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Government Deficits and Corporate Liquidity: IntroductionReeling from the effects of the recent global financial crisis, national governments around the world have been increasing government spending and running increasingly higher budget deficits to boost their respective economies. At the same time, many firms have been building up cash reserves in the belief that having sufficient internal funds can help them take advantage of investment opportunities and handle the crisis better (Duchin et al. 2010). Despite warnings that excess corporate saving can slow down economic recovery, such trend may not subside in the short run because the economy in the future is filled with uncertainty; thus, the precautionary motive for holding cash can remain strong under such circumstances (The Economist 2010). Therefore, relevant questions arise: Is government deficit a missing variable in explaining rising corporate liquidity? How should firms manage their liquidity in the presence of high government deficits?
Cash pileup of firms has been widely observed since the 1990s. Existing studies examine from different perspectives the factors that contribute to cash hoarding (Opler et al. 1999, Dittmar et al. 2003). These earlier studies focus on firm-specific determinants of corporate liquidity. More recent liquidity studies examine how corporate liquidity is determined by country-specific factors, including institutional variables, legal systems and macroeconomic conditions, such as access to capital market (Faulkender & Wang 2006); interest rates and GDP growth (Garcia Teruel & Martinez Solano 2008, Chen and Mahajan 2010); financial development (Khurana, Martin, & Pereira 2006); future economic conditions (Kim, Mauer, & Sherman 1998); and macroeconomic uncertainty (Baum et al. 2006, 2008). However, macroeconomic conditions are relatively less explored than other country-specific factors. In addition, they only mainly serve as control variables in existing liquidity studies.
Baum et al. examine how corporate liquidity is related to macroeconomic uncertainty, but their work does not address the impact of government deficit. Chen and Mahajan examine the impact of macroeconomic conditions on corporate liquidity in an international setting. However, their study simply provides a general survey of how macroeconomic conditions impact corporate liquidity, instead of focusing on the relationship between government deficit and corporate liquidity. In addition, their study examines the direct impact of government deficit on corporate liquidity without considering how the former can affect the latter indirectly through other macroeconomic channels, such as inflation, interest rate, and economic growth. Furthermore, they used a multi-country sample (Taiwan excluded), which complicates the analysis because it introduces cross-country differences inherent in multi-country setting.
Government spending is like a double-edged sword. On one hand, increasing government spending and running government deficit likely promote economic growth in the short run. Recently, the global economy has shown signs of recovery after huge amounts of government spending. If government spending can successfully boost the economy in the short run, firms should be inclined to hold more cash in anticipation of greater investment opportunities in the future. On the other hand, an increase in government spending may prove futile or detrimental to the economy in the long run because government deficits will have to be paid off eventually by money creation, increase in taxes, or more government borrowing. fully