Debt-Equity Ratios of Firms and Interest Rate Policy: Macroeconomic Effects of High Leverage in Developing Countries

The main purpose of this paper is to demonstrate that both the choice between debt and equity by firms and the institutional circumstances governing this choice have a crucial bearing on the effect of interest rate policy on saving and investment in developing countries. The reliance on debt finance has been quite substantial in some developing economies because loans from the banking system have constituted substitutes for stock issue, and the flow of foreign saving has been mainly in the form of debt rather than equity. In effect the banking system and, in some cases, the curb markets have together assumed the risk of bankruptcy of firms, and the equity instruments have remained underdeveloped.

Abstract

The main purpose of this paper is to demonstrate that both the choice between debt and equity by firms and the institutional circumstances governing this choice have a crucial bearing on the effect of interest rate policy on saving and investment in developing countries. The reliance on debt finance has been quite substantial in some developing economies because loans from the banking system have constituted substitutes for stock issue, and the flow of foreign saving has been mainly in the form of debt rather than equity. In effect the banking system and, in some cases, the curb markets have together assumed the risk of bankruptcy of firms, and the equity instruments have remained underdeveloped.

The main purpose of this paper is to demonstrate that both the choice between debt and equity by firms and the institutional circumstances governing this choice have a crucial bearing on the effect of interest rate policy on saving and investment in developing countries. The reliance on debt finance has been quite substantial in some developing economies because loans from the banking system have constituted substitutes for stock issue, and the flow of foreign saving has been mainly in the form of debt rather than equity. In effect the banking system and, in some cases, the curb markets have together assumed the risk of bankruptcy of firms, and the equity instruments have remained underdeveloped.

The economy of the Republic of Korea provides an interesting case study of rapid economic growth with heavy reliance on debt finance. The average debt-equity ratio (that is, the ratio of total liabilities to net worth) of firms in the industrial sector in Korea has grown from about 100 percent in the early 1960s to about 500 percent in recent years. This sharp rise is due mainly to the rapid growth of the Korean banking system that occurred after the interest rate reform in 1965 and to the large use of foreign borrowing. Other factors that contributed to the rise include the inadequacy of business saving in relation to investment needs and the biases in the tax system that have favored debt finance. Policymakers in Korea have in general held the view that the resultant overleveraged financial structure restricts their macroeconomic policy options and have, on various occasions, adopted measures to reduce the debt-equity ratio of firms as part of financial reform. (Sakong II (1977) has given a historical account of measures taken by the Korean authorities to improve the corporate financial structure.)

On the basis of an analysis of corporate financial structure in Japan—another example of rapid growth achieved predominantly through debt finance, with interesting parallels to the Korean situation—Patrick (1972) concluded that underdeveloped capital markets have not had any adverse effect on saving and realized investment.

Whereas rapid economic growth in Japan and Korea may suggest such a conclusion, a closer analysis of the situation in many developing countries reveals that the prevalence of high corporate debt-equity ratios is detrimental to macroeconomic stability, and that the effect of interest rate policy on saving and investment is significantly altered by the size of the ratio. Of interest is that when the debt-equity ratio exceeds a critical limit, even the direction of the effect of financial policies is changed, and stabilization policies involve very high costs in growth forgone. These macro-economic consequences of the financial structure of firms will become apparent when the role of interest rate policy is examined from the viewpoint of its effects on the cost of capital to investors, an aspect that is ignored in much of the debate on interest rate policy in developing countries.

The analysis of interest rate policy in developing countries has evolved along two distinct lines. The analytical framework pioneered by Shaw (1973) and McKinnon (1973) considers disequilibrium systems in which investment opportunities abound, but actual investment is constrained by available saving, in part because high inflation and controls on the monetary system foster financial repression. Because of controls on interest rates, short-run monetary equilibrium is achieved mainly through variations in the rate of inflation. The role of interest rate policy in this framework is to increase saving, improve allocative efficiency, spur the demand for financial assets, and facilitate stabilization.

An alternative line of analysis, developed in van Wijnbergen (1983) and Taylor (1983), focuses more closely on the specific characteristics of the financial markets in many developing countries. It is argued that active curb markets, or deregulated segments of the organized financial markets (“free markets” for brevity), exist in many countries and that private loans in these free markets often constitute an important share in the portfolios of savers. Therefore, the interest rate in the free markets can be expected to play a role in equilibrating demand and supply of credit. In this structuralist framework, both the administered interest rate and the curb market rate (or the free rate) influence saving, investment, portfolio choice, working capital costs, and inflation. Whereas the Shaw-McKinnon analysis deals with only two types of assets in savers’ portfolios—monetary assets and inflation hedges—the structuralist model introduces a third asset, private loans in the free market. This extension of the asset menu significantly alters the implications of interest rate policy.

In this paper the structuralist analysis of interest rate policy is extended by formulating an appropriate definition of the real cost of capital to investors in developing countries that are characterized by segmented financial markets, controls on the banking system, and substantial reliance on debt, including foreign-currency debt. The earlier models ignored the important issue of how the real cost of capital to investors is influenced by interest rate policy and the financial structure. Although this neglect is understandable in the Shaw-McKinnon framework, in which the emphasis is on saving and not on investment, it is not valid in the structuralist model, in which both investment and saving respond to interest rates. Even in the Shaw-McKinnon framework, the appropriate formulation of the real cost of capital is relevant because it is an important component of the rental-wage ratio that influences factor allocation and the efficiency of capital use. Such aspects of efficiency are highlighted in many models that are based on the Shaw-McKinnon tradition (for example, Sundararajan and Thakur (1980) and Fry (1982)).

The relation between the cost of capital, the interest rate, and the debt ratio is a subject with a long history and a voluminous literature in the field of finance. 1 (Throughout the paper, debt ratio (α) refers to the ratio of total liabilities to total assets, and the term debt-equity ratio (ε) refers to the ratio of total liabilities to net worth; the two terms will be used interchangeably in view of the one-to-one correspondence between the two ratios, given by ε = α/1 - α.) The discussion below will focus on those aspects which appear relevant to developing countries, with a view to providing a heuristic explanation of why debt ratios matter in understanding the effects of interest rate policy.

In its simplest formulation, the cost of capital, defined as the minimum required return on investment, can be expressed as a weighted average of the cost of equity and the cost of debt, with the weights representing the marginal shares in total assets of equity and of debt. Thus, the larger is the debt ratio, the greater is the effect of changes in the cost of debt on the overall cost of capital. If foreign currency debt is ignored, the cost of debt in most developing countries is simply the administratively controlled loan rate in the banking system. The cost of equity, however, cannot be readily identified in developing countries with underdeveloped and fragmented financial markets; it is the opportunity cost of equity funds or, equivalently, the rate of discount used by businessmen in capitalizing the net income stream from projects. By its nature, the cost of equity is likely to vary with the structure of the financial system and with the extent of financial repression. For example, in a heavily repressed financial system, the major perceived alternative to using funds for fixed in-vestment could be the acquisition of inflation hedges such as gold or inventories. If so, the expected rate of change in the price of gold or the general rate of inflation would be the relevant opportunity cost of equity. In general, the average rate of return on a representative portfolio of savings instruments—the curb market loans, inflation hedges, foreign-currency assets, and bank deposits—is likely to be the appropriate opportunity cost of equity funds. In general, however, the cost of equity is higher than the cost of debt, due in part to a risk premium. The gap between the two is particularly large in developing countries because of the repression of interest rates through administrative controls.

Against this background, it is clear that the ultimate impact on the cost of capital of an increase in the administered interest rate depends on how this increase affects the cost of equity and the share of debt, both of which also influence the cost of capital. Indeed, a change in interest rate can either reduce or increase the cost of capital and saving, depending on the initial size of the debt ratio and on the induced adjustments in the cost of equity and in the share of debt.

In other words, the financial structure of firms—or more broadly, the institutional framework of the financial system that underlies such structure—has significant implications for interest rate policy. This point can be illustrated by considering a dual financial structure, consisting of a controlled banking system and an unfettered curb market, where the rate in the curb market could be regarded as the relevant opportunity cost of equity. An upward adjustment in the administered interest rate would initially raise the cost of capital and lower investment demand. The reduction in investment demand would be larger, the greater the debt ratio, because as indicated the increase in the cost of capital from a rise in the interest rate grows with the debt ratio. With a high enough debt ratio, the reduction in investment would be sharp enough to depress the demand for funds in the curb market and thereby lower the curb market rate. (The effects on the supply of curb market funds, or of equity funds in general, arising from portfolio adjustments is ignored here for illustrative purposes; such effects are taken into account in the next section, where the complete model is presented.)

If, now, saving depends positively on real returns to available assets, then the negative effect on saving caused by the fall in the curb market rate would counter the positive effect on saving caused by the increase in the bank interest rate. The overall impact on saving would be negative, or would be weakened substantially, if the fall in the curb market rate is large because of a high debt ratio. Thus the debt ratio used by firms can significantly influence the effectiveness of interest rate policies. This fundamental result remains valid when the analysis incorporates both portfolio adjustments and adjustments in the debt ratio in response to interest rates and inflation.

The paper is organized as follows. Section I presents the model determining saving, investment, the debt ratio, the cost of capital, and portfolio adjustments. The model emphasizes the linkage between debt and investment. Such linkage is in general ignored in the theory of investment where the debt ratio is assumed to be fixed; in the theory of corporate financial behavior, the rate of investment is taken as exogenous. (For a recent analysis of the interdependence between investment and financing, see Hite (1977).) In Section II, the Fisher effect and the effects of interest rate policy are analyzed under alternative assumptions about the determinants of the debt ratios of firms. The first subsection of Section II (“Flexible Amortization, Exogenously Given Target Debt Ratio, and No External Debt”) demonstrates that a large debt ratio can lead to macroeconomic instability and can generate perverse effects from monetary policies.

The second subsection of Section II (“Financial Repression and Supply-Determined Debt Ratio”) considers a financially repressed environment in which considerable scope exists for raising the share of financial saving in total saving and, in this context, analyzes the links between interest rates, financial saving, and the cost of capital, thereby elucidating the relation between the analysis in this paper and the analytical framework of McKinnon (1973).

To the extent that an increase in the debt ratio raises the riskiness of net returns from investment, firms might adjust their debt ratio optimally to balance the benefits of additional subsidized credit from banks with the associated costs from the increased riskiness of investment. The implications of such optimal debt behavior for stability and interest rate policy are analyzed in the third subsection of Section II (“Optimal Choice of Debt Ratio”).

The fourth subsection of Section II (“Predetermined Amortization Schedule”) deals with an aspect of debt policy that in general has been ignored in the literature: the effect of the maturity structure of debt—the rate of amortization—on investment incentives. When the gap between the cost of equity and the cost of debt is large, as in most developing countries, it can readily be shown that the choice of the maturity pattern of debt will significantly influence the present value of the project and, hence, investment incentives (on the effect of such maturity decisions, see Morris (1976)). Moreover, the rate of amortization has an important bearing on how the debt ratio evolves over time. Therefore, behavior regarding amortization can significantly influence the effect of interest rates on investment and saving.

The effect of foreign-currency debt on the cost of capital is analyzed in the fifth and final subsection of Section II (“Foreign-Currency Debt with Predetermined Target Debt Ratio and Fixed Amortization Rate”) in view of the importance of such debt in financing investment in many developing countries. Section III contains conclusions from the analysis and highlights its policy implications. The algebraic details of the analysis are given in the two appendices.

I. A Model of Saving, Investment, and Debt

The model specifies the determinants of saving, investment, the cost of capital, the financial structure of firms, and the asset portfolios of savers in a dual financial system characterized by a controlled banking sector and a free financial market, such as the curb market. (The case of a curb market is used in this paper for illustrative purposes only: the model can readily be adapted for cases in which other substitutes for bank credit exist, such as credit from nonbank financial intermediaries or equity instruments whose yields are market determined and are not controlled by the government; the market-determined free rates can be substituted for the curb market rate, and the analysis can be appropriately modified.) The purpose of the model is to highlight the linkage between the debt behavior of firms and incentives for saving and investment. Special attention is paid to the determinants of the cost of capital to investors because the links between the financial structure of firms and investment incentives arise in part from the effects of financial policies on the cost of capital.

Saving and the Debt Ratio

It is assumed that aggregate real saving S depends positively on the real returns obtainable in the controlled banking system and on returns in the free market:

S=S(ρπ,Rπ),(1)

where ρ is the average nominal rate of return in the free market, or the opportunity cost of equity funds; R is the interest rate on bank deposits; and π is the fully anticipated rate of inflation. Other variables that influence saving, such as real wealth and transitory income, are assumed to be fixed and hence are suppressed for simplicity.

The interest sensitivity of aggregate saving is influenced by the distribution of saving among government, corporations, and households. For the purposes of this paper, real government saving is assumed to remain unchanged during the time span relevant for the analysis. Although government saving will change because of the differential response of receipts and expenditures to changes in inflation, these considerations will be left out for simplicity, and the focus will be on private saving, which is more likely to be sensitive to interest rates.

Private savers fall into two distinct categories: those who are unaware of the full spectrum of financial alternatives and rely mainly on banks for the placement of financial savings, and those who exhibit sophisticated portfolio behavior by diversifying their savings among available assets. The saving function specified above is consistent with these two behaviors if the rate of return p is interpreted not simply as the return in the curb market, but as the average return on the optimal portfolios of sophisticated savers.

In developing countries, such optimal portfolios will typically consist of (1) deposits in the financial system that yield risk-free returns (determined by government policy); (2) loans supplied to the unorganized money market, or to deregulated segments of the organized markets, that offer risky returns; (3) equity holdings that also offer risky returns; and (4) holdings of physical assets that embody saving in the form of producer durables (saving in the form of consumer durables is treated as consumption). In a world of diversification and risk aversion, an optimal portfolio and the return on it can be derived from a mean-variance framework (for a simple exposition of such a framework, see Rubinstein (1976)).

In this framework the share of various assets in the portfolios of private savers, and the mean return on those portfolios, will depend, among other things, on the variances and covariances of the returns to various assets and on the debt ratio of firms. An increase in the debt ratio, to the extent that it raises the riskiness of the equity streams in the portfolio, may require a higher return on the optimal portfolio to compensate for the additional risk. Given this typical assumption found in the literature, the debt ratio is seen to influence saving through its effect on the return on savers’ asset portfolios.

The interest sensitivity of saving is also influenced by the debt ratio: if the level of corporate debt is relatively large, an increase in interest rates will transfer significant amounts of resources from corporations to households (usually after a time lag), and this transfer may eventually depress aggregate private saving because corporate (and government) saving falls by the full amount of additional interest costs, whereas household saving rises by less than the increase in interest incomes. Therefore, the interest sensitivity of saving is likely to be inversely related to the debt ratio.

Investment and the Real Cost of Capital

Desired real investment depends on the real cost of capital, the real wage rate, output expectations, and the size and characteristics of the existing stock of capital. All factors other than the real cost of capital are assumed to be fixed, so that the analysis may focus on the short-run interactions. The real cost of capital, defined as the minimum acceptable return on investment, can be derived by assuming that firms choose the level of investment to minimize their total cost of producing the desired output, including the acquisition cost of capital, and their debt service costs.

Let Q* denote planned output, K real capital stock, and L employed labor; given the production function, and the nominal wage rate W, total labor cost C can be written as

WtLt=C(Qt*,Kt),(2)

where the subscript t denotes time. The present value of total costs TC is given by

TC0exp(ρt)[C(Qt*,Kt)+(1αm)ItPt+(Rd+ad)Gt+(Rf+af)FtEt]dt,(3)

where ρ is the opportunity cost of equity; I is real gross investment; P is the price level; αm is the proportion of investment financed by debt (that is, the marginal debt ratio); G is total domestic-currency debt outstanding; F is total external (foreign-currency) debt outstanding; E is the exchange rate, measured in number of domestic-currency units per unit of foreign currency; Rd is the domestic interest rate; Rf is the foreign interest rate; and ad, af are the amortization rates on domestic and foreign loans, respectively. At each point in time, total cost—cash outflows from the point of view of the owners of the firm—consists of labor costs C (Q*, K), funds supplied by the owners to acquire and install new plant and equipment (1 - αm) IP, and the debt service payments on domestic and external debt (Rd + ad) G and (Rf + af) FE.

The present value of these cash outflows is obtained by applying the rate of discount ρ, which is the opportunity cost of equity funds given by, say, the curb market rate, or the rate of return on the optimal portfolio of sophisticated savers. (In line with this assumption, loans in the curb market are treated as equity finance and are excluded from the computation of αm.) In some economies, the interest rate in the deregulated segment of the organized financial sector may serve as the opportunity cost of equity. In the rest of the discussion, discount rate will refer to the cost of equity, which can clearly take on a variety of forms depending on the structure of the financial system.

The task is to minimize the total cost—the present value of all cash outflows given by equation (3)—with respect to the control variable I, subject to the constraints:

K˙=IδK(4)
G˙=αmdIPadG(5)
F˙=αmfIP/EafF,(6)

where δ is the rate of economic depreciation, αmd is the proportion of investment financed by domestic-currency loans, and αmf is the proportion of investment financed by foreign-currency loans. The marginal debt ratio αm is the sum of αmd and αmf. The dot above a variable denotes a time derivative.

Equation (4) states that the change in capital stock, K˙ equals gross investment I minus depreciation. The rate of economic depreciation, stated as proportion δ of existing capital, is assumed to remain unchanged over time.

Equations (5) and (6) describe the time path of loans outstanding, both domestic and external. They state that the change in debt outstanding—the net inflow of loans—equals total new loans minus the amortization of existing loans. Equation (6) refers to foreign loans measured in foreign-currency units. Thus, the investor’s external debt obligations are all denominated in foreign-currency units, and the investor bears the full exchange risk. This is the typical situation in developing countries. The amortization payments on both domestic and external loans are assumed to be proportional to the stock of loans outstanding, whereas new loans are obtained only for financing fixed investment. Loans to finance working capital requirements can be readily incorporated, but such loans are ignored for simplicity (as is borrowing for the purposes of dividend distribution and the maintenance of cash reserves).

The problem of minimizing equation (3) subject to the constraints (4), (5), and (6) is a well-defined control problem that can be solved to characterize the path of optimal capital accumulation. The first-order conditions (see Appendix I) for the cost-minimizing investment path simply reduce to the familiar rule that states that, at each point in time, investment should be expanded until the present value of cost reductions from a change in investment minus the present value of debt service incurred in financing the investment equals the amount of equity finance supplied by the owners (both new and old). To highlight the expression for the cost of capital, this rule can be restated as follows:

C/Kexp(πt)=rb,(7)

where -∂C/∂K is the reduction in nominal labor costs from unit addition to capital stock, exp (πt) is the price level at time t, π is the rate of inflation, and rb is the real cost of capital given by

rb=(1αm)(ρπ+δ)+[αmdRd+adρ+ad+αmfRf+afρ+afx](ρπ+δ),(8)

where x is the expected rate of change in the nominal exchange rate. (For an alternative derivation of equation (8) that is based on proposition I of Modigliani and Miller (1963), see Appendix I.) The expression in large brackets on the right side of equation (8) is the present value of debt service payments on αmd of domestic loans and on αmf of foreign loans.

Differentiating equation (2) with respect to capital stock, and using equations (7) and (8), allows investment to be expressed as

I=I[Qt*,rb/(Wt/Pt),Kt].

Assuming that real wage W/P is constant and that the desired output is predetermined, and suppressing Kt in order to focus on the short run, allows the investment function to be written as

I=I(rb).(9)

An examination of the formula for the cost of capital (equation (8)) underscores the importance of explicit consideration of the debt policies of firms in developing countries. In the special case—when domestic capital markets are perfect, default risk is absent, capital is fully mobile internationally, and the exchange rate is expected to remain unchanged—all interest rates are equalized (Rd = ρ = Rf; domestic and foreign rates of inflation are assumed to be identical for the time being, so that the expected change in the exchange rate is zero), and the cost of capital is given by

rb=ρπ+δ.(8a)

Thus, only under these special assumptions, the cost of capital for investment purposes is independent of amortization rates as well as debt ratios. Clearly these assumptions do not adequately characterize developing economies. If for any reason the foreign interest rate differs from the domestic rate, then the share of external debt in investment finance will enter the calculations of the cost of capital. If, in addition, the interest rate on domestic debt deviates significantly from the discount rate, then debt policy assumes even greater significance. Therefore, the next section will examine the determinants of the debt ratio.

Determinants of the Debt Ratio

The marginal debt ratio that entered the calculations of the cost of capital is determined in part by the institutional environment—including in that term the stance of credit policy—and in part by the long-run average debt ratio αa that firms regard as prudent. (The average debt ratio refers to the share of debt in total assets, whereas the marginal debt ratio αm refers to the share of debt in financing additions to total assets.) If, for prudential reasons, financial institutions adhere to some predetermined debt-equity norms (see Madan (1978) for a discussion of the use of such norms in India), or if the rigidities and imperfections in the financial system lock firms into some historically determined debt-equity ratios, then it is best to regard the marginal debt ratio as an institutionally determined parameter.

In contrast, in the early stages of financial evolution when the scope for raising the share of financial saving in total saving is large, the debt-equity mix is likely to be determined mainly by the availability of financial savings, which, in turn, could be influenced by interest rate policy. 2 Quite often, however, firms in developing countries do have some flexibility in controlling the debt-equity mix. Firms can vary the debt-equity mix by adjusting the policy toward retention of earnings for reinvestment purposes, by varying the extent of use of foreign-currency debt, and by accessing domestic finance from informal and equity markets.

If firms are able to adjust their financing mix, then it is reasonable to assume, on the basis of available empirical evidence, that debt decisions by firms will be guided by the long-run average debt ratio that they strive to achieve. (For empirical evidence that firms try to achieve a target average debt ratio, see Ang (1976) and Marsh (1982).) This behavior is likely because the value of the firm, or equivalently the discount rate required by the owners of the firm, is likely to depend on the average debt ratio. It is the average debt ratio—not the marginal debt ratio—that is relevant for assessing the riskiness of equity streams of firms that arises from constraints on future investment options and from the likelihood of bankruptcy. Therefore, the target value for the average debt ratio is likely to be an important determinant of the marginal debt ratio. This consideration can be formalized by solving the differential equation (5) to obtain

αmd=αad[(g+ad+π)/(g+δ)],(10)

where αad is the long-run target value of the average domestic debt ratio, αmd is the marginal domestic debt ratio used by the firms, and g is the expected rate of growth of real capital stock. 3

Equation (10) states that the marginal share of debt in financing investment will depend not only on the target value chosen for the average debt ratio, but also on the expected rate of growth of capital stock, its rate of depreciation, the rate of amortization of debt, and the rate of inflation. For example, if inflation rises because of expansionary credit policies, firms will choose to raise the marginal debt ratio and will be able to do so. Although this decision would raise the average debt ratio temporarily, the higher inflation would eventually reduce the average debt ratio to its target level by raising the value of assets in relation to debt outstanding. Another implication of equation (10) is that whenever firms are able to adjust the rate of amortization—say, through frequent funding operations—to match the maturity structure of assets and the projected inflation (so that ad = δ - π), then the average and marginal debt ratios will be identical. (When inflation is high, the equation ad = δ - π implies a negative rate of amortization, and equation (10) implies a large marginal debt ratio that could even exceed unity; these situations occur when firms build up debt far in excess of investment needs as a consequence of the expected reduction in the real value of debt through inflation.) If the rate of amortization is fixed a priori, however, the fixed marginal debt ratio will fall short of the target average debt ratio when inflation is low (that is, less than δ - ad) and will exceed the average debt ratio when inflation is high (that is, exceeding δ - ad). This point can be illustrated by noting that, for any given expected inflation, a faster rate of amortization (that is, a shortening of loan maturities) will, by reducing the outstanding debt more rapidly than desired, induce firms to raise the marginal use of debt.

A relation similar to equation (10) can be derived for foreign currency debt:

αmf=αaf[(af+πx+g)/(g+δ)]=αaf[(af+πwθ+g)/(g+δ)],(11)

where αmf is the marginal share of foreign-currency debt; αaf is the long-run average share of foreign-currency debt; x is the expected rate of increase in the nominal exchange rate; πw is the foreign rate of inflation; and θ is the expected rate of change in the real exchange rate, given by θ = x - π + πw. It will be assumed that the rate of foreign inflation, as well as the rate of amortization of foreign loans, is fixed. Equation (11) implies that, given the long-run target value αaf of the ratio of foreign-currency debt to total assets, a reduction in domestic inflation (with no change in the rate of currency depreciation) will induce firms to lower the marginal share of foreign-currency debt. But if the fall in domestic inflation is expected to be offset by changes in the exchange rate, so that the expected path of the real exchange rate is unchanged, then the marginal foreign-currency debt ratio will remain stable. Thus the share of foreign-currency debt in financing investment will depend on exchange rate policy, a consideration that has important implications for the effect of alternative exchange rate regimes on the average cost of capital, and hence on investment incentives.

So far the analysis of the marginal debt ratio has been based on the assumption that the target value of the average debt ratio is given a priori. The next step is to specify how this target is chosen by firms. To simplify the analysis and to sidestep the difficult issue of determining the proper mix of domestic- and foreign-currency debt, it will be assumed that foreign-currency debt constitutes a fixed share (1 - β) of total debt. Therefore, given the average debt ratio αa, the average foreign-currency debt ratio is given by

αaf = (1 − β) αa,

and the average domestic debt ratio is given by αad = βαa.

The determinants of the target value of the average debt ratio can now be identified by analyzing the benefits and costs of raising the debt ratio. The benefit is simply the additional interest subsidy that can be garnered by increasing the share of the cheaper source of finance—loans from the financial system available at the controlled interest rate. The cost of incurring larger debt (in relation to assets) derives from the increased probability of future cashflow problems, hence of bankruptcy. This cost can be summarized by the equity-cost function that links the discount rate and the average debt ratio: 4

ρ=ρ(αa),ρα>0,ρα>0.(12)

(A prime denotes the first derivative with respect to the subscript variable; a double prime denotes the second derivative with respect to the subscript variable.)

Thus the discount rate is assumed to be a strictly concave and increasing function of the average debt ratio. The optimal value of this ratio can be chosen so as to minimize the overall cost of capital by balancing at the margin the benefit of additional interest subsidy with the cost of increased riskiness of investment, and the optimal debt ratio so derived will be treated as the target value that firms strive to achieve. 5

Because the choice variable in this optimization exercise is the average debt ratio, it is necessary to express the formula for the cost of capital, equation (8), which involves the marginal debt ratios αmd and αmf, in terms of the average debt ratios by using equations (10) and (11). A complete expression for the cost of capital is given by

rb=[1c1(π)αadc2(πw,θ)αaf](ρπ+δ)+[c1(π)αadRd+adρ+ad+c2(πw,θ)αafRf+afρ+afx](ρπ+δ),(13)

where

c1(π)=g+ad+πg+δc2(πw,θ)=g+af+πwθg+δαad=βαaαaf=(1β)αa.

The optimal debt ratio can be obtained by substituting equation (12) into equation (13) and equating the first derivative of rb (with respect to αa) to zero:

drb/dαa=0.(14)

The interpretation of condition (14) is facilitated if it is assumed for simplicity that the marginal and average debt ratios are identical, 6 so that the expression for the cost of capital simplifies to the weighted-average formula:

rb = (1 − α)(ρ − π + δ) + αβ(Rd − π + δ) + α(1 − β)(Rf − π + δ),

where α denotes the common value of the marginal and average debt ratios (α = αa = αm). In this special case, the first-order condition reduces to

(1α)ρα=ρ[βRd+(1β)RF].(14a)

The equation above serves to define implicitly the optimal target value of the average debt ratio. The expression on the right-hand side of equation (14a) is the implicit interest subsidy, whereas the expression on the left-hand side can be interpreted as the marginal risk premium demanded by the firm’s owners. Optimality thus requires balancing at the margin the benefits of additional subsidy with the costs of increased risk measured by the slope of the equity cost function. This balance will clearly be disturbed whenever domestic interest rate policy or the foreign interest rate changes. Equally important, a change in inflation would affect the discount rate, the marginal debt ratios, and probably also the marginal risk premium (through shifts in ρα) and thereby would induce changes in the average debt ratio.

Monetary Equilibrium

The discount rate, the rate of interest, and the rate of inflation are assumed to be consistent with equilibrium in the money markets. This requirement serves to capture the portfolio choices of private asset holders and can be incorporated into the model by specifying that the demand for real balances should equal supply:

M/P = f(Rd, ρ, π, y),

where M/P is the supply of real balances and the right-hand side represents the demand for real balances expressed as a function of real output (y) and returns to different types of assets in the portfolio. The money demand function specified above explicitly recognizes that individuals hold in their portfolios not only monetary assets and inflation hedges, but also loans in the curb market and claims to equity bearing similar risk.

Equilibrium in the Goods Market

Excess supply or demand in the goods market will clearly influence the rate of inflation and interest rates. Equilibrium in the goods market requires that

I=S+FS,(15)

where I is domestic investment, S is domestic saving, and FS is foreign saving, assumed to be determined outside the model. The equilibrium condition (15) states that investment should equal available saving, and that such equilibrium will come about through variations in the discount rate, the rate of inflation, and the debt ratio.

Complete Model

The model set out in Table 1 can be viewed as an adaptation of the standard IS-LM model, with emphasis on the determinants of the cost of capital and the debt ratio in developing economies with segmented financial markets. The model determines saving, investment, the discount rate, the overall cost of capital, the debt ratio, and the rate of inflation. Before a detailed analysis of the model is undertaken, it is useful to illustrate graphically the workings of the model for the simple case where the debt ratio as well as the administered interest rate are assumed to be fixed.

Table 1.

A Model of Saving, Investment, and Debt

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Note: Endogenous variables are as follows: S is domestic saving; I domestic investment; rb is the weighted-average real cost of capital; αmd is the marginal domestic-currency debt ratio; αmf is the marginal foreign-currency debt ratio; αa is the average debt ratio; π is the rate of inflation; P is the general price level; ρ is the curb market rate. Exogenous variables are as follows: Rd is the domestic interest rate; Rf the interest rate on external debt; αf is the rate of amortization of external debt; ad is the rate of amortization of domestic-currency debt; δ is the rate of depreciation of capital stock; β is the share of foreign-currency debt in total debt; M is the nominal quantity of money; x is the rate of change of the exchange rate, defined as the number of domestic-currency units per unit of foreign currency; FS is foreign saving.

In Figure 1, the IS curve denotes the combinations of the discount rate and the rate of inflation that are consistent with goods-market equilibrium. It is upward sloping because an increase in inflation with a fixed administered rate reduces the real administered rate and stimulates investment. To elicit a matching increase in saving, the discount rate rises. The usual upward-sloping LM curve represents money market equilibrium. The equilibrium values of the discount rate, and the rate of inflation, are given by(ρ*, π*)

Figure 1.
Figure 1.

Discount Rate and Rate of Inflation

Citation: IMF Staff Papers 1985, 003; 10.5089/9781451972863.024.A003

It will be shown in the next section that the magnitude as well as the direction of the slope of the IS curve is sensitive to the size of the debt ratio, the response of the administered interest rate to variations in inflation, and the conditions affecting debt service (for example, the rate of amortization). Because, as is well known, the stability of the system, as well as the impact of policy changes, depends on the relative slopes of the IS and LM schedules, it follows that differences in the debt-equity ratio, the interest rate policy, and other conditions governing debt will shift the impact of demand management policies. The next section illustrates that these shifts can indeed be substantial.

II. Analysis of the Model

The model is complex, and a general analysis of its comparative static properties is therefore not attemped in this paper. Useful insights can be gained, however, by analyzing several simple special cases. For example, it is convenient to assume that the rate of inflation is determined exogenously and is not influenced by changes in interest rates. This assumption will be valid if the demand for real balances is regarded as a function of the rate of inflation alone (for any given real output), a reasonable specification in many developing economies. Unless otherwise mentioned, this assumption will be maintained to simplify the analysis and thereby to highlight the critical role of the debt-equity ratio. Modifications that result from using a more general money demand function—thereby allowing for variations in inflation from changes in the interest rate—are indicated in several places in the text. The effects of interest rates on working capital costs, and on short-run capacity utilization, are ignored throughout for simplicity.

The effect of financial policies on the cost of capital and on returns to savers will be analyzed under alternative assumptions about debt and amortization. There are several cases of interest that depend on whether the rate of amortization is fixed or variable (in response to inflation), whether the average debt ratio is fixed or is determined by loan supply or by loan demand, and whether foreign-currency debt is significant. The choice of particular combinations of assumptions about debt influences the construction of the cost of capital and alters the final results. To underscore the effects of alternative assumptions about debt behavior, a sequence of simple models will be considered in turn.

Flexible Amortization, Exogenously Given Target Debt Ratio, and No External Debt

The importance of the debt ratio is best illustrated by considering the simplest possible model, in which it is assumed that foreign-currency debt is absent; the rate of amortization is varied in line with the rate of depreciation of capital assets and inflation (ad = δ - π), so that the marginal and average debt ratios are identical; and that the firm adheres to a target debt ratio a and does not optimally adjust the ratio as the environment changes. Foreign saving is ignored because there is no external debt in this model. Under these assumptions the model becomes

S (ρ − π, R − π) = I [(1 − α)(ρ − π + δ) + α (R − π + δ)].

The effect of inflation on the discount rate is obtained by differentiating the equilibrium condition with respect to π and regrouping terms, which yields

dρ/dπ=1+[(dR/dπ1)(αIrSR)Sρ(1α)Ir].(19)

In all subsequent discussions, it will be assumed that SR,Sρ0 unless otherwise specified.

The role of the debt ratio is brought out sharply in the special case in which saving is interest inelastic (Sρ=SR=0) and the controlled interest rate is not adjusted in line with inflation. In this case,

dρ/dπ=1+α/(1α).(19a)

The interesting aspect of the formula is the implied magnitude of the Fisher effect when the debt-equity ratio (α/1 - α) is large, as in many developing countries. For example, a debt-equity ratio of 3:1 implies dρ/dπ = 4; that is, the discount rate will increase by four times the increase in inflation, assuming passive interest rate policy. This result is a special case of the more general observation that in thin markets price fluctuations will be large; a large debt-equity ratio implies that the free market where the rate of discount is determined is quite thin.

The size of the debt ratio also governs the effect of interest rate policy on saving under inflationary conditions. Total saving will increase—equivalently, the cost of capital will fall—in response to an increase in inflation if and only if

dS/dπ=Sρ(dρ/dπ1)+SR(dR/dπ1)>0.

Substituting equation (19) into the above expression and simplifying allows the condition for improved saving to be given by:

(dR/dπ1){Sρ(αIrSR)+SR[Sρ(1α)Ir]Sρ(1α)Ir}>0.(19b)

It can be verified that when dR/dπ > 1 the above inequality will hold if and only if the debt-equity ratio is less than the critical limit η given by η = SR/Sρ. The parameter η—the ratio of the effect on saving of a change in the controlled interest rate to the effect on saving of a change in the free-market discount rate (the “interest-sensitivity ratio” for brevity)—is a critical determinant of the safe upper limit for the debt-equity ratio. If the debt-equity ratio exceeds η, then the policy of raising the administered rate by more than the increase in inflation (dR/dπ > 1) will depress saving.

Even when there is no change in inflation, the ultimate effect of interest rate policy on saving is governed by the critical limit η the effect of the interest rate on saving (dS/dR) is given by the expression within braces in equation (19b), which will be positive if and only if the debt-equity ratio is less than the interest-sensitivity ratio.

The rationale of the above results is simple. The rates of saving and investment depend on both the controlled interest rate and the discount rate. When the controlled rate is raised, the ultimate effect on saving or investment depends naturally on whether the resulting upward shift in the saving schedule (linking saving and the discount rate) exceeds or falls short of the downward shift in the corresponding investment schedule. What is interesting is that, for the response of saving and investment to interest rate policy to be positive, the interest-sensitivity ratio, which measures the relative effect of interest rates on saving, should bear an appropriate relationship to the debt-equity ratio, which influences the effect of interest rate on investment.

The conditions under which the debt-equity ratio may exceed the interest-sensitivity ratio are of interest. A high debt-equity ratio may induce a significant redistribution of incomes between households and businesses that, as indicated in the first subsection of Section I (“Saving and the Debt Ratio”), is likely to dampen the size of the saving response to a change in the controlled interest rate and thereby reduce the interest-sensitivity ratio. In other words, a high debt-equity ratio will by itself serve to reduce η and raise the likelihood of a perverse saving response to interest rate policy. Even if the redistributive aspect is empirically insignificant, the debt-equity ratio could exceed the interest-sensitivity ratio if investment is financed to a substantial degree through government net lending programs.

When financial markets are segmented, the interest-sensitivity ratio could be negative. For example, this is the case when the effect of the controlled interest rate on saving is opposite in sign to the effect of the discount rate, because the balance between income and substitution effects of interest rates is different for different groups of savers; hence the debt-equity ratio always exceeds the interest-sensitivity ratio, thereby causing perverse saving response. This result highlights the potential shortcoming of segmented financial markets—and the advantage of unifying these markets through financial reform.

The prevalence of high debt ratios can lead to macroeconomic instability—for example, progressively higher inflation and real discount rates—and the avoidance of such instability could involve high costs in the form of lower investment and saving. This assertion can be verified by extending the model to include portfolio equilibrium and by examining the relative slopes of the IS and LM schedules in Figure 1 as the debt ratio rises. Equation (19) implies that, when the administered interest rate is kept unchanged as inflation accelerates (or is raised by less than the increase in inflation), the slope of the IS curve is positive and becomes steeper as the debt ratio rises. In other words, with passive interest rate policy, the increase in the discount rate from a change in inflation (dρ/dπ) becomes larger as the debt ratio increases. Therefore, when the debt ratio is sufficiently large, the slope of the IS curve could become steeper than that of the LM curve, and this situation leads to an unstable economic system in which monetary action can trigger unpredictable effects, such as accelerating inflation or deflation. With a steeper IS curve, an increase in monetary expansion will yield a new unstable equilibrium with lower inflation.

Such instability in a high-debt economy can be avoided through more active interest rate policy. For example, an increase in the real administered interest rate will make the slope of the IS curve negative and eliminate the source of instability. As already noted, however, an increase in the real interest rate would depress saving and investment when the debt-equity ratio exceeds a critical limit or when the interest-sensitivity ratio is negative. In other words, achievement of stability in a high-debt economy or in an economy with segmented financial markets is likely to involve high cost in growth forgone.

Financial Repression and Supply-Determined Debt Ratio

The consequences of financial repression and large reliance on self-finance, the impact of the interest rate on financial saving, and the beneficial effect of increased financial saving on investment have been topics extensively discussed in the literature, notably in McKinnon (1973) and Galbis (1977). 7 These discussions, however, ignore the possible beneficial effect of increased financial saving on the cost of capital and investment incentives in financially repressed economies. In the model developed in this paper, the effect of larger financial saving on the cost of capital can be captured by assuming that the debt ratio is positively related to the administered interest rate R and negatively related to the discount rate ρ. That is,

α=α(Rπ,ρπ),αR>0,αρ<0.

In other words, an increase in the administered interest rate (or a fall in the discount rate) raises the debt ratio by increasing the availability of investment credit through the banking system, thereby reducing the share of self-financed investments. The increased availability of investment credit need not lead to a higher debt ratio for individual firms if banks finance additional projects on the basis of predetermined debt-equity norms and let firms obtain the needed equity finance from the free markets (at the market-determined discount rate). In situations of severe financial repression, however, the debt ratio is likely to rise in response to an increase in the bank interest rate.

Using this assumption and differentiating, as before, the saving-investment equilibrium condition, one can readily show that interest rate policy would improve saving (dS/dR > 0) if and only if

[α+αR(Rρ)]/[(1α)+αρ(Rρ)]<η.

The above condition for improved saving is less stringent than in the case of a fixed debt ratio, and it may not even be binding if the interest sensitivity of the debt ratio (αR) is sufficiently large and positive. The less stringent results obtain because an increase in the debt ratio from the higher administered interest rate, and the accompanying increase in the share of cheaper source of funds available through the banking system, serve to lower the cost of capital and to raise investment incentives and saving. Moreover, the inequality above implies that the scope for raising saving and investment through interest rate policy becomes greater as the initial distortion in the interest rate becomes greater (that is, R - ρ is large) and the increase in the debt ratio in response to higher interest rates and financial savings also grows larger. Once the banking system reaches a certain size and sophistication, however, the scope for raising the debt ratio through further improvements in financial saving would be limited, debt-equity ratios would be governed more by decisions of firms and by the debt norms used by banks, and the assumption of a supply-determined debt ratio would no longer be appropriate. (Preliminary empirical evidence for the Republic of Korea suggests that the assumption of a supply-determined debt ratio is not a valid description of the debt behavior of firms.) The next section discusses the consequences of firms choosing the debt ratio optimally.

Optimal Choice of Debt Ratio

To highlight the effect of optimal debt decisions, foreign-currency debt will continue to be ignored. In addition, as before, the rate of amortization will be assumed to be variable so that the marginal and target average debt ratios are identical. Under these assumptions, the model determining saving, investment, and the optimal debt ratio can be stated as follows:

S(ρπ,Rπ)=I(rb)(1α)ρα=(ρR)rb=(1α)(ρπ+δ)+α(Rπ+δ).

The first equation is the equilibrium condition between saving and investment. The second equation is the first-order condition for the optimal choice of the debt ratio and implies that an increase in the controlled interest rate will reduce interest subsidy and thereby cause a reduction in the optimal debt ratio (in contrast to the increase in the debt ratio under financial repression, discussed in the previous subsection). The third is the expression for the real cost of capital. Noting that the discount rate is now implicitly a function of α and π, one can differentiate the two-equation system obtained by substituting rb into the first equation and derive the effects of inflation on the discount rate and the debt ratio. The differentiation yields

[Sρ(1α)IrIr(ρR)1(1α)ρααρα][dρ/dπdα/dπ]==[B1B2],(20)

where

B1=Sρ(1α)Ir+αIr(dR/dπ1)SR(dR/dπ1)B2=dR/dπ(1α)ραπ,

and ραπ is the derivative of ρα with respect to inflation π

The stability condition for the model has an interesting economic interpretation that points to the possible adverse effects of large interest subsidy. Stability requires that the determinant of the matrix on the left-hand side of equation (20) be positive. That is,

Δ={[Sρ(1α)Ir][(1α)ρααρα]}+Ir(ρR)>0.

The first term on the right-hand side above (in braces) is positive because the second-order condition for the optimal choice of debt ratio ensures that (1α)ρααρα>0. But the second term is negative, and its magnitude depends on the size of the implicit interest subsidy, ρ - R. The larger is the subsidy, the greater is the likelihood that instability would obtain. The instability would manifest itself in the following way. A substantial distortion in the financial market, causing a large implicit subsidy ρ - R, would induce firms to raise the debt ratio so as to capture the subsidy. This behavior in turn would raise the discount rate because of higher risk. The increase in the discount rate would raise the implicit subsidy, inducing firms to borrow even more. Only stringent credit rationing would limit the achievable debt ratio, and excess demand for credit would continue to persist. This possibility, which is a realistic description of many developing economies, will be ignored, and the stability condition Δ > 0 will be assumed to hold.

The model and the stability conditions are illustrated in Figure 2. The line FF shows the combinations of ρ and α that ensure equilibrium between saving and investment. An increase in the debt ratio lowers the cost of capital, raises investment, and pushes up the discount rate. Therefore the slope is positive. The line OD shows the optimal combinations of ρ and α that are consistent with the minimization of the cost of capital. An increase in p raises the implicit interest subsidy obtainable on debt and induces a larger debt ratio. Again the slope is positive. The intersection of the two curves indicates the equilibrium level of the discount rate and the debt ratio (ρ*, α*). The slope of the OD curve should be steeper than the FF curve if stability is to be ensured.

Figure 2.
Figure 2.

Debt Ratio and Discount Rate

Citation: IMF Staff Papers 1985, 003; 10.5089/9781451972863.024.A003

Solving equation system (20) allows the effect of inflation to be stated as follows:

dρ/dπ=1+1/Δ[[[Ir(ρR)(1α)ραπ]+(dR/dπ1){Ir(ρR)+[(1α)ρααρα](αIrSR)}]];(21)
dα/dπ=1/Δ[[{(1α)ραπ[(1α)IrSρ]}+(dR/dπ1){αIrSR+(1α)IrSρ]]].(21a)

The magnitude of the derivatives depends on, among other things, the sign and size of ραπ, which is the shift in risk premium attributable to a change in inflation. If higher inflation is associated with increased uncertainty, and investors therefore perceive greater risks, then ραπ>0. Under this assumption, equations (21) and (21a) imply that dρ/dπ < 1 and that dα/dπ < 0, whenever dR/dπ ≥ 1. Thus an increase in the rate of inflation leads to a reduction in the optimal debt ratio—a counterintuitive result—because of increased marginal risk premiums required by investors.8 The decline in the debt ratio in turn implies a reduction in the share of the cheaper source of finance, hence an increase in the overall cost of capital. This effect on the cost of capital, however, is partially offset by the reduction in the real discount rate.

The consequences of optimal choice of debt ratio are best illustrated if it is assumed that the real administered rate is kept unchanged (that is, dR/dπ = 1). Under this assumption, it is seen from equation (19) that when the debt ratio is fixed, and not adjusted optimally, the real discount rate remains unchanged, and saving and investment hence remain unaffected. In contrast, when the debt ratio is adjusted optimally, equation (21) implies that the real discount rate falls, thereby reducing saving and investment. A matching reduction in investment obtains because of the fall in debt ratio that leads to an increase in the real cost of capital. This apparently counterintuitive result—that the real cost of capital increases in the presence of optimal debt behavior designed to minimize the cost of capital, but not so when the debt ratio is fixed—is due mainly to the effect of inflation on the risk premium required by investors, an effect that was ignored in analyzing the case of the fixed debt ratio. Indeed, when the risk premium is not affected by inflation—so that ραπ=0equation (21) implies that as long as the real administered interest rate is kept unchanged the optimal debt ratio does not change, and the real discount rate also remains unaffected—just as in the case of the fixed debt ratio.

If the controlled interest rate is raised by more than the increase in inflation, then the issue of the effect on saving under optimal debt policy can be analyzed by examining the sign of

dS/dπ=Sρ(dρ/dπ1)+SR(dR/dρ1).

Substituting from equation (21), it can be verified that saving will improve if and only if

α/(1α)<ηρα/{(1α)[(1α)ραα2ρα]}.

From the second-order condition for optimal debt ratio it is known that the second term on the right-hand side of the above inequality is positive. Thus, when debt is chosen optimally, the critical upper limit on the debt-equity ratio is smaller than in the case of the fixed debt ratio. This tighter upper limit on the debt-equity ratio continues to apply as the condition for an increase in the controlled interest rate to improve saving, even when there is no change in inflation. In other words, the likelihood that an active interest rate policy will have adverse effects on saving increases when firms choose the debt ratio optimally.

Predetermined Amortization Schedule

If the rate of amortization on loans cannot be adjusted when inflation accelerates, then the real value of amortization payments will be reduced, and the average and marginal debt ratios will begin to diverge. To understand the implications of these developments, it is convenient to abstract from the existence of foreign-currency debt and to assume that all debt is denominated in domestic currency and offered at the rate R, which is lower than the discount rate ρ. Firms strive to reach an average debt ratio in the long run, however, and therefore adjust the marginal debt ratio in line with inflation and growth prospects. For simplicity it will be assumed that the average debt ratio a is a predetermined target and is not chosen optimally. Under these assumptions, the cost of capital can be expressed as

rb=[1αc(π)](ρπ+δ)+αc(π)R+aρ+a(ρπ+δ),

where

c(π)=(g + π + a)/g + δ

The differentiation of the saving-investment equilibrium condition with respect to inflation yields

dρ/dπ=1+[Ir(A4A2+A3)SR(dR/dπ1)SρIr(1A1A4)],(22)

where

A1αc(π)ρRρ+a;A2αc(π)ρπ+δρ+a.dRdπA¯2dRdπ;A3α1g+δρRρ+a;A4αc(π)R+a(ρ+a)2(ρπ+δ).

An analysis of the expression above reveals that the size of the Fisher effect depends not only on interest rate policy (dR/dπ), but also on whether the real discount rate initially exceeds or falls short of the expected real growth of capital stock. This result can be summarized as follows:

(dp/dπ), > 1

if and only if

dR/dπ<1+[AIr/SR+A¯2Ir],

where

A=α(ρπ+δ)(ρR)(ρπg)(ρ+a)2(g+δ).

The implication of this result is best illustrated when dR/dπ = 1. In this case,

dρ/dπ<1ifρπ<g;dρ/dπ>1ifρπ>g.(22a)

Thus, when the administered rate is maintained in real terms, the real discount rate would rise, and so would saving and investment, if initially the real discount rate is greater than the expected growth of capital stock. Otherwise the real discount rate would fall, and with it saving and investment. These results imply that, with a fixed amortization rate and a real discount rate that is large to begin with, inflation will make the real discount rate even larger, and the slope of the IS curve will become steeper as the discount rate rises, possibly intersecting the LM curve twice. The intersection corresponding to the higher discount rate will be unstable because of the steeper slope of the IS curve when the discount rate is large (see equations (22) and (22a)).

The dependence of the effects of macroeconomic policies on the size of the real discount rate is related to two conflicting forces that act on the real cost of capital when the rate of amortization is fixed. If both the discount rate and the controlled interest rate are assumed to increase temporarily as inflation rises, by the same amount as inflation, it follows that the present value of debt service costs—R + a/ρ + a—also increases, thereby raising the cost of capital. But the increase in inflation induces a larger use of debt at the margin, and the marginal debt ratio—α(g + π + a)/(g + δ)—increases, thereby lowering the cost of capital. The net effect on the cost of capital depends on the initial size of ρ, which affects the present value of debt service in relation to the expected magnitude of the growth in assets (g + π), which in turn affects the marginal debt ratio.

The conditions under which saving improves in response to interest rate policy depends, as before, on the size of the debt-equity ratio, but the critical limit on this ratio is influenced not only by the initial size of the discount rate, and of the interest rate, but also by interest rate policy. In more formal terms, if it is assumed that dR/dπ > 1, the condition for improvement in saving and investment is

dS/dπ > 0

if and only if

(α/1α)(1B)<η,(23)

where

B=(ρgπ)(ρR)(dR/dπ1)(g+δ)(ρ+a).

Note that the limit on the debt-equity ratio has been derived by evaluating the derivative at a = δ - π. Without this simplifying assumption, the expressions become more complex, but the conclusions remain unaffected.

If ρ - π > g, then B is positive and can be extremely large for small increments in the real controlled interest rate. In this case the condition for improved saving will always hold because the left-hand side of inequality (23) is negative. Moreover, for large changes in the real controlled interest rate, the improvement in saving depends on a much less stringent condition on the debt ratio than in the case of flexible amortization. If ρ - π < g, then B is negative, and the condition on the size of the debt ratio is much more stringent than in the case of flexible amortization. The earlier condition p—ρ - π > g, however, is most likely to hold under normal circumstances: the larger is the real discount rate, the more efficient is the use of capital stock, implying that, for any given target of output growth, the required growth in real capital stock is likely to be less. This association of a larger real discount rate ρ - π with a smaller real asset expansion g would lead to the condition ρ - π > g. In any case, the results clearly demonstrate that, depending on the initial conditions in the financial markets and of interest rate policy, the behavior of the rate of amortization can make an important difference to the impact of interest rate policy.

As in previous cases, the effect of interest rate policy, unaccompanied by a change in inflation, is also governed by the size of the debt-equity ratio. An increase in the administered interest rate will improve saving if and only if

αc(π)/[1 − αc(π)] < η,

where, as before, η is the interest-sensitivity ratio. The upper limit η now applies to the marginal debt-equity ratio. Because the rate of amortization is assumed to be fixed, the average and marginal debt ratios can diverge. Therefore, although the average debt ratio is not large (in relation to η), it is conceivable that a high level of inflation and the associated credit policies induce a large marginal use of debt. If so, an increase in the controlled interest rate could lead to adverse effects on the cost of capital and saving. The analysis suggests that such adverse effects can be mitigated by allowing for a more flexible amortization schedule and, at the same time, restraining the share of debt in project finance. If the average debt ratio is already quite large, however, the adverse effects cannot be avoided.

It is legitimate to ask why firms would try to achieve the target for the average debt ratio by raising the marginal ratio in line with an increase in inflation, when the target can be readily reached by simply amortizing the existing loans at a slower rate (the importance of such funding operations for the validity of the formulas for the weighted-average cost of capital is noted in Linke and Kim (1974) and Beranek (1975)). From the firm’s point of view, the latter option may be preferable—if it is available—but the option chosen will depend on particular institutional circumstances and historical practices. For example, many countries impose norms on debt-equity ratios for project finance, a practice that would restrict the freedom at the margin. If firms have extensive overdraft facilities with banks, then the rate of amortization can be easily adjusted by varying the use of overdraft limits. Often it may be easier to raise a loan that is a larger than normal fraction of the project’s current value than to obtain rollover credits for the principal amounts falling due. Depending on which option is the norm—or on how the marginal debt ratio is determined—the impact of interest rate policy will be changed. 9 Such differences in the effects of policies can be significant, as has been demonstrated.

Foreign-Currency Debt with Predetermined Target Debt Ratio and Fixed Amortization Rate

To highlight the effect of foreign-currency debt on the cost of capital, considerations of optimal choice of debt are ignored. The average domestic- and foreign-currency debt ratios are given as targets that remain fixed. Domestic and foreign interest rates are allowed to diverge by assuming that capital mobility is subject to restrictions. In view of the limited, and often uncertain, access to international capital markets in many developing countries, the rate of amortization of foreign-currency loans is assumed to be fixed. Amortization of domestic-currency loans, however, is assumed to be flexible, so that the marginal and average domestic debt ratios are identical. Under these assumptions, the cost of capital is given by:

rb={[1αβα(1β)C2(πw,θ)](ρπ+δ)}+αβ(Rdπ+δ)+α(1β)C2(πw,θ)[(Rf+af)/(ρ+afx)](ρπ+δ),(24)

where

C2w, θ) = (af + πw − θ + g)/(g + δ).

The expression above reveals that the cost of capital depends on, among other things, the expected rates of increase in the nominal and real exchange rates, which influence the present value of the debt service on foreign-currency loans as well as the share of such loans in investment finance. This relation suggests that the type of exchange rate regime influences the effect of interest rate policies.

First, suppose that the expected change in the nominal exchange rate is fixed a priori. This would be the case when the nominal exchange rate is pegged to a currency basket (x = 0) or, for instance, the path of the depreciation of the nominal exchange rate is preannounced (x > 0) independently of other relevant variables. Under such exchange rate regimes, the expected change in the real exchange rate varies with inflation and thereby influences the marginal debt ratio (that is, C2 varies with θ). Differentiating the saving-investment equilibrium condition allows the Fisher effect to be obtained as

dρ/dπ1=1/Δ[(dR/dπ1)(SR+αβIr)+D2Ir],(25)

where

Δ=Sρ{[1αβα(1β)C2]+D1}Ir>0D1=α(1β)C2[(Rf+af)/(ρ+afx)2](af+πδx)D2=α(1β)[(ρπ+δ)/(g+δ)]{[(Rf+af)(ρπg)]/(ρ+afx)21}<0.

With the terms of equation (25) rearranged, it can be verified that

dρ/dπ > 1

if and only if

dR/dπ<1+[D2Ir/(SRαβIr)].(26)

The sign of the term D2 is in general negative. Only when the foreign interest rate substantially exceeds the domestic discount rate would D2 be positive. The likelihood of this happening in a developing economy is quite remote. Therefore, equation (26) implies that the real discount rate will increase with inflation as long as the controlled interest rate is not increased by significantly more than the increase in inflation. In other words, when the real controlled interest rate is raised slightly, but within limits set by equation (26), saving will improve because the induced increase in the real discount rate will reinforce the positive impact on saving of a rise in the controlled interest rate. Despite the increases in real interest rates, a matching increase in investment occurs because the real cost of capital actually falls—owing both to an increase in the share of foreign-currency loans, which is cheaper than domestic equity, and to the rise in the nominal discount rate, which reduces the opportunity cost of external debt service payments.

The result is illustrated in Figure 3 for the special case of dR/dπ = 1. When inflation rises from π0 to π1, the saving schedule either remains fixed or shifts to the right, to the extent that foreign saving (current account deficit) increases because of the appreciation of the real exchange rate. The investment schedule also shifts to the right, thereby raising saving and investment. The upward shift in investment can be deduced from equation (24), in which the present value of the projected debt service payments on external loans is given by the expression [(Rf + af)/(ρ + af - x)]. This term is clearly reduced (thereby reducing the cost of capital) when p increases because of higher inflation, but x remains fixed. Moreover, the share of foreign-currency debt in financing investment rises because of the appreciation of the real exchange rate (θ falls, raising C2; the increased share of foreign-currency debt in financing investment may be facilitated by the increase in foreign savings, but this need not be the case). This development also reduces the cost of capital and contributes to the upward shift in investment.

Figure 3.
Figure 3.

Effect of Increase in Inflation Given Foreign-Currency Debt and Fixed Nominal Exchange Rates

Citation: IMF Staff Papers 1985, 003; 10.5089/9781451972863.024.A003

Conditions under which saving and investment improve can be summarized as follows. With dR/dπ > 1 and foreign saving assumed to be fixed, 10 saving will improve (dS/dπ > 0) if and only if

αβ/(1α¯+D1)<η+[D2/(dR/dπ1)(1α¯+D1)],(27)

where

1 − ᾱ = 1 − αβ − α(1 α β)C2.

The left-hand side of inequality (27) is approximately the ratio of domestic-currency debt to equity. The right-hand side is the sum of the interest-sensitivity ratio and a positive term. This positive term is quite large when dR/dπ is close to unity, and inequality (27) always holds; therefore, saving improves regardless of the size of the debt ratios. When the controlled rate is raised substantially in real terms, however, the size of the debt ratio becomes binding. But the upper limit on the debt ratio now applies only to domestic debt; moreover, the limit is larger than in the case of no foreign-currency debt.

When the controlled interest rate is allowed to decline in real terms as inflation rises (or is allowed to rise as inflation falls), inequality (27) is necessary and sufficient to ensure a reduction in saving and an increase in the real cost of capital. This underscores the need for an active interest rate policy in the presence of substantial use of foreign-currency debt. If foreign-currency debt is substantial and the domestic debt ratio is therefore small enough to satisfy inequality (27), then the emergence of a negative interest rate (owing to increased inflation) will reduce investment, thus producing precisely the opposite of the effect intended.

When there is no change in inflation, interest rate policy will improve saving if and only if the domestic debt ratio is sufficiently small:

αβ/[1αβα(1β)C2+D1]<η.(28)

It is important to note that, even if the average domestic debt ratio a£ is small, the above inequality may be violated if, at the margin, firms use substantial amounts of foreign currency loans to finance investment in the hope that the debt ratio will revert to target levels in the long run. In this case the left-hand side of inequality (28) could become large (that is, C2 is quite large because of high growth and expectations of inflation), thereby violating the necessary (and sufficient) condition for ensuring positive saving response. This type of adverse outcome for interest rate policy can be avoided if foreign-currency loans can be amortized more flexibly, thereby permitting a reduction in marginal debt ratios.

So far the analysis has been based on the assumption that the path of the nominal exchange rate is fixed. Similar analysis can be readily completed under the assumption that the real exchange rate (or its rate of change) is fixed a priori, so that the nominal exchange rate varies with changes in inflation. Therefore, the present value of external debt service payments varies because of changes in the nominal exchange rate, but the marginal share of foreign-currency debt remains unaffected (C2 does not change, since πw, and θ remain fixed). As a result, the effects of interest rate policy turn out to be different from the case of a fixed nominal exchange rate. But the safe limit on the domestic debt ratio remains as that shown in inequality (28), which now applies to both the pure interest rate action as well as to interest rate responses to changes in inflation. Thus, irrespective of the exchange rate regime, the availability of foreign-currency loans serves to ease the constraint governing the improvement of saving and investment through interest rate policy.

The discussion above suggests that the impact of interest rate policy can be sensitive to the exchange rate regime. Proper analysis of this aspect of interest policy, however, would require the explicit incorporation of the effect of exchange rates on inflation, output, and capital flows. Such analysis is beyond the scope of the present paper.

III. Conclusions and Policy Implications

In many developing countries, enterprises rely largely on debt finance. Equity capital remains scarce, in part because the banking system and (in some cases) the unregulated segments of the financial system such as the curb markets have together provided substitutes for stock issue in the form of long- and short-term loans, whereas the flow of foreign saving has been mainly in the form of debt rather than equity. For example, the average debt-equity ratio of firms in the industrial sector in the Republic of Korea has grown from about 100 percent in the early 1960s to about 500 percent in recent years, in part because of the rapid growth of the banking system after interest rate reform in 1965. The resultant overleveraged financial structure of firms is often perceived to restrict the economic policy options open to the authorities. The purpose of this paper has been to analyze the macroeconomic consequences that flow from enterprises financing their investment with a large share of debt in relation to equity.

For this purpose, the paper developed a model of saving, investment, portfolio adjustments, and the debt ratio in developing countries that are characterized by segmented financial markets, controls on the banking system, and substantial reliance on debt, including external debt. The financial structure of firms, and plausible behavioral assumptions regarding how firms adjust their financing patterns, were explicitly built into the model by appropriately defining the cost of capital in developing economies, thereby emphasizing the linkage between debt behavior and incentives for saving and investment. The model was used to analyze the impact of interest rate policy on stability and growth.

The major conclusions of the analysis are as follows. The debt-equity ratios of firms make a sizable difference for the impact of stabilization policies, particularly of interest rate policies. When debt ratios used by firms are large, pursuit by the authorities of a passive interest rate policy—that is, maintenance of the controlled interest rate unchanged when inflation changes—can lead to macroeconomic instability that is characterized by perverse effects of monetary policy and accelerating inflation or deflation. Therefore, in economies in which firms tend to have a large debt-equity ratio, appropriate adjustments in the real administered interest rate become necessary to achieve macroeconomic stability. The impact of such action on saving and investment, however, is conditioned by the relative shares of domestic- and foreign-currency debt and by the ability of firms to adjust these relative shares and to change the debt ratio in general.

There usually exists a safe upper limit on the debt-equity ratio of firms in the aggregate, defined as the limit that, if exceeded, leads to perverse effects on saving and investment when the real interest rate is raised. This limit depends mainly on the interest sensitivity of saving, but it is also influenced by a host of other considerations, including the initial conditions in domestic financial markets, the ability of firms to adjust the rate of amortization and the target debt ratio, the terms and availability of foreign-currency loans, and the size of the increase in the controlled interest rate. For example, when the debt ratio is governed primarily by the availability of financial saving—as would be the case in a financially repressed environment—the safe limit on the debt-equity ratio becomes less stringent than in the case of a fixed debt ratio. In contrast, more stringent limits apply when the debt ratio is determined by demand, so that firms are able to adjust the debt-equity ratio optimally to balance the benefits of additional subsidized credit from banks with the associated costs arising from the increased riskiness of investment. A more stringent limit also applies when the rate of amortization is fixed and the discount rate is low. The availability of foreign capital, however, serves to ease the constraint on the debt-equity ratio.

When the debt ratio exceeds the safe limit, appropriate increases in the real interest rate to ensure stability would also involve considerable cost in growth forgone. Because of this high cost, maintenance of low and stable inflation is the optimal policy in economies with firms relying on high leverage.

In view of the significant implications of the debt-equity mix used by firms, an evaluation of the financial structure of firms and the institutional framework of the financial system that underlies such structure is important for a proper assessment of the impact of stabilization policies. Often the effectiveness of stabilization policies, particularly of interest rate policies, can be enhanced by implementing appropriate financial reform measures that include steps to reduce the debt-equity ratios of firms. To the extent that the financing patterns used by firms are conditioned by the institutional framework of the financial system, substantial changes in the debt-equity mix can be brought about only in the long run through institutional reforms (for example, through promoting corporate saving, developing capital markets, and establishing debt-equity norms). An assessment of the safe limit on the debt-equity ratio that is based on the macroeconomic framework suggested in the paper can help to devise debt-equity norms for project finance and to decide the extent to which the reforms of the financial system should emphasize a restructuring of company finance. In any event, the financial reform package should strive to reduce segmentation of the financial markets and to reduce interest subsidy because, as demonstrated in the paper, such actions can also contribute to macroeconomic stability, improve the effectiveness of interest rate policy, and eventually reduce the cost, in growth forgone, of stabilization policies. In addition, appropriate adjustments in lending practices relating to the rollover of credits, both domestic and foreign, and to the provision of adequate access to foreign capital can complement stabilization policies in a significant way.

APPENDIX I: Derivation of the Expression for Real Cost of Capital

Two approaches to the derivation of the equation for real capital cost are considered. The first is based on an optimal control technique, the second on the well-known Modigliani-Miller (1963) theorem (their proposition I).

Optimal Control Approach

The problem is to minimize total cost,

0exp(ρt)[C(Q*,K)+(1α)IP+(Rd+ad)G+(Rf+af)FE]dt,

with respect to the control variable I, subject to the following differential equations on the state variables K, G, and F:

K˙=IδK(29)
G˙=αβIPadG(30)
F˙=1/Eα(1β)IPafF.(31)

The notation is explained below (for convenience, the time subscript as well as the superscript m to denote the marginal ratio have been omitted):

article image

The Hamiltonian for the control problem is

H=exp(ρt)[C(Q*,K)+(1α)IP+(Rd+ad)G+(Rf+af)FE]+λ1[IδK]+λ2[IPadG]+λ3[(1β)IP/EafF].

The first-order conditions are given by

λ˙1=H/K=[exp(ρt)C/Kλ1δ](32)
λ˙2=H/G=(Rd+ad)exp(ρt)λ2ad(33)
λ˙3=H/F=[(Rf+af)Eexp(ρt)λ3af](34)
0=H/I=(1α)Pexp(ρt)+λ1+λ2αβP+λ3(1β)P/E.(35)

Solving the differential equations (33) and (34) yields the present value of one unit of domestic-currency loan,

λ2exp(ρt)=(Rd+ad)/(ρ+ad),(36)

and the present value in foreign currency of one unit of foreign-currency loan,

λ3exp(ρt)/Et=(Rf+af)/(ρ+afx).(37)

It is assumed that the exchange rate at time t is given by Et = E0 exp (xt), where x is the expected rate of change in the nominal exchange rate.

Substituting the values of λ2 and λ3 given in equations (36) and (37) into equation (35) and regrouping terms allows λ1 to be expressed as

λ1=(1α)exp[(ρπ)t]exp[(ρπ)t]{αβ[(Rd+ad)/(ρ+ad)]+α(1β)[(Rf+af)/(ρ+afx)]},(38)

where the price level P is entered as exp (πt), with π denoting the rate of inflation. The initial price level has been normalized to unity.

Differentiating both sides of equation (38) with respect to time allows an alternative expression for λ˙1 to be given by

λ˙1=(1α)(ρπ)exp[(ρπ)t]+{αβ[(Rd+ad)/(ρ+ad)]+α(1β)[(Rf+af)/(ρ+afx)]}(ρπ)exp[(ρπ)t].(39)

On substituting equations (38) and (39) into equation (32) and rewriting, it is seen that along the optimal path the following relation should hold:

exp(πt)C/K=(1α)(ρπ+δ)+{αβ[(Rd+ad)/(ρ+ad)]+α(1β)[(Rf+af)/(ρ+afx)]}(ρπ+δ)rb,(40)

where rb is the real cost of capital.

In the special case when there is no foreign-currency loan (β = 1), the cost of capital can be written as

rb=(1α)(ρπ+δ)+α[(Rd+ad)/(ρ+ad)](ρπ+δ).(41)

Modigliani-Miller Approach

An alternative approach to deriving the cost of capital formula (41) is based on proposition I of Modigliani and Miller (1963). For simplicity the role of foreign-currency debt will be ignored.

Consider a project, with an earnings stream given by X exp [(π - δ)t], that is financed by an initial debt D0 that is amortized at the rate a. Thus, the stream of debt outstanding over time is given by D0 exp (-at). As before, π is the rate of inflation (perfectly anticipated), but δ now stands for the rate of output decay (deriving from the real economic depreciation of the underlying equipment). Let S denote the value of equity and V the value of the project. By definition,

S=0[X¯exp(πδ)t(R+a)D0exp(at)]exp(ρt),(42)

where ρ is the required return to equity from the point of view of the equity investors in the project, and R is the rate of interest on debt. From Modigliani and Miller’s proposition I, the overall cost of capital c0 is fixed given the risk characteristics of the project. Therefore, the value of the project is given by

V=0X¯exp[(πδ)t]exp(c0t)=X¯/(c0π+d),(43)

which should equal, at the margin, the total initial cost of the project, I. Assume that a proportion α of the initial cost of the project is financed by debt; for the marginal project,

D0=αV=αX¯/(c0π+δ).(44)

Because by definition V = S + D0, substituting from equations (42), (43), and (44) and solving for c0 yields

c0π+δ=(1α)(ρπ+δ)+α[(R+a)/(ρ+a)(ρπ+δ)].(45)

This is exactly the expression for cost of capital shown in equation (41) obtained from the optimization exercise.

An interesting implication of equation (45) is that the required return to equity ρ is a nonlinear function of a for any given c0, π δ, and with a ≠ δ - π. When a = δ - π, then the familiar linear function derived in Modigliani and Miller’s proposition II is obtained. With the assumption that a ≠ δ - π, the required return to equity ρ is the positive root of the following quadratic equation:

0 = (1 − α)ρ2 + ρ[(1 − α)(δ − π) + αRd + adc0] + [(αRd + ad)(δ − π) − coad].

APPENDIX II: Relation Between Marginal and Average Debt Ratios

First the relation between the marginal and average debt ratios will be derived. Solving the differential equation (30) of Appendix I allows the level of domestic debt of a firm to be expressed as

Gt=exp(adt)αmd0texp[(ad+π)s](K˙+δK)ds+G0,(46)

where G0 is the initial level of debt, assumed to be zero, and αmd is the marginal debt ratio for domestic loans. Integrating by parts allows equation (46) to be rewritten as

Gt=αmdKtexp(πt)+αmdexp(adt)(δπad)0tKsexp[(π+ad)s]ds.(47)

If it is assumed for simplicity that real capital stock is expected to grow at the rate g, so that Ks = K0 exp (gs), then

Gt=αmdKtexp(πt)+αmdexp(adt)(δπad)/(π+ad+g)K0{exp[(π+ad+g)t]1}.(47a)

By using equation (47a), the average debt ratio αtad at time t can be expressed as

αtad=Gt/Ktexp(πt)αmd+αmd[(δπad)/(π+ad+g)]αmd[(δπad)/(π+ad+g)]exp[(g+π+ad)t].(47b)

In the long run, the last term of the above equation approaches zero, and the following relation between the average and marginal debt ratios emerges:

αad = αmd[(g + δ)/(π + ad + g)].

This is equation (10) of the text, in which αad is the limit of αtad as t tends to infinity.

A similar analysis for external debt (by solving equation (31) of Appendix I) yields

Ft=αm(1β)Kt(1/E0)exp[(πx)t]+exp(aft)αm(1β)(1/E0)(δafπ+x)0tKsexp[(af+πx)s]ds,(48)

where E0 is the initial exchange rate, and x denotes the expected rate of increase in the nominal exchange rate. Therefore E0 exp (xt) denotes the exchange rate expected at time t. From equation (48) it is clear that, when the rate of amortization on foreign loans af equals δ - π + x, the average external debt ratio FtEt/Kt · exp (πt) equals the marginal ratio αmf. The condition af = δ - π + x reduces to af = δ - πw + θ if the real exchange rate is expected to change at the rate θ, so that x = π - πw + θ, where πw, is the foreign rate of inflation. It will be assumed that the rate of foreign inflation and the rate of amortization of foreign loans are fixed. With the procedure as before, it can be verified that the marginal and the long-run average external debt ratios are related as follows:

αmf = αaf[(af + π − x + g)/(g + δ)] = αaf[(af + πw − θ + g)/(g + δ)].

This is the same as equation (11) of the text.

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*

Mr. Sundararajan, Advisor in the Central Banking Department, is a graduate of the Indian Statistical Institute and Harvard University.

1

For a survey of this literature, see Nickell (1978) and Beranek (1981); the basic reference on the subject is Modigliani and Miller (1963).

2

The assumption that the debt ratio would rise with larger financial savings would be reasonable mainly when debt ratios are initially small because of the low level of financial saving and high level of self-finance. This is the case of financial repression. The focus of this paper, however, is on situations in which debt ratios are relatively high.

3

See Appendix II for the derivation of equation (10). The particular functional form has been used for analytical convenience only, despite its limitation that the marginal debt ratio can exceed unity when inflation is large. A more satisfactory specification, linking the marginal ratio to the target average ratio, the rate of inflation, and other variables, would complicate the analysis without materially affecting the main results.

4

For example, see Feldstein, Green, and Sheshinski (1978); Feldstein and Green (1979); and Ericksson (1980). Myers (1977) and Kim (1978) contain interesting discussions of the reasons that the riskiness of returns from equity, and hence the required rate of discount, rises with increased use of debt. For a brief summary of this literature on the supply side of debt, see Modigliani (1982).

5

Ideally, the debt ratio should be treated as a control variable along with the rate of investment, and the full optimal control problem of minimizing the present value of costs should be solved by using the appropriate constraints on control variables. The problem has been simplified by assuming that the marginal and the target average debt ratios are linearly related. For an analysis of debt policy under the optimal control framework, see Ekman (1982), which also contains a detailed bibliography on this area of research. In most of these studies, the rate of interest is assumed to vary with debt, whereas the cost of equity is fixed. In the problem considerd here, the cost of equity varies with debt, whereas the interest rate is fixed by policy. This considerably complicates an optimal control approach to the problem.

6

Marginal and average debt ratios will be equal if ad = δ - π and af = δ - π + x, so that c1(π) = caw, θ) = 1. These conditions require that firms operate in a well-developed domestic financial system, with easy access to international capital markets, so that the maturity of loans can be readily adjusted in line with inflation and the rate of depreciation of assets. Therefore, the equality of marginal and average debt ratios will be an unrealistic assumption for most developing countries.

7

McKinnon emphasizes the complementarity between financial saving and investment that arises from the “conduit” effect, whereas Galbis emphasizes the improved efficiency of investment allocation that arises from increased financial intermediation.

8

Gordon (1982) has analyzed the effect of inflation on the debt ratio in the U.S. economy. Preliminary empirical tests suggest that ραπ>0 is a valid assumption for the Republic of Korea. The sign will probably depend on the level of inflation, and no a priori judgments are possible.

9

In this subsection the marginal debt ratio has been assumed to depend on the target average debt ratio, the rate of inflation, the rate of growth, the rate of amortization, and the rate of depreciation. More interesting formulations are possible. For example, the rate of amortization or the average maturity of loans can be made a function of growth and interest rates. For a discussion of the determinants of the rate of amortization of corporate debt in the United States, see Morris (1976).

10

The assumption of fixed foreign saving is for expository convenience only. Making foreign saving a function of the real exchange rate does not alter the qualitative conclusions about the effects of interest rates and exchange rate policy on investment.

IMF Staff papers: Volume 32 No. 3
Author: International Monetary Fund. Research Dept.