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Corporate debt and inflation: what you need to know

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Jincheng Tong, Alexandre Corhay

With inflation at a 40-year high, every corner of the economy is feeling the pinch.

But just as sky-high prices affect consumers unevenly — with meat-eating, car-driving Toronto renters hit harder than home-owning vegetarians who take public transit — so too are there disparities among businesses.

One stark divide relates to corporate debt, the subject of a 2021 paper by assistant finance professors Jincheng Tong and Alexandre Corhay. Their research examines the effects of inflation on financial and non-financial firms, a phenomenon that has implications for executives, policymakers and, ultimately, the health of the economy.

When the researchers began working on the paper in 2019, they couldn’t have predicted how pertinent it would become in the months following its publication. At the time, most of Europe and North America hadn’t seen rising inflation in three decades and some colleagues questioned the timeliness of the topic. 

But, Tong points out, corporations were already borrowing at historical rates even before the pandemic. And as governments and central banks rushed to support the economy in 2020 with near-zero interest rates and fiscal stimulus packages, they set the stage for inflation’s renewed relevance. 

For their working paper, Tong and Corhay explored both non-financial companies that borrow money from banks to invest in growing their businesses and the financial intermediaries who lend to these companies. Because corporate loans are a liability for the former segment and an asset for the latter, inflation impacts their real value in opposite ways, reducing the debt burden for non-financial firms and eroding lenders’ asset value. 

“If a company already has a lot of debt, high inflation might be a good thing,” explains Tong. “You have more resources; you need to pay less; you can invest more and expand your business.”

Say, for instance, a soda company takes out a 10-year loan equivalent to the price of 10,000 cans of cola. By the time the debt matures, the price of soda has increased by 20 per cent. Now the company only owes the equivalent of 8,000 cans.

These effects are more pronounced for firms with longer debt maturity and banks with longer asset maturity; if the soda company had taken out a five-year loan, the term would only expose the debt to five years of inflation news.

In their paper, Tong and Corhay looked at real-world data, testing the impacts of inflation on a panel of publicly traded stocks. Controlling for factors like interest rate changes, they found that surprise inflation negatively effects banks’ stock returns and positively impacts non-financial firms’ stock returns. An unexpected one per cent increase in inflation led to a 0.31 per cent dip in banks’ returns, while non-financial firms saw a rise of 0.52 per cent.  

What these impacts mean for the economy — whether companies continue to expand amid high inflation or whether they cut investment and trigger or deepen a recession — depends on the relative health of the financial sector, the researchers found.

When banks are financially constrained — that is, when they face greater liquidity and solvency risks, such as during a financial crisis — unexpected inflation leads to an increase in financing costs for the companies from borrowing and investing, and ultimately hurts the economy. When banks are less constrained — meaning, in part, that the corporations and banks that borrow from them are at relatively low risk of default — inflation is expansionary. In this scenario, banks have the resources to continue to lend, and indebted businesses are better off, encouraging them to borrow and invest.

Tong suggests this finding is key for the paper’s policy implications. Whenever central banks pursue expansionary monetary policy they “need to really keep an eye on the health of the banks,” he says. “You don't want to enter into a situation where you have high inflation as well as a financial crisis.”

Looking back to the early days of the pandemic, the Bank of Canada’s response was “close to optimal,” says Tong. The central bank communicated that it was keeping a close watch on the financial sector's health and took steps to buttress it amid business closures and widespread unemployment.

However, these expansionary measures carry the risk of revving up inflation, and it’s possible the bank may not have sufficiently accounted for the degree to which this outcome might also hurt the financial sector, Tong says. 

With inflation hitting 8.1 per cent in June 2022, the Bank of Canada is taking increasing action to cool demand, raising the benchmark interest rate by a full percentage point to 2.5 per cent. While this alone may not fully lower inflation — Tong points to other factors like supply-chain bottlenecks and fiscal stimulus spending — it’s historically been an effective tool.

As far as the Canadian economy’s ability to weather this period of steep inflation, there are indications that the financial sector is relatively well-positioned to do so.

“​​If you think about the financial crisis [of 2008], we can definitely say that Canada did better than the U.S. in terms of how severely the crisis hit the economy,” says Tong. “There's also reason to believe that this time we might be better off because we have tougher regulations, our banks seem to be well-capitalized, and a lot of these banks’ assets have shorter maturities than in the U.S.”

Jincheng Tong is an assistant professor of finance in the department of management at the University of Toronto, Scarborough, with a cross-appointment to the finance area at the Rotman School of Management.
Alexandre Corhay is an assistant professor of finance at Rotman School of Management.