis

When the global financial crisis hit, there was a great hue and cry about the level of debt that had been built up by business and households. We were told by policymakers in no uncertain terms to get our houses in order and pay it back. So we did.

Almost a decade on, the Reserve Bank became so concerned about the lack of investment (outside of mining), that it commissioned a paper to understand why businesses refused to borrow more in the face of such low rates.

The RBA implied that businesses were ignoring “objective decision rules” in favour of a “highly subjective” approach – and thus were sitting on their hands. 

So why might businesses act subjectively – hoarding cash while abhorring the banks? 

As an economist, I have to believe that companies will act rationally and in their own self-interests (despite occasional evidence to the contrary).

“Investment... is still well ahead of levels prevailing over the three decades prior to this mining boom.” Nicki Hutley

One hypothesis, put forward by a leading think tank, is they are so worried about “disruption” they are too nervous to invest. 

A different interpretation is that, at 12 per cent of GDP, investment may be off its recent lofty high (16 per cent), but is still well ahead of levels prevailing over the three decades prior to this mining boom. That investment is now being directed towards less capital-intensive sectors, such as services, in place of manufacturing.

The question should probably be: with interest rates at all-time lows, why aren’t governments borrowing more?

SEAN PINDER

Associate professor in the Department of Finance at the University of Melbourne

Our research shows that the cost of debt is only one factor that firms consider when deciding on their optimal debt-equity mix – and a pretty minor one at that! Taking on debt creates a repayment obligation that can create financial distress for firms during periods when operating cash flows are lower than expected. 

University of Melbourne research shows the two most important factors CFOs consider when making a decision about issuing debt are: 

  • the volatility of their earnings stream;
  • the need to maintain financial flexibility to ensure enough cash is left over after interest payments to fund new projects. 

Beyond that, our discussions with CFOs over recent years have highlighted how many were scarred by the global financial crisis and the effective overnight closure of credit markets.

“I would be surprised to see firms binging on cheap debt in recognition of the indigestion they may face.” Sean Pinder

With this in mind, I would be surprised to see firms binging on cheap debt in recognition of the indigestion they may face when they need to go back and refinance in credit markets that are facing significant levels of uncertainty.

As a final point, let’s recall that interest rates represent only the explicit cost of debt – the other cost of debt is the increased volatility of shareholder returns that accompanies higher leverage. 

At a time of huge global uncertainty about future economic conditions, it’s not clear to me that shareholders have all that much appetite for greater risk, even if it is accompanied by slightly higher returns due to cheap debt.

JANU CHAN

Senior economist with St.George Bank

Based on interest rates, companies should be borrowing more. It’s a very cheap form of funding for them so, in theory, now is a good time to go out and get it. However, the issue for business is what will they be investing in? What are they going to be spending the funding on? Interest rates are only one part of the equation.

When the cost of funding is low it makes sense to borrow more, but the problem now is that businesses are concerned about the economic outlook and, in many industries, they are uncertain that they will get the demand for their products to justify additional investment. If they’re not confident about that, they are less inclined to borrow for expansion. 

The economy is not in bad shape now. We’re travelling along quite nicely and have reached middle ground where the economy is not contracting and there’s still growth. It’s just not a boom time. Companies need to be a little more confident that sales will be coming through before they make the decision to borrow more.

“We just need confidence levels to be a little higher and this will translate to more borrowing.” Janu Chan

Overall, yes, companies should be borrowing more given the current interest rate levels. We just need confidence levels to be a little higher and this will translate to more borrowing.

Former RBA governor [Glenn Stevens] summed it up best: you can lead a horse to water, but you cannot make it drink.

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The experts

Nicki Hutley
Before joining Urbis in 2013, Hutley held senior positions with Access Economics and KPMG. She has also worked extensively in financial markets, including for Rothschild Asset Management, Deutsche Bank and Lloyds Bank. Throughout her career, Hutley has led large and complex economic forecasting and modelling projects and policy reviews. She has worked for all levels of government across Australia and New Zealand, as well as private and third sector clients.

Sean Pinder
Associate professor Sean Pinder of the Department of Finance at the University of Melbourne has a long and distinguished history of research in corporate finance, bringing industry participants into the lecture theatre and providing customised training in financial decision-making to clients around the globe.

Janu Chan
Before joining St.George in 2011, Janu Chan was an economist at Nomura Australia and has been working as an economist in financial markets for several years. In her current role, she provides in-depth analysis on the Australian economy. Chan writes regular economic reports on developments and outlook, and assists in developing forecasts on the economy, interest rates and currencies. She appears frequently in the media, including TV, radio and print. She has a degree in finance and economics from the University of Technology, Sydney, and a Master of Economics from the University of Sydney.

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