A company takes on considerable risk when it relies exclusively on debt
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Written by Atila on September 17, 2008 – 5:09 pm
In a bank-based economy, the capital market is underdeveloped and only a small portion of corporate financing needs are met through the issuance of securities. Therefore, bank financing predominates.
Companies borrow heavily from banks, whose refinancing needs are mainly covered by the central bank. The central bank tends to have a strong influence on the level of investment and, consequently, on overall economic growth. In this scenario, interest rates represent the level desired by the government, for reasons of economic policy, rather than an equilibrium point between supply and demand for loans.
A bank-based economy is viable only in an inflationary environment. When inflation is high, companies readily take on debt because they will repay their loans with devalued currency. In the meantime, after adjustments are made for inflation, companies pay real interest rates that are zero or negative.
A company takes on considerable risk when it relies exclusively on debt; however, inflation mitigates this risk. Inflation makes it possible to run this risk and, indeed, it encourages companies to take on more debt.
The bank-based (or credit-based) economy and inflation are inextricably linked, but the system is flawed because the real return to investors is zero or negative. Their savings are insufficiently rewarded, particularly if they have invested in fixed-income vehicles.
