Sunday, January 24

Move to a free country and your firm will have lower cost of debt

Now here’s an interesting research paper which popped into my inbox. In short, the more the political rights, the more free the country, the level of property rights, free and fair elections, competitive political parties, important role played by opposition, minority group rights, a system of checks and balances across the legislature, judiciary and executive, etc, the lower are the costs of debt. To be precise, a one standard deviation in political rights is equivalent to an 18.6% decline in bond spreads. Now that is a serious chunk of change. The authors concentrate on Eurobonds and come up with the following main countries within their study: USA (799 issues), Japan (231 issues), Australia (214 issues), Germany (213 issues), and the U.K. (180 issues). India is also there which surprised me because the Indian bond market is generally anaemic but then the Eurobond market is slightly different. So what are the correlations like? Some very interesting results pop up:


  Log yield spread Bond rating
Log yield spread 1  
Bond rating -0.65 1
Political rights -0.25 0.3
SPI 0.08 -0.18
Freedom of the press -0.31 0.37
Corruption 0.39 -0.46
Expropriation 0.33 -0.39
Creditor rights -0.09 0.16
Log GDP/capita -0.24 0.33
Sovereign rating -0.34 0.42
Cross-list 0.03 0.02
Log total assets -0.34 0.47
ROA -0.13 0.06
Leverage 0.06 -0.05
Public -0.46 0.48
Floating 0 0.08

Not going to go too deep into the analysis of each factor to each other and please bear in mind that correlations do not mean causality. But interesting results none the less. One can do couple of PhD's just on this :)

The researchers then do some rather complicated regression testing. One of their regressions is to analyse the joint impact of creditor rights and political rights on the bond yield spread. This is what they find out.

Pretty stunning visual results, eh? reduce the political and creditor rights and the surface starts to peak. And the gradient is pretty smooth, no lumps or bruises or troughs or peaks. The authors go about doing much more in terms of determining firm level impacts, checking cross listing implications, and other confusing things to me. So I am going to ignore them as the basic answer seems to be pretty clear. I quote 1 paragraph from their paper:

This paper examines the impact of country-level political rights on credit markets while controlling for legal institutions. Higher political rights are associated with significantly higher ratings and lower spreads for corporate bonds issued in both the Eurobond and the Yankee bond markets. A one standard deviation change in political rights is associated with an 18.6% decline in yield spreads on average; political rights impact international debt markets as much as creditor rights. We find that the interaction term between political rights and creditor rights is positively associated with yield spreads, thus, political rights and creditor rights partially act as substitutes.

We also consider the channels by which political rights impact bond markets. Freedom of the press appears to capture much of the effects of political rights, suggesting that part of the advantage of political freedom to credit markets may be due to greater information availability. Socio-political instability in the 25 years prior to the bond issue impacts the cost of debt, but does not capture the effects of political rights, suggesting that political rights are more important as a forward-looking measure of bondholder risk. Corruption and expropriation risk are also priced in bond yields; however, the effects of these variables appear to be more independent of political rights.

Now here’s the interesting take which I took away. Now that firms are becoming more and more globally footloose and capital becoming more and more aggressive, it is but natural that people will try to move these types of firms to countries which have more political rights so as to raise cheaper finance. On the other hand, think about what governments go about doing. They actually give tax benefits and a whole host of other benefits to attract FDI and capital. Here’s a silly thought. Instead of going about offering these kinds of tax breaks, why not try to improve the political rights? That will kill two birds with one stone, improve the society as well as attract firms. Neato, no?

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