CAPITAL STRUCTURE IN INDIA: IMPLICATIONS FOR … · While FRBM speaks of the responsibilities of the ... Section 6 provides the conclusion. 2. ... and Frank and Goyal (2003), while

Indian Journal of Economics & Business, Vol. 14, No. 2, (2015) : 245-267

* Indian Institute of Management Indore, Prabandh Shikhar, Rau-Pithampur Road, Indore - 453331,MP (India), E-Mail: [email protected]; [email protected]

CAPITAL STRUCTURE IN INDIA: IMPLICATIONSFOR THE DEVELOPMENT OF BOND MARKETS

GAURAV SINGH CHAUHAN*

Abstract

Unlike many other emerging markets, debt ratios in India remain low and fallingover the years. While low debt ratios can be a conscious choice of firms in growthphase, firms in India seems to be deprived of the availability of credit through poorcredit market infrastructure and its development. Low debt ratios coupled with highertax rates entail higher tax payments by the firms in India. More importantly,government seems to rely heavily on these tax receipts to finance its fiscal expenditure.While development of debt markets would benefit the firms, it would seriously distortthe magnitude of fiscal deficit in India. The article here highlights this moral hazardwith government of India to develop debt markets in India.

Keywords: debt ratios; fiscal deficit; corporate financing; value creation; tax benefits.

JEL Classifications: E60; E62; G32; G38

1. INTRODUCTIONOne of the core agenda in the Fiscal Responsibility and Budget Management (FRBM)Act, 2003 is to improve the management of public funds and achieve a sustainablelevel of fiscal deficit in India. While FRBM speaks of the responsibilities of thegovernment to finance its expenditures largely through its receipts, it remains silenton the optimality of the ways to incur expenses and earn revenues. Quite pertinently,a wholesome legislative provision for sustainability of fiscal deficit, in spirit, wouldcertainly take care of the stability of the means of financing the deficit.

Unfolding the data available on fiscal deficit, the break-up of government receiptsshows that the percentage contribution of corporate taxes becomes significantovertime. Corporate taxes as a percentage of total government receipts were 7.51%in 1992, which steadily rose to 29.08% in 2012. Figure 1 shows the trend. Whileincreased share of corporate taxes in total receipts may be an outcome of growingcorporate sector overtime, it becomes imperative to systematically understand thesource of this buoyancy. This is because the stability of fiscal deficit cannot be

246 Gaurav Singh Chauhan

ascertained if the increased share of corporate taxes is not a natural evolution orcould not be fully explained by growing corporate sector.

Important determinants of the magnitude of taxes paid by the firms are theiroperating income, interest expenses and tax rates. While tax payments wouldincrease with higher earnings and tax rates, firms could save taxes by incurringhigher interest expenses for their borrowings. If increasing tax receipts ingovernment exchequer is due to growing corporate sector or increased earningsalone, one would expect the ratio of tax paid to operating income to remain stableovertime, at a constant tax rate. However, the ratio of taxes paid by firms to theiroperating income increased almost consistently since 1992 in India. Importantly,tax rates in India remained fairly stable over this period. This is possible whenfirms would choose to incur lesser interest expenses owing to lesser borrowings asthey tend to grow further.

While there are several determinants which describe the optimal debt capacityof firms, any choice of capital structure1 or leverage by a firm is a conscious choiceof increasing value for its investors to the fullest extent possible. In other wordschoosing low or high leverage must be accompanied by increasing profitability orhigher value creation by any firm.

In Indian context, we see a trend where debt ratios2 of firms show a steadydecline over a period of time. Interestingly, such a trend is quite contrary to thetrend in other emerging markets3 where debt ratios are consistently increasingover time. While region specific characteristics might suggest varying pattern ofdebt ratios suited to their firm’s requirements, our preliminary analysis in this

Figure 1: Corporate taxes as a percentage of total government receipts

Capital Structure in India: Implications for the Development of Bond Markets 247

article suggest that declining debt ratios in India is probably not supported byincreasing profitability of firms. Moreover, other firm level characteristics whichseem to explain increasing debt ratios in other emerging markets show a similarpattern, on an average, in India too. This suggests that low debt ratios in Indiamay be primarily due to the restricted availability of credit to the firms. Suchavailability, in part, is attributable to the repressive policy regime of underdevelopedcredit markets in India.

A critical underpinning of the source of low debt ratios in India is important inorder to appreciate the sensitivity of government receipts to the change in leveragestructures of the firms in India. Further, non-endogenous choice of leverage forfirms in India will have adverse implications regarding the sustainability of fiscaldeficit and the competitiveness of Indian firms globally. Low debt ratios imply highertax receipts for government which therefore faces a moral hazard to develop bondmarkets in India. Further, restricted credit to Indian firms looms large for theirglobal competitiveness at a time where Indian markets are increasingly accessibleto foreign players through measures such as systematic increase in FDI limits forseveral sectors including retail.

In this article we will take a closer look into the issues discussed above asfollows. Section 2 describes the theoretical discussion on choice of leverage structureby firms and empirical findings associated with major determinants of leverage.Section 3 elicits trends in the leverage structure and its determinants identified insection 2 for Indian corporate sector. This section explores the possible explanationfor low debt ratios in India due to the plausible determinants of capital structure.Section 4, will highlight development of debt markets and availability of credit inIndia. Section 5, will take up important implications for low debt ratios in India.Section 6 provides the conclusion.

2. CHOICE OF CAPITAL STRUCTUREAccording to Modigliani and Miller (1958), under certain conditions where thereare no taxes and there is no asymmetry of information, capital structure does notmatter for the value created by firms. However, in absence of such idealisticconditions, we see that firms devote excessive attention to the design of their capitalstructures. Firms can attribute their choice of capital structure to several factors.A prime reason for firms to choose different claims for their investors is to reduceagency costs involved with management4. Owing to information advantage,managers may not exert adequate efforts so as to maximize value of the firm or itsinvestors. Governance structures are enabled by issuing variety of claims. Theseclaims are such that they can monitor or occasionally intervene in the managementof firms.

Other considerations in the literature5 which describes the choice between debtand equity claims relates to corporate taxes, non-debt tax shields, size of the firm,nature of assets, profitability, availability of debt, growth opportunities and degree


of investor’s protection or enforcement of financial contracts. While there are severalother variables being tested across time, the above mentioned factors are some ofthe determinants which have got considerable and consistent empirical support inthe literature.

Interest payments on debt claims are tax deductible in most of the countries.Thus, for the same level of operating income a firm having more debt would savemore in taxes and hence more can be returned to the owners i.e. equity holders.This in turn leads to higher profitability for the owners as measured by return onequity. However, excessive debt can further lead to bankruptcy owing to the fixednature of the claims. Thus, solely based on tax considerations, there is a tradeoff inchoosing debt for more value creation for owners and the probability of default by afirm6. In fact, theory suggests an optimal debt level where the value of the firm ismaximized. The tradeoff between tax savings and financial distress is mentionedin the literature as static tradeoff hypothesis. Notwithstanding this tradeoff, wecan generally infer that higher tax rates would induce firms to take on more debtfor the same probability of default. Literature does provide evidences for suchinferences. For example, Desai et al. (2004) document that higher local tax ratesare associated with higher debt ratios in multinational firms.

Firms can alternatively save taxes by incurring heavy depreciation, depletion,and amortization expenses for their assets. In such a case, these expenses tend tosubstitute interest payments7 by firms and hence a negative relationship betweenthe presence of non-debt tax shields and debt ratios can be expected8. However,empirical tests on the relationship between the two variables seem to showinconclusive or mixed results. Some of the studies show insignificant or even positiverelationship between these two factors9.

Empirically it has been found that larger firms have lower probability of defaultand are also able to economize on cost of financial distress in case of default. Further,asymmetry of information is less critical for large firms as compared to the smallerones. This suggests that larger firms tend to have higher debt in their books. Apositive relationship between size and debt is documented in Marsh (1982), Rajanand Zingales (1995), and Frank and Goyal (2003), while Titman and Wessels (1988)find a negative relationship.

Nature of firm’s assets or their degree of tangibility also seems to have significanteffect on debt ratios for firms. Since tangible asset can well serve as good collateral,larger tangible assets in a firm is associated with higher debt ratios. A positivecorrelation between asset tangibility and debt has been shown in several studiesincluding Scott (1977), Friend and Lang (1988), Harris and Raviv (1990), Rajanand Zingales (1995), and Frank and Goyal (2003).

As per the pecking order hypothesis of Myers and Majluf (1984), owing toinformational asymmetries firms will turn to debt financing when internal equityis insufficient. Thus, following this argument, profitability seems to be negativelyassociated with debt ratios. On the other hand, static trade-off theory of debt would


suggest a reverse pattern for debt ratios. According to the tradeoff argument, firmswith greater profitability would carry more debt. In addition, a positive associationbetween debt ratios and profitability can be expected following the literature whichdescribes debt as a disciplining device for managers of the firms having higher freecash flows. In fact, Jensen (1986) and Stulz (1990) show such relationship. While,the association between debt ratios and profitability remains ambiguous, a negativerelationship is highlighted in number of studies including Titman and Wessels(1988), Rajan and Zingales (1995), Fama and French (2002), and Frank and Goyal(2003).

Firms with lot of growth opportunities are expected to retain low debt ratios asdebt restricts the flexibility needed to avail these opportunities. Debt comes withseveral covenants which can deter firm to take on the required level of risk, as debtholders do not reap any upside gains by excessive risk taking while shareproportionate losses in case of default. Myers (1977) suggests that excessive leveragemay force firms to pass up profitable investment opportunities (see also Stulz, 1990).It is also possible however, that financially constrained firms with higher growthopportunities will issue debt prior to issuing equity due to informationalasymmetries. While a positive relationship between growth opportunities and debtratio is highlighted in Kremp et al. (1999), negative association is documented inRajan and Zingales (1995), Fama and French (2002), and Frank and Goyal (2003).

Apart from factors considered above which are endogenous to the firms, debtratios might be influenced by exogenous factors also. Importantly, availability ofcredit through alternate means including debt markets is a significant factordetermining debt ratios for a firm. Credit market development in a country isexpected to be positively associated with debt ratios, while a negative relationshipis associated between debt ratios and stock market development (Booth et al., 2001).However, Demirguc-Kunt and Maksimovic (1996) find that stock marketdevelopment is associated with lower debt ratios in developed markets but notemerging markets. Further, Edison et al. (2002) show that the ease of availingcredit through foreign borrowings might have significant impact on debt ratios.

Another important consideration in choosing debt ratios is the enforcement offinancial contracts or degree of investor’s protection in case of bankruptcy. Even ifwe have well documented bankruptcy procedures, it is often noticed that bankruptcylaws, even in developed countries, may be time consuming and lax inimplementation. In some cases, they could lead to reshuffling of claims, as theymight be biased towards senior or junior claim holders.

3. CORPORATE FINANCING TRENDS IN INDIAIn India we see a discernible deleveraging trend in the capital structure of firms.Ratios such as debt to equity and debt to asset show consistent decline sinceliberalization of economy in 1992. We have analyzed annual data for non-financialfirms in India from 1992 to 2012. The data being captured form databases of Centre


for Monitoring of Indian Economy (CMIE). We chose non-financial firms as theybeing the major users of financial markets, would shape the real demand for differentclaims such as debt and equity. Figure 2 shows such a trend in total equity to assetand total borrowings to asset ratios.

Figure 2. Debt and equity ratios

A striking feature of this deleveraging trend is that most of the assets areincreasingly being financed by reserves and surpluses or internal financing. Figure3 shows break-up of equity capital into capital raised (CR) and reserves andsurpluses (RS) and their ratio to total assets.

Figure 3: Break-up of equity capital to asset ratios


Firms, in general, do prefer financing from internal resources, i.e. reserves andsurpluses, as far possible because accessing capital market is extremely costly anduncertain. This is quite a finding in developed countries too and a major postulateof pecking order theory by Myers and Majluf (1984). However, more importantlywe see that share of internal financing rose from about 15% in 1992 to above 33%in 2012. This may be possible if firms are facing increasing growth opportunities orprofitability is increasing so that investors are allowing firms to use internal funds.Alternatively, this is also possible if external financing is difficult to avail. Firmsincreasingly would use internal funds because availability of funds may not beadequate or is costly.

Growth opportunities, if any, for firms would lead them to choose lesser debt onaccount of flexibility constraints put up by debt on firms. Therefore, debt ratiosincreases as growth opportunities become limited. To capture growth opportunitieswe look for trend in market to book equity capital (M/B) ratio as has been used inmany studies previously. Another proxy used for growth opportunities is the ratioof capital expenditures10 to total asset or sales for firms. Figure 4a and 4b showstrend in these two ratios.

Increasing growth opportunities can be inferred for firms if M/B and capitalexpenditure increases in proportion over time. However, as we can see while M/Bratio does not show any discernible trend, capital expenditure to asset ratio hasdeclined over time, although not steadily. M/B ratio declined from 2.23 to 1.85 from1992 to 2012. Capital expenditure to asset ratio has declined from 8.57% to -3.69%,with an average of 7% from 1992-2012. The average for last 5 years excluding 2012(where capital expenditure is negative) comes out to be 6.14% from 2007-2011.

Figure 4a: M/B ratios


Looking into such trends, growth opportunities seems to be limited at best and donot really warrants a decrease in debt ratios over time.

To capture profitability, we look into number of profitability measures such asoperating income to asset ratio (PBDITA/A), operating income to sales (PBDITA/S), return on equity (ROE) and operating income to total capital employed (PBDITA/TC). Figure 5 shows trend in these ratios.

Figure 4b: Capex/Asset ratio

Figure 5: Profitability ratios


While there is no definite trend in any of these ratios, profitability does notreally show marked improvement over the years which could warrant a strict declinein debt ratios over time. Profitability for Indian firms, as expected to be for anyemerging markets, is not showing any increasing trend over years. As firms maturein emerging markets, profitability is expected to decline. This is in line with thealignment of emerging markets with developed world and subsequently their riseas developed markets themselves.

Further, while nothing conclusive can be said about increasing use of internalfinancing by looking into the trend for growth opportunities and profitability, weneed to closely observe the availability of funds for the firms in India. We will tryand do this in Section 4 which looks into the availability of credit in India in details.

Now, let us turn into the share of borrowings in financing assets for the firms.Figure 6 shows the trend in borrowings from financial institutions and banks.

Figure 6: Borrowings from financial institutions and banks

Important is to see the increasing role of banks in external financing. Share ofbank borrowings as a percentage of total assets (BB/A) has increased almost steadilyfrom about 8.74% from 1992 to 15% in 2012. On the contrary, share of borrowingsfrom other financial institution, apart from banks, as a percentage of assets (FI/A)has declined almost steadily from 7.72% in 1992 to 1.59% in 2012. Interestingly,share of external finance from all the financial institutions including banks (AFI/A) as a percentage of assets have remained stagnant at an average of about 15%.Further, there is no definite trend showing any increase or decrease in these totalborrowings over the years. This shows that banks just tend to replace the funds


earlier being provided by other financial institutions. Thus, overall no additionalcapital is being provided by financial institutions jointly in India. This may bepartly due to the reorganization of large industrial credit institutions as commercialbanks, for example ICICI has been reorganized as ICICI bank.

Apart from this, share of external finance by any other means remain dismalfor Indian corporate sector. Figure 7 shows trend in borrowings through sourcesother than financial institutions.

Figure 7: Borrowings through sources other than financial institutions

Interestingly, share of bonds and debentures (BD/A) declined from about 7% in1992 to about 3% in 2012; share of inter-corporate loans (ICL/A) remains stagnantat an average of 2.17% and share of commercial papers remain insignificant at anaverage of 0.18% from 1992 to 2012. Further, owing to restricted internationalcapital flows, foreign commercial borrowings, which can replace domestic debtissuances, remained subtle. The ratio of foreign commercial borrowings as apercentage of total assets declines from 7.2% in 1992 to 5.06% in 2012. However,there is no discernible trend in this component also. Thus, foreign borrowings mayhave only marginally contributed towards the availability of debt in India.

Looking into the statistics above, we see that role of external financing isshrinking for Indian corporate sector. We now will focus into the trend in othertheoretical factors that could determine leverage for firms in India. As discussed insection 2 above, higher tax rate induces higher leverage for firms. However, if wecompare the corporate income tax rates for several emerging markets (Table 1), wesee that firms in India faces very high tax rates and yet debt ratios show decliningtrend for them.


Table 1Corporate income tax rates*

Country Corporate Income Country Corporate IncomeTax Rates (2012) Tax Rates (2012)

Argentina 35 Mauritius 15Brazil 34 Mexico 30Chile 18.5 Nigeria 30China 25 Philippines 30Hong Kong 16.5 Russia 20India 32.44 Singapore 17Indonesia 25 South Africa 34.55Israel 25 Taiwan 17Jordan 14 Thailand 30Republic of Korea 24.2 Turkey 20Malaysia 25 Vietnam 25

Source: KPMG# includes duties, surcharges and additional cess

Another important reason for low leverage as cited in section 2 may be increasingnon-debt tax shields. This can be defined as share of depreciation and amortizationexpenses as a percentage of operating income (PBDITA). Figure 8a and 8b showtrend in these two ratios. Depreciation expenses as a percentage of operating income,although does not show any definite trend, certainly does not increase and ratherhas dropped from over 28% in 1992 to less than 23% in 2012. Amortization expensesas a percentage of operating income has also declined from 1.36% in 1992 to 0.13%in 2012.

Figure 8a: Depreciation as a percentage of operating income


As discussed above, size of the firms are positively correlated with leverage.Size as measured by total assets of non-financial firms when compared to totalGDP (A/GDP) has increased significantly from over 25% in 1992 to about 125% in2012. Alternatively, size as measured by total sales of non-financial firms whencompared to total GDP (S/GDP) has also increased significantly from 19.8% in 1992to about 92% in 2012. Figure 9 shows trend in aggregate size of the firms in India.Here also, we see that despite of increasing size, Indian firms are less levered.

Figure 8b: Amortization as a percentage of operating income

Figure 9: Size of firms


Regarding asset tangibility, while we can see an increase in intangible assetsas a percentage of total assets, the magnitude itself is very small compared to totalasset. Figure 10a shows such a trend in net intangible assets over time. Netintangible assets for non-financial firms rose from 0.05% in 1992 to 2.19% in 2012.The average net intangible asset over this period is only 0.75%. Further, there is noconclusive evidence for tangibility of asset going down over the year. Specificallythis ratio does not show any trend as such. Figure 10b shows trend in net tangiblefixed assets11 as a percentage of total assets. The average of the ratio of net tangiblefixed asset to total asset is 32.8% over 1992 to 2012. Looking onto the data of assettangibility, it is difficult to conclude that debt ratios may be declining due to increasein intangible assets.

As we see, endogenous factors for firms considered so far may not able tocomprehensively determine the low leverage for firms in India. Thus, we shall nowturn our attention towards exogenous factor pertaining to availability of funds forfirms in India. Although we see very buoyant stock markets in India, as in otheremerging markets, figure 3 shown above tells us that capital raised through equityissuances (or book value of capital raised through equity) as a percentage of totalassets steadily declines from 14% in 1992 to 6.8% in 2012. That means equityissuances as a source of finance is not quite a preferred mode of external financingin India. The increased share of equity capital in financing assets for the firms isprimarily due to more and more use of the reserves and surpluses or the internalfunds. Thus, role of credit markets as an alternative source of external financebecome crucial for firms. In the next section we will try and explore how debt ratiosmight have impacted through credit market development in India.

Figure 10a: Intangible asset proportions


4. DEVELOPMENT OF CREDIT MARKETS IN INDIAAs seen from the data on borrowings above, while banks in India remained the solevehicle for credit, the grim state-of-the-affairs in corporate borrowings from non-banks can be attributed to several factors which somehow indicated towards theunderdevelopment of debt markets in India.

One can readily observe a buoyant and happening equity market in India;however, the bond market is yet to see its potential as an alternate source of capitalor investment. As per the World Federation of Exchanges, the equity markets inIndia stands in top 5 countries in terms of number of trades per day; in top 20 interms of traded volumes and in top 10 in terms of market capitalization. On theother hand bond markets in India seem to be struggling with basic issues concernedwith key market microstructure such as liquidity and price discovery. Unlike, mostother nations, market capitalization of secondary12 equity market in India is higheras compared to debt markets. Interestingly, two-third of market capitalization indebt market is accounted for by central government securities only. Further, lowlevel of market activities are reflected in debt markets by their total turnover whichis only about 20% of the total turnover of equity and bond markets combinedtogether. Average turnover per day for debt markets remains at Rs. 16 billion ascompared to average turnover per day of Rs. 68 billion for equity markets in August2012.

Interestingly, bond markets in India seem to be completely dominated bygovernment securities and turnover in corporate securities remains marginal at

Figure 10b: Net Tangible Fixed asset proportions


best. Almost all the activities in secondary market transactions are actuallyoverwhelmed by the share of government securities. Turnover of corporate bondsas a percentage of total turnover is 8.85% in August 2012. Average turnover perday turns out be Rs 1.43 billion for corporate bonds as compared to Rs. 10.80 billionfor government securities. Market capitalization of corporate bonds as a percentageof total market capitalization of Wholesale Debt Market (WDM) segment at NSE is4.95% as compared to 64% for central government securities in August 2012.

For international comparison, as quoted in Raghvan and Sarwono (2012), thevalue of outstanding government bonds in India was 39.5% of GDP as of 2010 andcompares favorably with other Asian countries such as China (27.6%) and SouthKorea (47.2%). The value of corporate bond outstanding in India however was only1.6% of GDP in 2010 compared to Malaysia (27%) and South Korea (37.8%) at theend of 2010. Despite similar growth environment, India has surprisingly laggedbehind in developing corporate bond markets.

The observed activities in government securities market further needs to beseen in light of the fact that the current magnitude of government securities marketcome into existence due to heavy borrowings by government to finance the fiscaldeficit. Financing of fiscal deficit through market borrowings increased substantiallyover the years. Average share of financing of gross fiscal deficit through marketborrowing from 1992 to 2012 stands at 60.43%; average share since 2006 stands at86.23% and share of financing through borrowing in fiscal 2011-12 stands at 92.78%of gross fiscal deficit. Figure 11 shows trend in market borrowings as a percentageof gross fiscal deficit13.

Figure 11: Market borrowings as a percentage of total gross fiscal deficit


However, market microstructure even in government securities market hasnot developed with the pace at which the fiscal deficit and hence the marketcapitalization grew over time. Liquidity and participation in government securitiesis not very encouraging either. Top 5 central government securities constitute morethan 85% of turnover in government securities and more than 30% in total turnoverincluding all the securities in August 2012. On the participants’ side too, top 5market participants, which are essentially commercial banks, constitutes morethan 83% of total turnover in August 2012.

Moreover, the picture posed above would have at least provided some confidencein government securities market, if participation in such markets would have beenfairly liberal and without any repressive constraints. However, bulk of theparticipation in government securities comes from commercial banks and insurancecompanies, which owns more than two-third of total outstanding governmentsecurities. Further, such holding comes out through repressive governmentintervention to hold such securities14. For example, despite uncertain inflationforecasting, government bonds of 30 years maturity are floated by Reserve Bank ofIndia (RBI) and banks were asked to buy such securities. This hampers true pricediscovery even in government security markets.

The state of debt markets in India is alarming given the fact that growingcorporate and infrastructure demand for funds in India requires a stable alternatesource of domestic funding. As per the last planning commission (2007-2012)workings, the estimated infrastructure financing were estimated to be about USD500 billion up to 2012 and would remain strong at about USD 700 billion in thenext five year plan for 2012-17. The generic development of the political economyin most countries would indicate that increasing risk aversion of banks, asunderstood by critical prudential regulation, might loom large for developingeconomies such as India, if alternate source of funding for firms are notoperationalized. Further, resilience of an economy during recessions criticallyrequire alternate domestic source of funding. During low economic activities, fundingfrom banks cannot be relied upon due to their excessive focus on managing creditquality, no matter whether the deterioration in quality is due to systematic or firmspecific factors.

Even large corporate houses in India seem to rely on funding from banks whenthey are capable of raising debt on their own. This might primarily be due to thetradeoff between cost of capital raised and cost of issuance of securities is notfavorable for them in India. This has serious consequence of squeezing credit forsmall and mid-cap firms, which has no other alternate source of financing apartfrom banks.

Among several other deterrents to bond market development15 is the issue ofinvestor’s participation. Banks, financial institutions, insurance companies, pensionand provident funds, other institutional and corporate investors seemingly formthe base of investors for corporate bonds worldwide. However, what is interesting


in India is that participation from conventional institutional investors such asinsurance companies, pension funds and banks are rather bleak. This is primarilydue to excessive and inordinate regulations posed on them16. For instance, insurancecompanies can keep bonds which are rated AA or lower at a maximum limit of 25%of their portfolio values. Further, these companies, along with banks and otherfinancial institutions, can invest only up to 10% of the total funds collected incorporate bonds and that too of investment grade only. Adding to this, regulationrequires that such bonds when purchased should largely be kept till maturity.

Historically, high domestic savings rates have been the strength of Indianeconomy. Despite this, the participation of retail investors is non-existent in Indiaand has not been encouraged through any policy frameworks17. Retail participation,as a fraction of total investment in corporate securities, seems to be low even indeveloped economies. However, such low fractional participation rates in developedmarkets are partially due to the fact that fractional institutional investment isvery high in such bonds, which is not the case in India. Institutional participationitself is not very encouraging in India. Moreover, such participation by retailinvestors in developed markets is significant when compared to equity marketparticipation. Participation in corporate debt by retail investors enables them todiversify their portfolios to a greater extent to manage risk exposures for theirinvestments.

While there are not enough innovative instruments to support the fragilecorporate debt market, one cannot even find the much needed support for activeexposures in interest rate derivatives in India18. Despite the fact that interest ratefutures being formally launched in the markets way back in 2003, activity seems tobe non-existent even today, owing to lack of variety in instruments and lack ofcritical participation from diverse agents. This critically undermines the possibilityof managing the risk exposure by primary dealers as interest rates remains quitevolatile in India. This leads to unwarranted risk aversion which further hampersthe true price discovery in the markets. Moreover, absence of such critical supportinginstruments for primary dealers leads them to provide liquidity at higher costs.

Features such as stamp duties are levied differentially at state levels and alsobetween players19. Such taxes increase the cost of transactions and hence financing.Firms are thus taxed for entering into financing transactions over and above thetaxes they pay for their incomes.

Notwithstanding the debate on improving the market microstructure ofcorporate debt markets, an important issue for stabilizing the supply of credit is tosecure creditors in the event of default. The modalities of recovery of assets offailed firms remain lengthy and costly in India. Defaulted firms were reported atBoard for Industrial and Financial Reconstruction (BIFR) and more recently to theAsset Reconstruction Company of India, Ltd. (ARCIL) and the final settlement ofrecoveries can take from five to seven years. A remarkable improvement in creditors’rights is enthused through the Securitization and Reconstruction of Financial Assets


and Enforcement of Security Interest (SARFAESI) Act of 2002, where securedcreditors are given the right to take possession of assets and sell them in case ofdefault by the firms. However, SARFAESI provides these rights to secured creditorsonly and there is not much to offer for unsecured creditors. This is important andconcerning given the extensive and much sought after participation of unsecuredcreditors in corporate debt markets.

Information dissemination is another challenge in emerging markets to developcapital markets. Banks in India share proprietary data on defaulting firms with acredit information bureau called the Credit Information Bureau of India, Ltd.(CIBIL). Although, banks can access this database, it is not accessible to non-bankentities. Such skewness in information sharing further worsens the price discoverymechanism in corporate debt markets in India.

In order to appreciate the issue of underdeveloped bond markets in India, notmuch has been done through setting up of intellectual forums or administrativecommittees by government directly. Among those rare instances, Government ofIndia has constituted a committee in 2003 under the chairmanship of Dr. R HPatil, founder of the National Stock Exchange, to study the shortcomings of corporatedebt markets and to recommend ways and means to establish a buoyant market inIndia. The committee has submitted the report in year 2005, where most of therecommendations were approved by the government in 2006. Even after six year ofsuch approval not much could be done to implement measures suggested by thecommittee20. From above discussion we can infer that development of debt marketin India would require not only a wholesome understanding and coordinationbetween various stakeholders but also it requires a serious political will.

5. IMPLICATIONS OF LOW DEBT RATIOS IN INDIAIf firms would choose low leverage voluntarily, their profitability should increasesomehow. However, profitability ratios indicated above do not really show thispattern. To capture this reduction we first highlight the effective taxes paid by thefirms for a given operating income over the years. Figure 12 shows a trend whereeffective taxes (referred as corporate taxes as a percentage of operating income)rise almost consistently from 9.11% in 1992 to 15.11% in 2012. Thus, firms on anaverage are paying more taxes for a given level of operating income. That wouldmean that less value is created for their investors. An indirect implication for thisis that investors are less keen to invest in firms due to lesser returns or profitability.This induces a discouraging investment climate for private investments in India.

On the other hand, Government gains from such rise in effective taxes. Importantis to analyze the fiscal deficit position given the low leverage structure by firms inIndia. As noted in Figure 1, corporate taxes contribute 29.08% to the totalgovernment receipts in 2012. This is a significant increase from 7.51% in 1992. Asargued in this paper, this increase in share seems not to be a natural outcome ofgrowing corporate sector but increasing tax burden for firms. The stability of fiscal


deficit is, therefore, threatened given government is increasing its reliance on asource of finance which comes as a result of market distortions. In other words,government receipts probably thrive by not providing a level playing field tocorporate sector in terms of their ability to raise capital through debt markets.

An interesting dimension to this analysis is the impact on fiscal deficit byrationalizing the tax payments which might emerge when firms are able to raiseoptimal debt for themselves. If effective taxes, measured as tax paid as a percentageof operating income, is reduced by 1%, from the existing levels of about 15%, thegovernment receipts will reduce by Rs. 265 billion and fiscal deficit21 will, therefore,increase by the same amount. This is an increase of 132% in fiscal deficit, giventhat the level of deficit currently is about Rs. 200 billion.

The current scenario looks like a moral hazard problem for government wheregiven the sensitivity of fiscal deficit to debt ratios of the firm, government may notlike to see debt ratios of the firm going up due to development of credit markets.The analysis here underscores the sustainability of government finances and alsothe weakness in assuming its fiscal responsibilities as deemed in principle throughlegislative measures such as FRBM Act, 2003.

Further such a proposition acts as a double whammy for the globalcompetitiveness of firms in India. Apart from not being able to raise funds ininternational capital markets, firms in India are also not being able to raisecompetitive finances domestically. Given that firms are restrained to tap alternativeand cheap source of capital when compared to firms globally, it is imperative thatthey are sacrificing their competitiveness internationally. This issue might cause a

Figure 12: Effective Taxes


sense of urgent attention when government seems to open up the marketsextensively for foreign players. A recent incidence is the issue of retail FDI in India.

6. A WAY FORWARDThe discussion above about the current state of the affairs of credit availability forfirms in India highlights a potential moral hazard for government to develop bondmarkets. However, it can be seen positively as an opportunity for government tostimulate economy without fiscal interventions in real terms. If credit marketscould be developed in India, it can somewhat substitute the fiscal stimulus providedby the government to revive the real sector in Indian economy. Firms themselvescould get the necessary stimulus for private investments through competitive capitalmarkets.

A major concern for government here would be the drop in revenue. To alleviatethis, if we have sound credit markets in place, government can systematically raisetax rates even further. On one hand, this will increase the tax receipts forgovernment and on the other, it will stimulate firms to take on more debt to maintainsame return on equity for equity holders. An important caveat is the assumptionthat increasing debt ratios are not increasing financial risk for firms inordinately.A liquid market in corporate debt will be instrumental in dealing with suchinordinate risk taking by firms when investors will be compensated fairly for risktaking.

For sufficient political and economic reasons though, the suggestion forincreasing tax rates might sound rather radical and irrational given the alreadyhigh tax structure in India. However, the concern for drop in government receiptsby developing credit markets may not be realized practically. With sound availabilityof credit, firms would increase their investments and hence their operating incomesproportionately. Higher operating income would in turn provide higher tax receiptsto the government exchequer again. Raising tax revenue this way will be moreorganic and aligned to welfare in the long run. This collectively might resolve theissue of drop in government receipts from corporate taxes and would also stimulatethe investment climate in the country. This in turn will improve the status quo ofIndian firms vis-à-vis foreign players. Fiscal deficits will now be more sustainableand policies can be directed with much ease and relevance.

Further, notwithstanding any policy moves for developing credit markets,government has to closely look and monitor other sources of financing itsexpenditure, provided it wishes to bring in sustainability to the fiscal deficit positionin India. While, bringing in sustainability is desired, a strong political will is requiredfor developing credit markets in India.

Notes1. Capital structure choice here refers to the choice of the form (claims like equity and debt)

and quantity of its capital.


2. Debt ratio is defined as the ratio total borrowings to total assets of a firm.

3. See Mitton (2007) for a discussion on increasing debt ratios in emerging markets over time.4. See Myers and Majluf (1984) for earliest discussions on agency costs involved in capital

structure choices.

5. See Harris and Raviv (1991), Rajan and Zingales (1995) and Frank and Goyal (2003) forseveral determinants of capital structures.

6. See Scott (1972) and Kraus and Litzenberg (1973) for the initial literature on “static tradeofftheory” relating tax savings and financial distress by increased probability of failure forfirms. Also See Graham (2003) for a review of the literature on the influence of taxes oncapital structure choice.

7. DeAngelo and Masulis (1980) and Modigliani and Miller (1958) show such substitutability.8. Bowen, Daley, and Huber (1982) and Kim and Sorensen (1986) show such negative

relationship.

9. See Harris and Raviv (1991), Bradley et al. (1984), MacKie-Mason (1990) and De Miguel andPindado (2001) for such results.

10. Capital expenditure is estimated as change in gross fixed assets.

11. Defined as the sum of net land, buildings, plant, machinery, electrical installation, transportand communication equipments, furniture and social amenities etc.

12. Secondary market activities are referred to from National Stock Exchange (NSE), India.

13. Source RBI.14. More on captive buyer story of government securities can be looked into Shah, Thomas and

Gorham (2008).

15. See Mitra (2009) for a critical highlight on corporate bond market development in India.

16. See R H Patil committee (2003) recommendations on corporate bond market development inIndia with regard to institutional investors’ participation.

17. Retail Debt market segment was formally launched at NSE in 2003, with a view that initiallytrading be allowed in government securities and subsequently in phase wise developmenttrading would be allowed in other securities. Despite of the fact that number of trade reportedin 2003-04 was 912, trading is eventually evaporated from this segment as there was notrade reported in the fiscal 2011-12.

18. No trade being reported in Interest rate futures for six out of first eight months for year 2012at NSE up to August 2012.

19. See Patil (2010) for discussion on stamp duty structure in India.

20. See Patil (2010) for a commentary of the progress in recommendations made to governmentof India.

21. Fiscal deficit here is measured as difference between total government receipts andexpenditures.

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CAPITAL STRUCTURE IN INDIA: IMPLICATIONS FOR … · While FRBM speaks of the responsibilities of the ... Section 6 provides the conclusion. 2. ... and Frank and Goyal (2003), while