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.
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).
APPENDIX II: Relation Between Marginal and Average Debt Ratios
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
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
By using equation (47a), the average debt ratio
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
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.
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.
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.
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).
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.
Marginal and average debt ratios will be equal if ad = δ - π and af = δ - π + x, so that c1(π) = ca (πw, 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.
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.
Gordon (1982) has analyzed the effect of inflation on the debt ratio in the U.S. economy. Preliminary empirical tests suggest that
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).
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.