This Selected Issues paper examines how surges in global financial market volatility spill over to emerging market economies (EMs) including India. The results suggest that a surge in global financial market volatility is transmitted very strongly to key macroeconomic and financial variables of EMs, and the extent of its pass-through increases with the depth of external balance-sheet linkages between advanced countries and EMs. The paper also looks at food inflation, which has often been singled out as a key driver of India’s high and persistent inflation.

Abstract

This Selected Issues paper examines how surges in global financial market volatility spill over to emerging market economies (EMs) including India. The results suggest that a surge in global financial market volatility is transmitted very strongly to key macroeconomic and financial variables of EMs, and the extent of its pass-through increases with the depth of external balance-sheet linkages between advanced countries and EMs. The paper also looks at food inflation, which has often been singled out as a key driver of India’s high and persistent inflation.

Corporate Leverage and Investment in India1

About one-third of the decline in India’s corporate investment-to-GDP ratio since 2011/12 compared to the previous decade can be attributed to the build-up of corporate leverage. The corporate investment outlook will remain subdued in the near term, reflecting a weak investment pipeline and strains in corporate and financial balance sheets, which will take time to repair. Further measures to enhance the investment climate, alleviate supply side bottlenecks, and strengthen financial system buffers are needed.

1. Corporate leverage in India has been rising, is at high levels compared to other countries, and is concentrated in key sectors. The deterioration of corporate balance sheets in India has been concentrated in certain sectors, namely infrastructure, natural resource extraction, and construction. The share of debt of highly leveraged firms (firms with debt to equity ratios greater than two) has been increasing since the Global Financial Crisis, jumping from 21 percent in 2010/11 to 28 percent the following year, and then to 31 percent at the end of 2013/14. This raises the concern that the emergence of debt overhang in these sectors could hinder investment going forward.

2. Investment in India has slowed in recent years,

with gross fixed capital formation growth averaging 11½ percent per year over the decade ending in 2011/12 but falling to less than ½ of one percent during 2012/13–2013/14, to a large extent due to a fall in corporate investments. The economic significance of the fall in corporate investment has been large, with corporate investment as a share of GDP falling from 12.8 percent to 9 percent between 2010 and 2012. Anand and Tulin (2014) find that standard macro-financial variables cannot fully explain the slowdown in investment at the aggregate level, and that heightened uncertainty and deteriorating business confidence have played a key role.

3. High leverage has hindered corporate investments in India in recent years. Economic theory postulates that debt overhang leads to underinvestment (Myers, 1977) and credit rationing (Stiglitz and Weiss, 1980). Indeed, in recent years India’s most leveraged companies have had markedly lower investment rates when compared to their less-leveraged peers. To quantify the economic significance of leverage on investments, we estimate the econometric relationship between investment and leverage for Indian corporates. Given the increasing share of corporates with high leverage in recent years, and that investment has slowed more for highly-leveraged firms, estimation of threshold effects in the relationship between investment and leverage is also conducted.

A09ufig01

Corporates: Median Debt to Equity

(In percent)

Citation: IMF Staff Country Reports 2015, 062; 10.5089/9781498316200.002.A009

Sources: IMF, Corporate Vulnerability Utility.
A09ufig02

Corporate Fixed Investment

(as percent of GDP)

Citation: IMF Staff Country Reports 2015, 062; 10.5089/9781498316200.002.A009

Source: Haver Analytics.
A09ufig03

Corporates: Average Investment for Highly Leveraged and Less Leveraged Firms

(In percent)

Citation: IMF Staff Country Reports 2015, 062; 10.5089/9781498316200.002.A009

Sources: Prowess; and IMF staff calculations.

4. The analysis is based on a large and comprehensive sample of Indian companies and takes into account a range of corporate financial metrics. The data is from the annual balance sheets of 4,537 non-financial firms from 2001/02 to 2013/14, taken from the Centre for the Monitoring of the Indian Economy (CMIE) Prowess database. The following equation is estimated:

Investmentit=α+βLeveragei,t1+δXi,t1+μi+νt+εit

where Investment for firm i in year t is purchases of fixed assets (expenditure on plants, property, and equipment) in year t as a share of previous year’s capital stock. Leverage is the debt to equity ratio, and X is a vector of control variables including:

  • lagged investment

  • the current ratio (current assets/current liabilities) as a measure of liquidity

  • corporate profits, and

  • the natural log of sales to control for firm size.

Period effects, νt, to capture aggregate shocks, and firm-specific fixed effects, μi, are included.

5. The regression results confirm the expected negative impact of leverage on investment. Specifically, a one percentage point increase in a company’s leverage ratio leads to a 2½ percentage point decline in investment as a share of its capital stock. High leverage is often associated with higher debt service costs, which reduces space for companies to undertake fresh investments. The interest cover metric (ICR, the ratio of the earnings before interest and taxes to interest payments) of the Indian corporate sector’s financial health has deteriorated significantly over recent years (see Lindner and Jung 2014). Our econometric results confirm that a deterioration of ICR adversely affects investment. In particular, firms with a 1 percentage point better interest cover ratio have about 16 basis points higher investment to capital. Furthermore, these results are robust to GMM estimation methods, which account for the endogeneity of the lagged investment variable.

Dependent variable: Investmentt

article image
Source: IMF staff estimates.Note: Standard errors in parentheses, *** p<0.01, ** p<0.05, * p<0.1.

6. The results also reveal a greater adverse impact of leverage on investment for highly-leveraged companies. We investigate whether leverage above certain thresholds has a more detrimental effect on investment using three threshold leverage ratios: debt to equity ratios of one, two, and three. In each case, corporates with a leverage ratio over the threshold level have lower investment, on average, than firms with below-threshold leverage, and the relationship between leverage and investment is more negative for these firms. For example: (i) firms with a debt to equity ratio greater than two have 9 percent lower investment on average; and (ii) for a leverage ratio greater than two, a one percentage point increase in leverage is associated with investment that is an additional 0.5 percentage points lower.

Dependent variable: Investmentt

X=Leverage threshold dummy

article image
Source: IMF staff estimates.Notes: Standard errors in parentheses, *** p<0.01, ** p<0.05, * p<0.1. Lagged investment, current ratio, profit, log(sales) not shown.

7. The drag on investment by highly-leveraged companies will remain in the near term. About 15 percent of the firms in the sample have leverage ratios greater than two, while the remaining 85 percent of firms have an average leverage ratio of 0.6. Highly-leveraged corporates may need to focus on deleveraging before taking advantage of future investment opportunities. Some corporates are likely already credit constrained due to high leverage, which in turn continues to put pressure on the health of the financial system, in particular on the balance sheets of public sector banks (PSBs). This will further affect bank risk taking as well as the ability of the banking system to finance economic recovery (see also Selected Issues Chapter VIII).

8. The investment outlook remains subdued. Investment project announcements have shown weakness over the last couple of years, due to supply-side bottlenecks and policy uncertainty. Notwithstanding recent improvement in new project announcements, actual investment will take time to pick up, reflecting muted new private corporate undertakings of the last few years. As well, durable solutions to underlying supply bottlenecks (e.g. power sector and natural resource allocation) are needed to ensure viability of future investment. For firms that have become highly leveraged and the banks involved, further progress on working out stressed corporate debt is needed to ensure that the banking system has sufficient resources to provide credit commensurate with economic recovery. Enhancing PSBs’ loss absorbing buffers, specifically by raising their capital positions, would also help.

A09ufig04

Investment

(In billions of Rupees)

Citation: IMF Staff Country Reports 2015, 062; 10.5089/9781498316200.002.A009

Sources: CAPEX; and IMF staff calculations.
A09ufig05

India: Investment Project Announcements

(Value of new projects minus value of shelved projects, In percent of GDP)

Citation: IMF Staff Country Reports 2015, 062; 10.5089/9781498316200.002.A009

Sources: CAPEX Database; and IMF staff calculations.

References

  • Anand, R. and V. Tulin, 2014, “Disentangling India’s Investment Slowdown,” IMF Working Paper WP/14/47, March 2014.

  • Lindner, P. and S. Jung, 2014, “Corporate Vulnerabilities in India and Banks’ Loan Performance,” IMF Working Paper WP/14/232, December 2014.

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  • Myers, S., 1977, “Determinants of Corporate Borrowing,” Journal of Financial Economics, Vol 5, No 2, pp. 147175.

  • Stiglitz, J. and A. Weiss, 1980, “Credit Rationing in Markets with Imperfect Information, Part II: A Theory of Contingency Contracts” mimeo. Bell Laboratories and Princeton University.

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1

Prepared by Sonali Das and Volodymyr Tulin.

India: Selected Issues Paper
Author: International Monetary Fund. Asia and Pacific Dept
  • View in gallery

    Corporates: Median Debt to Equity

    (In percent)

  • View in gallery

    Corporate Fixed Investment

    (as percent of GDP)

  • View in gallery

    Corporates: Average Investment for Highly Leveraged and Less Leveraged Firms

    (In percent)

  • View in gallery

    Investment

    (In billions of Rupees)

  • View in gallery

    India: Investment Project Announcements

    (Value of new projects minus value of shelved projects, In percent of GDP)