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Government Deficits and Corporate Liquidity: Literature reviewTwo sets of hypotheses are tested in the study. First, government deficit generally causes inflation and interest rates to rise. As such, corporate cash holdings should be reduced because of the accompanying reduction in the real purchasing power of cash and increase in opportunity cost of holding cash. In addition, government deficit tends to reduce economic growth in the future (Saleh and Harvie 2005). Therefore, cash holdings should be decreased because investment opportunities are expected to be fewer and the inclination to hold cash for investment opportunities is weakened under such circumstances (Kim et al., 1998). Firms can hoard cash due to the lack of investment opportunities, more costly external financing, and higher economic uncertainty that could come with higher government deficit. However, if these effects are relatively weaker, the present study hypothesises that corporate liquidity should be lower when government deficit is higher. fully
Second, this study examines further the indirect impact of government deficit on corporate liquidity. It also investigates the potential interactions between government deficit and other macroeconomic variables (i.e., inflation, interest rate, and economic growth) in determining corporate liquidity to infer the potential signal effects of government deficits.
This study hypothesises that if government deficit signals an increase in inflation and interest rates, any negative impact of inflation and interest rates on corporate liquidity should be reinforced. On the other hand, if government deficit signals economic slowdown, any positive impact of economic growth on corporate liquidity should be weakened.
Using single-country data from Taiwan from the period 1981 to 2009, the study indicates that government deficit, indeed, plays a role in determining corporate liquidity. Specifically, corporate liquidity is lower when government deficit is higher, supporting the major hypothesis proposed in this study. In addition, inflation and interest rates have a negative impact on corporate liquidity; such negative impact is reinforced when government deficit is higher, suggesting that government deficit signals an increase in inflation and interest rates. Economic growth has a positive impact on corporate liquidity, and such positive impact is weakened when government deficit is higher, suggesting that government deficit signals a decrease in economic growth.
Firms hold cash for three major motives, namely, transaction cost motive, precautionary motive, and agency cost motive. More precisely, they hold more cash when transaction costs are higher. They also keep cash reserves to take advantage of investment opportunities because external financing is more costly. Furthermore, cash is free cash flow; thus, management tends to hoard cash under their discretion.
Previous studies explain liquidity using tradeoff theory, financing hierarchy theory, and agency theory. However, results do not favor any particular theory (Almeida, Campello, & Weisbach 2004; Bates, Kahle, & Stulz 2009; Opler et al. 1999). However, empirical evidence supports the presence of optimal cash holdings resulting from balancing marginal cost and marginal benefit of corporate liquidity, concurring with the prediction of tradeoff theory (Keynes 1936). The presence of optimal corporate liquidity is also implicitly supported by agency theory, because hoarding cash to gain discretionary power entails agency cost of cash (Jensen, 1986). In contrast, financing hierarchy theory states that cash is preferred to debt, followed by equity in financing. Hence, there is no optimal corporate liquidity because variation in internal funds dictates the respective cash holdings of different firms (Myers & Majluf 1984; Shyam-Sunder & Myers 1999).