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Impact of Leverage on Firms’ Investment
It has been observed that the economic growth cycle coincides with the investment cycle in India. It is found that firm-level leverage could provide early signals about the movements in the investment cycle. Furthermore, a firm’s leverage adversely affects its investment activity after a threshold. Regression results, after controlling for firm’s price to book ratio and operational variables, indicate that the adverse impact of high leverage is predominant on low-growth firms. The initiatives to clean up the balance sheets of banks and deleveraging by non-financial corporates should help in the revival of the investment cycle. The results are consistent with the agency cost of debt and trade-off theory of capital structure, wherein firms set targets for leverage by balancing costs and benefits of debt.
The views expressed in the paper are personal to the authors and do not represent the views of the Reserve Bank of India or of the Indian Institute of Technology Bombay, Mumbai. The authors are thankful to the anonymous referee for their valuable comments. They are thankful to K Narayanan and Ranjan Kumar Panda of the Department of Humanities and Social Sciences, IIT Bombay for their comments on an earlier version on the paper. They would also like to extend their gratitude towards Golaka C Nath, Jaichander, Pankaj Kumar and Kunal Priyadarshi for their inputs in an internal presentation at the RBI.
India’s gross domestic product (GDP) growth rate at the constant prices after 2017–18 slowed below 7% vis-à-vis the average growth rate of 7.5% during 2014–15 to 2016–17.
It was 4.0% in 2019–20. This outcome has reinvigorated the debate about the challenges of returning to a durable and sustained high-growth trajectory, notably the one the Indian economy had achieved before the global financial crisis (GFC) (RBI 2019). The GDP growth during 2012–20 was characterised by a significant slowdown in capital formation. Previous studies centering around India provide evidence that the slowdown in investment growth was driven by lower capital formation in the private sector (Pattanaik et al 2013; Anand and Tulin 2014; GoI 2017; RBI 2018). Decline in investment growth was particularly noticeable in manufacturing, electricity and other utilities, construction, transport and communication services. The private sector firms in these sectors recorded a significant increase in leverage after the GFC. This paper analyses the nexus between leverage and investment.
The literature has sought to explain investment slowdown in terms of macroeconomic factors such as higher real interest rate, increased policy uncertainty after GFC, tepid domestic and global demand conditions and appreciated real exchange rate (Kose et al 2017; Chhibber and Kalloor 2016; Pattanaik et al 2013). Although the macroeconomic factors are important determinants of investment behaviour, they do not fully explain the slowdown in investment activity. Therefore, this study attempts to explore whether firm-level characteristics, especially leverage, which increased sharply after the GFC (Alfaro et al 2017), has affected investment behaviour in India. Capital structure and debt overhang in the balance sheets of non-financial firms, after the GFC, have played an important role in capital formation slowdown in many economic jurisdictions (Gebauer et al 2018; Kalemli-Ozcan et al 2020). Similar conclusions are drawn in the case of Canada (Aivazian et al 2005) and China (Firth et al 2008). According to the trade-off theory of capital structure, firms set a target for leverage ratio, considering the costs and benefits of debt (Myers and Majluf 1984). In a scenario of debt overhang, a firm may try to restore the leverage target and give up valuable investment opportunities when internal funds are not sufficient (Meyers 1977; Myers and Majluf 1984). This phenomenon becomes even more pronounced during times of financial duress when the probability of bankruptcy increases.
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