Greater corporate leverage means firms are less able to withstand negative shocks to income or asset values, say MEGHA JAIN and Aishwarya Nagpal
One of the underlying problems faced by firms is to finance assets. As per key principles of financial management, a proper mix of debt and equity capital is the foremost financing decision towards an assertive governance framework. Interestingly, despite seminal concerns against value creation through debt financing, debt has been an integral part of a typical corporate leverage. Leverage refers to lever action. In the capital structure, debt is a bar to move greater Returns on Equity. Corporate debt of non-financial firms across major economies rose from around four trillion dollar in 2004 to over $18 trillion in 2014, thereby indicating rapid acceleration of debt growth. Average emerging market corporate debt-to-GDP ratio, too, widened by 26 per cent in the same period but with marked heterogeneity. As per the IMF (2014), the debt-to-equity ratio of India’s corporate sector stood at 83 per cent, the highest among emerging market peers. Although rising emerging market corporate leverage can bestow significant benefits, such as expediting productive investment and economic growth, reflecting a healthy financial system, but ultimately, it raises concerns related to sensitivity to imminent shocks and crisis situation.
High debt levels, relative to equity in corporate balance sheets, create leverage, which can accentuate losses to owners and generate elevated debt service requirements. This can in turn lead to exacerbated cash flow stress, deteriorating credit worthiness and debt rollover risks. Moreover, if credit risk is underpriced, spikes in default rates may permeate through the financial system as investors and creditors, including the banking system, will incur losses. One of the important alterations in the corporate leverage structure in emerging markets like India is its ever-changing composition.
Though loans still constitute the largest component of the corporate debt, the proportion of bonds has been rapidly increasing — from nine per cent of overall debt in 2004 to 17 per cent of overall debt in 2014 — with a majority of the increase materialising after the global financial crisis of 2008. However, the acceleration of corporate issuance since the crisis is largely explained by global push factors. The growth and changing composition of corporate leverage can mainly be attributed to an unprecedented monetary expansion in advanced economies and a shift in the global financial landscape. A preponderant factor has been the accommodative global monetary policy that has jolted emerging markets.
Through these channels, expansionary global monetary conditions can facilitate greater corporate leverage through relaxation of emerging market borrowing constraints, owing to widespread availability of lower-cost funding and appreciated collateral values. To cite an example, as monetary policy becomes expansionary in developed countries, Central banks will have to respond in part by keeping their rates lower in order to alleviate pressures on their currencies. Thus, the key risk associated with mounting emerging market corporate leverage is reversal of post-crisis accommodative global financial conditions. Firms, that are most leveraged, stand to endure the sharpest rise in their debt-service costs, once monetary policy rates in advanced economies rise. Furthermore, interest rate risk can be aggravated by rollover and currency risks. Although bond finance tends to have longer maturities than bank finance, it exposes firms to more volatile financial market conditions. In addition, local currency depreciation associated with rising policy rates in advanced economies would make it increasingly difficult for emerging market firms to service their foreign currency-denominated debts if they are not hedged adequately.
In the backdrop of recent occurrences, the contraction of global bank lending (mainly via deleveraging in certain banking systems) has been replaced by expansion of capital market lending via bond issuance. These shifts from bank lending to capital markets, and the shift of foreign exchange risk from bank balance sheets to corporate balance sheets, are aggravated by the recent phase of exceptional low interest rates and quantitative ease in developed economies. In non-financial sectors, leverage can symbolise a source of systemic financial instability as it can amplify changes in fundamentals and make households, Governments and non-financial businesses more responsive to shocks.
Mounting debt burden in developing economies is certainly endangering prospects for global growth. Finally, corporate distress could readily be transmitted to the financial sector and contribute to adverse feedback loops. Greater corporate leverage can render firms less able to withstand negative shocks to income or asset values. This vulnerability has implications on the financial system partly because corporate debt constitutes a significant share of emerging market banks’ assets. Shocks to the corporate sector could quickly spill over to the financial sector and generate a vicious cycle as banks curtail lending. From a policy-making outlook, it only reflects the value of the Government stepping up to the plate on public investment.
(The writers are Senior Research Scholars, Faculty of Management Studies, University of Delhi)
