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Inflation and Corporate Liquidity Management: What Should Managers Do? An article by Assistant Professor of Finance Bektemir Ysmailov

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Inflation and Corporate Liquidity Management: What Should Managers Do?

Assistant Professor of Finance Bektemir Ysmailov shared his opinion Inflation and Corporate Liquidity Management.

Inflation throughout the world has been running at multi-decade highs over the past several months. Fighting inflation is item number one on the agendas of governments and central banks. In this blog post, I explore how should corporations adjust their liquidity management practices in such an environment.

The key tool being deployed in the fight against inflation is the tightening of monetary policy, or, equivalently, the increase in interest rates. Higher interest rates encourage saving and discourage short-term consumption, which, in turn, puts downward pressure on prices. Therefore, an alternative way to define current macroeconomic environment as that of high inflation would be to define it as that of increasing interest rates. We can therefore rephrase the key question of this blog post to how corporations should adjust their liquidity management practices in an environment of increasing interest rates.

In my recently published paper in the Journal of Banking and Finance titled “Interest Rates, Cash and Short-Term Investments”, I study this question in the sample of all U.S. publicly traded firms over the period of almost 50 years. Specifically, I examine the trade-off of holding two key types of liquid financial assets available to corporations: non-interest-bearing cash holdings (e.g., cash in checking accounts) and interest-bearing short-term investments (e.g., short-term government bonds). While the prior literature has lumped these two types of financial assets together arguing that they have the same determinants, I show that it is not the case when it comes to interest rates.

Specifically, I show that high (low) interest rates are associated with high (low) short-term investments and low (high) cash due to the opportunity cost of holding the latter. In other words, when interest rates are high, it is more costly to forgo interest payments by holding cash than when interest rates are low. Therefore, firms have an incentive to invest more in short-term investment in an environment of increasing interest rates. I show that this pattern holds in a variety of samples, periods, and under various econometric specifications.

The question is whether this is the right thing to do. The main yardstick that financial managers use to evaluate a certain corporate action (such as adopting a new liquidity management policy or undertaking a new project) is whether it adds value to the firm. In my study, I show that shareholders place a higher value on a marginal dollar of liquid assets held in short-term investments when interest rates are high, and a lower value when interest rates are low. The opposite pattern holds for the non-interest-bearing cash. These results suggest that holding liquid assets in short-term investments when interest rates are high is a value enhancing strategy.

One thing to keep in mind with academic studies is that they typically derive from a broad sample of firms over a long period of time. The results may hold on average but may not be applicable to any one particular firm. Although my findings may serve as a general guide, they should not be used as a general prescription for all firms at all times.

References
Ysmailov, B., 2021. Interest rates, cash and short-term investments. Journal of Banking & Finance, Volume 132, 2021, 106225, ISSN 0378-4266,