THE MAIN PURPOSE of the paper is to analyze empirically the impact of interest rates on the overall cost of capital, saving, investment, and growth in the Korean economy during 1963–81. The analysis takes into account the simultaneous linkages between these variables. Among the various linkages, the paper emphasizes the relationship between interest rates and the financial structure of firms, and highlights the interdependence between financing and real decisions of firms, and the consequences of this interdependence for the effectiveness of interest rate policy.
It is by now well recognized that a proper analysis of the role of interest rates requires a dynamic framework that recognizes the complex interactions between saving, investment, and growth.1 Single-equation analysis of saving or investment often provides a misleading and inconclusive picture of the effectiveness of interest rate policy, because such analysis focuses only on the immediate and direct effects of interest rates, and the identification of these effects is fraught with a host of theoretical and econometric complications. Only on the basis of a well-specified, simultaneous-equation framework can the dynamic effects of interest rate policies be studied, and the relative importance of the direct as well as indirect channels through which interest rates affect growth be understood. The model developed in this paper provides an integrated framework that incorporates the effects of interest rates—both the administered rate in the banking system and the rate in the unregulated financial market—operating through their influence on the cost of capital to investors as well as on returns to various groups of savers. A change in the administered interest rate affects the unregulated rate, the debt-equity choice of firms, the overall cost of capital, and real interest rates, and thereby sets in motion a chain of responses influencing the desired level of the capital stock and its productivity, as well as the availability of saving and the consequent speed of adjustment of the actual capital stock to the desired level. Thus, the model incorporates various channels of effects that are emphasized in the classical and modern theories of interest rates.2
The Korean economy offers 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 increased from about 100 percent in the early 1960s to about 500 percent in recent years.3 Policymakers in Korea have in general held the view that the resultant, over-leveraged 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.4 The analytical rationale for policies to reduce the heavy reliance on debt is contained in Sundararajan (1985), where the macroeconomic consequences of the financial structure of firms in developing countries is analyzed, based on a stylized model applying to countries such as Korea.
The debt-equity ratio is important because the overall cost of capital to investors—which influences fixed investment, its efficiency, and profits—can be expressed as a weighted sum of the opportunity cost of bank debt and that of equity, with the weights depending upon the debt-equity ratio. Therefore, the multiplier effects on the overall cost of capital, and, hence, on investment incentives and the productivity of capital, of changes in the cost of bank debt (that is, the administered interest rate) depends, among other things, on the share of debt in investment financing, and on the induced adjustments in this share and in the cost of equity. In addition, empirical estimates show that the cost of equity, approximated by the unregulated rate, incorporates a risk premium which first falls and then rises as the debt-equity ratio rises. The resulting U-shaped, cost of capital schedule is shown to have far-reaching implications for the effectiveness of interest rate policy.
In contrast to the above findings, the well-known Modigliani-Miller theorem states that the cost of capital is independent of the financing mix (the debt-equity ratio) in a world with rational investors, perfect capital markets, no taxes, and no default or bankruptcy risks. In this framework, a firm’s investment decisions are independent of financing decisions, and a unique optimal debt-ratio does not exist, with the actual ratio representing a corner solution. Since these implications are both counterfactual and counterintuitive, the Modigliani-Miller theorem has given rise to a large body of theoretical work focusing on the determinants of the financing mix used by firms. It is by now well recognized that due to default and bankruptcy risks, due to the costs of institutional arrangements needed to protect creditors (agency costs), and due to the possibility in a growing economy that valuable investment opportunities would be forgone in the presence of large debt-service commitments, there exists an optimum debt-equity mix for firms. In other words, the cost of capital depends upon the debt-equity mix first falling and then rising as the debt ratio rises. As a result, the financing and real decisions are no longer independent. For references to this literature and a brief survey, see Modigliani (1982). Thus, the effect of the debt ratio on the cost of capital is essentially an empirical issue.
If this effect is significant, the implied interdependence between financing and real decisions necessarily complicates the task of a model builder, who must now specify a model of financing decisions of firms in order to assess properly the impact of interest rates on the real economy. The novel feature of this paper is to address the complexity of modeling financing decisions of firms, and thereby assess the empirical significance of the interdependence of financing and real decisions for the first time in the context of a developing economy.
The different channels of influence of interest rates are first specified and estimated, and the complete model is then simulated to assess the impact of interest rate policy. Model simulations reveal that the direct effects of interest rates on saving and investment are either reinforced or offset by the substantial indirect effects arising from the optimal adjustments in the debt-equity ratios. An increase in the regulated interest rate reduces the implicit interest subsidy, and hence induces a fall in the debt-equity ratio. Given the estimated U-shaped, cost of capital schedule, when the initial debt ratio is sufficiently small, as in earlier years, the actions of firms to reduce the debt ratio raises the overall cost of capital and reinforces its increase due to higher interest rates. In contrast, when the debt ratio is sufficiently large, as in more recent years, the fall in the debt ratio reduces the unregulated rate and the cost of capital in line with the U-shaped schedule, and offsets their normal increase. This offsetting effect is indeed substantial, producing weak or even perverse multiplier effects of interest rates on saving and growth. In other words, the effectiveness of interest rate policy has become substantially weakened in recent years owing primarily to the large corporate debt ratios that now prevail.
Derivation of the Optimal Debt-Equity Ratio
Assuming for simplicity that in the computation of the optimal debt ratio firms regard the marginal and average debt ratios to be identical, the weighted average cost of capital can be written as,
where α = the common value of the average and marginal debt ratio (αm = αa = α), and
First, the expression for Rc will be rewritten in terms of the debt-equity ratio DE. For this purpose, the following considerations are relevant. The average and marginal debt ratio refers only to the financing of fixed assets, whereas the debt-equity ratio DE reflects the financing mix governing both fixed and current assets. While α is relevant in defining the cost of capital for fixed capital formation, the overall debt-equity ratio is relevant in assessing the riskiness of firms and the cost of equity iu. By assumption, fixed assets are financed by debt from the regulated financial markets as well as equity, while current assets are financed entirely by debt, including the debt to the unregulated market. Assuming, in addition, that the ratio of current assets to fixed assets is exogenous to the model, the following relationship between α and DE can be verified,
Thus, there is a unique one-to-one relationship between a and DE. Substituting equation (31) into the expression for Rc and simplifying yields:
where R denotes other factors which are independent of the debt-equity ratio.
Differentiating the above expression with respect to DE, and equating the derivative to zero yields the first-order condition which can be simplified to:
Computing the required derivative from equation (30) yields:
Substituting the above derivative into equation (32) gives the quadratic equation:
where a=2U6, b = U5 + 2U6+ U7∏, c = (iu+U5+ U7∏ The positive root of the above expression, given by
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Mr. Sundararajan, Chief, Economics Division of the Central Banking Department, is a graduate of the Indian Statistical Institute and Harvard University.
For a discussion of alternative models of interest rate policy in developing countries, see Galbis (1982).
Throughout the paper, debt ratio (α) refers to the ratio of total liabilities to total assets, and the debt-equity ratio (DE) 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 DE = α/1 − α.
Owing to restrictions on capital flows, both the volume of foreign currency debt and external interest rates are treated as exogenous, and the effect of external interest rates on domestic rates is ignored.
For a statement of the optimal control problem used to derive the expression for the cost of capital, see Sundararajan (1985).
In anticipation of empirical results, it is assumed that loans from the unregulated market are not used in financing fixed investment. Fixed assets are financed by debt from the regulated financial system (bank debt and foreign currency loans) and by equity, while current assets are financed entirely by debt, including unregulated market debt. This is the assumption used throughout the paper and its relevance is tested in the empirical section of the paper.
It is interesting to note that although the long-term unregulated rate—the integrai of the short-term unregulated market rates—is relevant for discounting future cash flows, the appropriate interest rate for defining the user cost of capital is the short-term rate. The appropriateness of the short-term rate is emphasized in Hall (1977), based on a discrete time framework.
This technique of introducing variability in the speed of adjustment is similar to the one used by Coen (1971).
By specifying output as a function of capital stock and real factor prices—instead of capital stock and labor—an explicit modeling of the labor market has been avoided. Such modeling is beyond the scope of the present paper.
The linearization was dictated by the lack of adequate data on capital stock. Instead of using the rental-wage ratio in the linearized specification by theory, the real-wage rate and the real rental price of capital could be entered separately to allow for their possible differential effects on output arising from constraints in adjusting the extent of factor use. Such formulation was rejected on empirical grounds (see Section II).
As noted in Spellman (1976), the impact of financial deepening could be either neutral, merely shifting the production function uniformly, or factor augmenting.
The excess demand for money measures disequilibrium in the money markets; this variable could influence consumption expenditure and hence saving.
The measure of the real interest rate given by (iu−Πc)/(1 + Πc), is more accurate than (iu−Πc), when large changes in inflation and interest rates are involved.
For the time being corporate taxes are ignored, but they are taken into account in the empirical analysis.
Even during the high-interest-rate period of 1965–71, real lending rates for banks were much lower than those that prevailed in the unregulated markets.
Cole and Park (1983) note that the unregulated rate closely reflected the rate of return to capital in Korea.
For a discussion of the relationship between inflation and relative price variability, see Blejer (1982).
See Cole and Park (1983) for a partial equilibrium analysis of the complementarity hypothesis, and Sundararajan (1985) for a more general treatment. Van Wijnbergen (983) emphasizes substitutability and assumes that at the margin expenditures are financed fully in the unregulated financial market owing to the lack of bank credit.
The impact of inflation on the curb market rate depends upon the size of the debt-equity ratio and the response of the administered rate to inflation. This relationship is analyzed in depth in Sundararajan (1985).
In deriving this relationship, it is assumed that the marginal debt ratio moves in line with the average debt ratio.
The availability of debt finance should properly be measured by including the unregulated market debt which is a substitute for bank debt in the financing of current assets. However, the requisite data are not available and hence the specification includes only bank credit.
Since linear investment functions are used, the error in estimating the initial capital stock can be readily absorbed into the intercept term.
These productivity differentials are crucial in the analysis of crowding out by public investment, as shown in Sundararajan and Thakur (1980), but for this paper, the differentials may be ignored.
See Sundararajan (1985) for an analysis of the relationship between marginal and average debt ratios.
The significance of the rental-wage ratio could simply reflect the effect of variations in the real wage rate, insofar as short-run output decisions depend mainly on the cost of the variable factor, namely labor. The output functions estimated by replacing the rental-wage ratio by real wages alone, or by entering real wages and real rental price of capital separately, yielded significantly inferior results with much larger standard errors. Thus, the relevance of the rental-wage ratio for explaining annual variations in output is strongly confirmed. It is, however, possible that for shorter-term variations in output (monthly or quarterly), the real wage rate could be the more important determinant than the rental-wage ratio. The choice of the specification of the role of interest rates on output could affect some of the simulation results significantly.
While van Wijnbergen (1982) finds that the real unregulated market rate has a strong negative effect on investment, other studies—Norton and Rhee (1981), Sundararajan and Thakur (1980), and Yusuf and Peters (1985)—do not find a significant interest rate effect. However, van Wijnbergen uses only financial variables in the investment function and ignores real output. None of these studies focuses on the appropriate measure of the cost of capital for investment and production decisions.
Therefore, a complete analysis of the effect of public sector investment on private investment requires the computation of the impact and dynamic multipliers of public sector investment based on model simulation. See Sundararajan and Thakur (1980) for such simulation exercises.
The addition of other variables such as a measure of the excess demand for money, or the use of alternative measures of the real interest rate—obtained by measuring the expected inflation in terms of an average inflation rate over the preceding three years, or by measuring the real rate as (i - IIe)/(1 + IIe) instead of (i - IIe)—all yielded much higher standard errors than the one reported for equation (1) of Table 4.
These results are not spurious, simply reflecting a strong collinearity between the bank and the unregulated rates. Although the bank interest rate is one among many variables affecting the unregulated rate, as shown in the next subsection, the direct correlation coefficient between the two variables was only about 0.5 during 1963–81.
For studies on Korean saving behavior, see Brown (1973), Frank et al (1975), Kwang Suk Kim (1977), Mahn Je Kim and Yung Chul Park (1977), Williamson (1979), van Wijnbergen (1982), Sundararajan and Thakur (1980), and Yusuf and Peters (1984). While van Wijnbergen reports the results using only the unregulated market rate, others use only the time deposit rate, and there are substantial differences in the size and significance of interest elasticity reported in these studies. With the exception of Frank et al, who report separate equations for household consumption and corporate saving, all other studies use gross domestic or national saving.
The lag distribution was estimated using a second-degree polynomial without any end point restrictions. The sum of the coefficients (0.12) is significant at 95 percent probability level.
A positive effect of nominal interest rates on corporate saving in Korea is also noted in Frank et al (1975).
Apparently, the increase in the legal depreciation rates of major industries from 30 percent to between 40 percent and 80 percent following the 1972 Presidential Decree has had only a temporary effect.
Schmidt (1976) discusses the role of corporate profits in the determination of debt-equity ratios in Germany.
This result probably reflects the possibility that, insofar as bank credit reduces the use of curb market loans, the overall debt ratio that includes both bank debt and the unregulated market debt would not change much.
The measured debt-equity ratio would also be influenced by the timing of the revaluation of assets, which is regulated by the 1965 Assets Revaluation Law. These effects can be absorbed in the random disturbance term.
The full model used for simulations consisted of the behavioral equations chosen in the previous section, and the set of definitional identities to link various variables shown in Table 1.
Using as performance criterion the mean squared error in the simulated values of saving, investment, and output, the complete model with endogenous adjustment in the debt-equity ratio performs about as well as the truncated model.
While the reduction in the debt ratio in response to a fall in the desired ratio (a function of interest subsidy) is appropriate when the initial ratio is already above its optimum level, such a reduction may seem counterintuitive if the initial ratio is below the optimum level. However, this is the result of the partial adjustment Specification. Simulation results would be clearly modified if a different adjustment mechanism is specified.
Since the long-run multiplier is approximately the sum of the impact and lagged multipliers, a decline in the long-run effect implies that the impact and lagged multipliers are declining, and possibly becoming negative.
The complexity of the distributed lag effects of interest rates on saving and investment is noted in Molho (1986), in a different context.
As explained in the subsection on the empirical results from the savings equation, the income effect of the higher interest rate dominates the substitution effect for savers using the banking system, so that the bank interest rate has a directly negative effect on household saving. The opposite is true for savers using the unregulated market.