Capital structure in India: implications for the development of bond markets.

Chauhan, Gaurav Singh

Abstract

Unlike many other emerging markets, debt ratios in India remain low and falling over the years. While low debt ratios can be a conscious choice of firms in growth phase, firms in India seems to be deprived of the availability of credit through poor credit market infrastructure and its development. Low debt ratios coupled with higher tax 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 distort the magnitude of fiscal deficit in India. The article here highlights this moral hazard with 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. INTRODUCTION

One 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 sustainable level of fiscal deficit in India. While FRBM speaks of the responsibilities of the government to finance its expenditures largely through its receipts, it remains silent on the optimality of the ways to incur expenses and earn revenues. Quite pertinently, a wholesome legislative provision for sustain ability of fiscal deficit, in spirit, would certainly take care of the stability of the means of financing the deficit.

Unfolding the data available on fiscal deficit, the break-up of government receipts shows that the percentage contribution of corporate taxes becomes significant overtime. 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. While increased share of corporate taxes in total receipts may be an outcome of growing corporate sector overtime, it becomes imperative to systematically understand the source of this buoyancy. This is because the stability of fiscal deficit cannot be ascertained if the increased share of corporate taxes is not a natural evolution or could not be fully explained by growing corporate sector.

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

While there are several determinants which describe the optimal debt capacity of firms, any choice of capital structure (1) or leverage by a firm is a conscious choice of increasing value for its investors to the fullest extent possible. In other words choosing low or high leverage must be accompanied by increasing profitability or higher value creation by any firm.

In Indian context, we see a trend where debt ratios (2) of firms show a steady decline over a period of time. Interestingly, such a trend is quite contrary to the trend in other emerging markets (3) where debt ratios are consistently increasing over time. While region specific characteristics might suggest varying pattern of debt ratios suited to their firm's requirements, our preliminary analysis in this article suggest that declining debt ratios in India is probably not supported by increasing profitability of firms. Moreover, other firm level characteristics which seem to explain increasing debt ratios in other emerging markets show a similar pattern, on an average, in India too. This suggests that low debt ratios in India may be primarily due to the restricted availability of credit to the firms. Such availability, in part, is attributable to the repressive policy regime of underdeveloped credit markets in India.

A critical underpinning of the source of low debt ratios in India is important in order to appreciate the sensitivity of government receipts to the change in leverage structures of the firms in India. Further, non-endogenous choice of leverage for firms in India will have adverse implications regarding the sustainability of fiscal deficit and the competitiveness of Indian firms globally. Low debt ratios imply higher tax receipts for government which therefore faces a moral hazard to develop bond markets in India. Further, restricted credit to Indian firms looms large for their global competitiveness at a time where Indian markets are increasingly accessible to foreign players through measures such as systematic increase in FDI limits for several sectors including retail.

In this article we will take a closer look into the issues discussed above as follows. Section 2 describes the theoretical discussion on choice of leverage structure by firms and empirical findings associated with major determinants of leverage. Section 3 elicits trends in the leverage structure and its determinants identified in section 2 for Indian corporate sector. This section explores the possible explanation for 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 in India. Section 5, will take up important implications for low debt ratios in India. Section 6 provides the conclusion.

2. CHOICE OF CAPITAL STRUCTURE

According to Modigliani and Miller (1958), under certain conditions where there are no taxes and there is no asymmetry of information, capital structure does not matter for the value created by firms. However, in absence of such idealistic conditions, we see that firms devote excessive attention to the design of their capital structures. 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 reduce agency costs involved with management (4). Owing to information advantage, managers may not exert adequate efforts so as to maximize value of the firm or its investors. Governance structures are enabled by issuing variety of claims. These claims are such that they can monitor or occasionally intervene in the management of firms.

Other considerations in the literature (5) which describes the choice between debt and 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 several other variables being tested across time, the above mentioned factors are some of the determinants which have got considerable and consistent empirical support in the 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 save more 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 on equity. However, excessive debt can further lead to bankruptcy owing to the fixed nature of the claims. Thus, solely based on tax considerations, there is a tradeoff in choosing debt for more value creation for owners and the probability of default by a firm (6). In fact, theory suggests an optimal debt level where the value of the firm is maximized. The tradeoff between tax savings and financial distress is mentioned in the literature as static tradeoff hypothesis. Notwithstanding this tradeoff, we can generally infer that higher tax rates would induce firms to take on more debt for the same probability of default. Literature does provide evidences for such inferences. For example, Desai et al. (2004) document that higher local tax rates are 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 to substitute interest payments (7) by firms and hence a negative relationship between the presence of non-debt tax shields and debt ratios can be expected (8). However, empirical tests on the relationship between the two variables seem to show inconclusive or mixed results. Some of the studies show insignificant or even positive relationship between these two factors (9).

Empirically it has been found that larger firms have lower probability of default and 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 smaller ones. This suggests that larger firms tend to have higher debt in their books. A positive relationship between size and debt is documented in Marsh (1982), Rajan and 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 significant effect 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 positive correlation between asset tangibility and debt has been shown in several studies including Scott (1977), Friend and Lang (1988), Harris and Raviv (1990), Rajan and Zingales (1995), and Frank and Goyal (2003).

As per the pecking order hypothesis of Myers and Majluf (1984), owing to informational asymmetries firms will turn to debt financing when internal equity is insufficient. Thus, following this argument, profitability seems to be negatively associated 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, firms with greater profitability would carry more debt. In addition, a positive association between debt ratios and profitability can be expected following the literature which describes debt as a disciplining device for managers of the firms having higher free cash flows. In fact, Jensen (1986) and Stulz (1990) show such relationship. While, the association between debt ratios and profitability remains ambiguous, a negative relationship 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 as debt restricts the flexibility needed to avail these opportunities. Debt comes with several covenants which can deter firm to take on the required level of risk, as debt holders do not reap any upside gains by excessive risk taking while share proportionate losses in case of default. Myers (1977) suggests that excessive leverage may force firms to pass up profitable investment opportunities (see also Stulz, 1990). It is also possible however, that financially constrained firms with higher growth opportunities will issue debt prior to issuing equity due to informational asymmetries. While a positive relationship between growth opportunities and debt ratio is highlighted in Kremp et al. (1999), negative association is documented in Rajan and Zingales (1995), Fama and French (2002), and Frank and Goyal (2003).

Apart from factors considered above which are endogenous to the firms, debt ratios might be influenced by exogenous factors also. Importantly, availability of credit through alternate means including debt markets is a significant factor determining debt ratios for a firm. Credit market development in a country is expected to be positively associated with debt ratios, while a negative relationship is associated between debt ratios and stock market development (Booth et al., 2001). However, Demirguc-Kunt and Maksimovic (1996) find that stock market development is associated with lower debt ratios in developed markets but not emerging markets. Further, Edison et al. (2002) show that the ease of availing credit through foreign borrowings might have significant impact on debt ratios.

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

3. CORPORATE FINANCING TRENDS IN INDIA

In 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 since liberalization of economy in 1992. We have analyzed annual data for non-financial firms 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 they being the major users of financial markets, would shape the real demand for different claims such as debt and equity. Figure 2 shows such a trend in total equity to asset and total borrowings to asset ratios.

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A striking feature of this deleveraging trend is that most of the assets are increasingly being financed by reserves and surpluses or internal financing. Figure 3 shows break-up of equity capital into capital raised (CR) and reserves and surpluses (RS) and their ratio to total assets.

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Firms, in general, do prefer financing from internal resources, i.e. reserves and surpluses, as far possible because accessing capital market is extremely costly and uncertain. This is quite a finding in developed countries too and a major postulate of pecking order theory by Myers and Majluf (1984). However, more importantly we 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 or profitability is increasing so that investors are allowing firms to use internal funds. Alternatively, this is also possible if external financing is difficult to avail. Firms increasingly would use internal funds because availability of funds may not be adequate or is costly.

Growth opportunities, if any, for firms would lead them to choose lesser debt on account of flexibility constraints put up by debt on firms. Therefore, debt ratios increases as growth opportunities become limited. To capture growth opportunities we look for trend in market to book equity capital (M/B) ratio as has been used in many studies previously. Another proxy used for growth opportunities is the ratio of capital expenditures (10) to total asset or sales for firms. Figure 4a and 4b shows trend in these two ratios.

Increasing growth opportunities can be inferred for firms if M/B and capital expenditure increases in proportion over time. However, as we can see while M/B ratio does not show any discernible trend, capital expenditure to asset ratio has declined over time, although not steadily. M/B ratio declined from 2.23 to 1.85 from 1992 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. Looking into such trends, growth opportunities seems to be limited at best and do not really warrants a decrease in debt ratios over time.

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To capture profitability, we look into number of profitability measures such as operating 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.

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

Further, while nothing conclusive can be said about increasing use of internal financing by looking into the trend for growth opportunities and profitability, we need to closely observe the availability of funds for the firms in India. We will try and 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.

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Important is to see the increasing role of banks in external financing. Share of bank borrowings as a percentage of total assets (BB/A) has increased almost steadily from about 8.74% from 1992 to 15% in 2012. On the contrary, share of borrowings from 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 total borrowings over the years. This shows that banks just tend to replace the funds earlier being provided by other financial institutions. Thus, overall no additional capital is being provided by financial institutions jointly in India. This may be partly due to the reorganization of large industrial credit institutions as commercial banks, for example ICICI has been reorganized as ICICI bank.

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

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Interestingly, share of bonds and debentures (BD/A) declined from about 7% in 1992 to about 3% in 2012; share of inter-corporate loans (ICL/A) remains stagnant at an average of 2.17% and share of commercial papers remain insignificant at an average of 0.18% from 1992 to 2012. Further, owing to restricted international capital flows, foreign commercial borrowings, which can replace domestic debt issuances, remained subtle. The ratio of foreign commercial borrowings as a percentage 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 may have only marginally contributed towards the availability of debt in India.

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

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

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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 total GDP (A/GDP) has increased significantly from over 25% in 1992 to about 125% in 2012. Alternatively, size as measured by total sales of non-financial firms when compared to total GDP (S/GDP) has also increased significantly from 19.8% in 1992 to 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 9 OMITTED]

Regarding asset tangibility, while we can see an increase in intangible assets as a percentage of total assets, the magnitude itself is very small compared to total asset. Figure 10a shows such a trend in net intangible assets over time. Net intangible 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 no conclusive evidence for tangibility of asset going down over the year. Specifically this ratio does not show any trend as such. Figure 10b shows trend in net tangible fixed assets (11) as a percentage of total assets. The average of the ratio of net tangible fixed asset to total asset is 32.8% over 1992 to 2012. Looking onto the data of asset tangibility, it is difficult to conclude that debt ratios may be declining due to increase in intangible assets.

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

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4. DEVELOPMENT OF CREDIT MARKETS IN INDIA

As seen from the data on borrowings above, while banks in India remained the sole vehicle for credit, the grim state-of-the-affairs in corporate borrowings from nonbanks can be attributed to several factors which somehow indicated towards the underdevelopment 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 capital or investment. As per the World Federation of Exchanges, the equity markets in India stands in top 5 countries in terms of number of trades per day; in top 20 in terms of traded volumes and in top 10 in terms of market capitalization. On the other hand bond markets in India seem to be struggling with basic issues concerned with key market microstructure such as liquidity and price discovery. Unlike, most other nations, market capitalization of secondary (12) equity market in India is higher as compared to debt markets. Interestingly, two-third of market capitalization in debt market is accounted for by central government securities only. Further, low level of market activities are reflected in debt markets by their total turnover which is only about 20% of the total turnover of equity and bond markets combined together. Average turnover per day for debt markets remains at Rs. 16 billion as compared to average turnover per day of Rs. 68 billion for equity markets in August 2012.

Interestingly, bond markets in India seem to be completely dominated by government securities and turnover in corporate securities remains marginal at best. Almost all the activities in secondary market transactions are actually overwhelmed by the share of government securities. Turnover of corporate bonds as a percentage of total turnover is 8.85% in August 2012. Average turnover per day turns out be Rs 1.43 billion for corporate bonds as compared to Rs. 10.80 billion for government securities. Market capitalization of corporate bonds as a percentage of total market capitalization of Wholesale Debt Market (WDM) segment at NSE is 4.95% as compared to 64% for central government securities in August 2012.

For international comparison, as quoted in Raghvan and Sarwono (2012), the value of outstanding government bonds in India was 39.5% of GDP as of 2010 and compares favorably with other Asian countries such as China (27.6%) and South Korea (47.2%). The value of corporate bond outstanding in India however was only 1.6% of GDP in 2010 compared to Malaysia (27%) and South Korea (37.8%) at the end of 2010. Despite similar growth environment, India has surprisingly lagged behind in developing corporate bond markets.

The observed activities in government securities market further needs to be seen in light of the fact that the current magnitude of government securities market come into existence due to heavy borrowings by government to finance the fiscal deficit. Financing of fiscal deficit through market borrowings increased substantially over the years. Average share of financing of gross fiscal deficit through market borrowing from 1992 to 2012 stands at 60.43%; average share since 2006 stands at 86.23% 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 percentage of gross fiscal deficit (13).

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

Moreover, the picture posed above would have at least provided some confidence in government securities market, if participation in such markets would have been fairly liberal and without any repressive constraints. However, bulk of the participation in government securities comes from commercial banks and insurance companies, which owns more than two-third of total outstanding government securities. Further, such holding comes out through repressive government intervention to hold such securities (14). For example, despite uncertain inflation forecasting, government bonds of 30 years maturity are floated by Reserve Bank of India (RBI) and banks were asked to buy such securities. This hampers true price discovery even in government security markets.

The state of debt markets in India is alarming given the fact that growing corporate and infrastructure demand for funds in India requires a stable alternate source of domestic funding. As per the last planning commission (2007-2012) workings, the estimated infrastructure financing were estimated to be about USD 500 billion up to 2012 and would remain strong at about USD 700 billion in the next five year plan for 2012-17. The generic development of the political economy in most countries would indicate that increasing risk aversion of banks, as understood by critical prudential regulation, might loom large for developing economies such as India, if alternate source of funding for firms are not operationalized. Further, resilience of an economy during recessions critically require alternate domestic source of funding. During low economic activities, funding from banks cannot be relied upon due to their excessive focus on managing credit quality, no matter whether the deterioration in quality is due to systematic or firm specific factors.

Even large corporate houses in India seem to rely on funding from banks when they are capable of raising debt on their own. This might primarily be due to the tradeoff between cost of capital raised and cost of issuance of securities is not favorable for them in India. This has serious consequence of squeezing credit for small and mid-cap firms, which has no other alternate source of financing apart from banks.

Among several other deterrents to bond market development (15) is the issue of investor's participation. Banks, financial institutions, insurance companies, pension and provident funds, other institutional and corporate investors seemingly form the base of investors for corporate bonds worldwide. However, what is interesting in India is that participation from conventional institutional investors such as insurance companies, pension funds and banks are rather bleak. This is primarily due to excessive and inordinate regulations posed on them (16). For instance, insurance companies 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 other financial institutions, can invest only up to 10% of the total funds collected in corporate bonds and that too of investment grade only. Adding to this, regulation requires that such bonds when purchased should largely be kept till maturity.

Historically, high domestic savings rates have been the strength of Indian economy. Despite this, the participation of retail investors is non-existent in India and has not been encouraged through any policy frameworks (17). Retail participation, as a fraction of total investment in corporate securities, seems to be low even in developed economies. However, such low fractional participation rates in developed markets are partially due to the fact that fractional institutional investment is very high in such bonds, which is not the case in India. Institutional participation itself is not very encouraging in India. Moreover, such participation by retail investors in developed markets is significant when compared to equity market participation. Participation in corporate debt by retail investors enables them to diversify their portfolios to a greater extent to manage risk exposures for their investments.

While there are not enough innovative instruments to support the fragile corporate debt market, one cannot even find the much needed support for active exposures in interest rate derivatives in India (18). Despite the fact that interest rate futures being formally launched in the markets way back in 2003, activity seems to be non-existent even today, owing to lack of variety in instruments and lack of critical participation from diverse agents. This critically undermines the possibility of managing the risk exposure by primary dealers as interest rates remains quite volatile in India. This leads to unwarranted risk aversion which further hampers the true price discovery in the markets. Moreover, absence of such critical supporting instruments for primary dealers leads them to provide liquidity at higher costs.

Features such as stamp duties are levied differentially at state levels and also between players (19). Such taxes increase the cost of transactions and hence financing. Firms are thus taxed for entering into financing transactions over and above the taxes they pay for their incomes.

Notwithstanding the debate on improving the market microstructure of corporate debt markets, an important issue for stabilizing the supply of credit is to secure creditors in the event of default. The modalities of recovery of assets of failed firms remain lengthy and costly in India. Defaulted firms were reported at Board for Industrial and Financial Reconstruction (BIFR) and more recently to the Asset Reconstruction Company of India, Ltd. (ARCIL) and the final settlement of recoveries 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 secured creditors are given the right to take possession of assets and sell them in case of default by the firms. However, SARFAESI provides these rights to secured creditors only and there is not much to offer for unsecured creditors. This is important and concerning given the extensive and much sought after participation of unsecured creditors in corporate debt markets.

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

In order to appreciate the issue of underdeveloped bond markets in India, not much has been done through setting up of intellectual forums or administrative committees by government directly. Among those rare instances, Government of India has constituted a committee in 2003 under the chairmanship of Dr. R H Patil, founder of the National Stock Exchange, to study the shortcomings of corporate debt markets and to recommend ways and means to establish a buoyant market in India. The committee has submitted the report in year 2005, where most of the recommendations were approved by the government in 2006. Even after six year of such approval not much could be done to implement measures suggested by the committee (20). From above discussion we can infer that development of debt market in India would require not only a wholesome understanding and coordination between various stakeholders but also it requires a serious political will.

5. IMPLICATIONS OF LOW DEBT RATIOS IN INDIA

If firms would choose low leverage voluntarily, their profitability should increase somehow. However, profitability ratios indicated above do not really show this pattern. To capture this reduction we first highlight the effective taxes paid by the firms for a given operating income over the years. Figure 12 shows a trend where effective 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 an average are paying more taxes for a given level of operating income. That would mean that less value is created for their investors. An indirect implication for this is 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. Important is to analyze the fiscal deficit position given the low leverage structure by firms in India. As noted in Figure 1, corporate taxes contribute 29.08% to the total government receipts in 2012. This is a significant increase from 7.51% in 1992. As argued in this paper, this increase in share seems not to be a natural outcome of growing corporate sector but increasing tax burden for firms. The stability of fiscal deficit is, therefore, threatened given government is increasing its reliance on a source of finance which comes as a result of market distortions. In other words, government receipts probably thrive by not providing a level playing field to corporate sector in terms of their ability to raise capital through debt markets.

[FIGURE 12 OMITTED]

An interesting dimension to this analysis is the impact on fiscal deficit by rationalizing the tax payments which might emerge when firms are able to raise optimal debt for themselves. If effective taxes, measured as tax paid as a percentage of operating income, is reduced by 1%, from the existing levels of about 15%, the government receipts will reduce by Rs. 265 billion and fiscal deficit (21) will, therefore, increase by the same amount. This is an increase of 132% in fiscal deficit, given that the level of deficit currently is about Rs. 200 billion.

The current scenario looks like a moral hazard problem for government where given the sensitivity of fiscal deficit to debt ratios of the firm, government may not like 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 also the weakness in assuming its fiscal responsibilities as deemed in principle through legislative measures such as FRBM Act, 2003.

Further such a proposition acts as a double whammy for the global competitiveness of firms in India. Apart from not being able to raise funds in international capital markets, firms in India are also not being able to raise competitive finances domestically. Given that firms are restrained to tap alternative and cheap source of capital when compared to firms globally, it is imperative that they are sacrificing their competitiveness internationally. This issue might cause a sense of urgent attention when government seems to open up the markets extensively for foreign players. A recent incidence is the issue of retail FDI in India.

6. A WAY FORWARD

The discussion above about the current state of the affairs of credit availability for firms in India highlights a potential moral hazard for government to develop bond markets. However, it can be seen positively as an opportunity for government to stimulate economy without fiscal interventions in real terms. If credit markets could be developed in India, it can somewhat substitute the fiscal stimulus provided by the government to revive the real sector in Indian economy. Firms themselves could get the necessary stimulus for private investments through competitive capital markets.

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

For sufficient political and economic reasons though, the suggestion for increasing tax rates might sound rather radical and irrational given the already high tax structure in India. However, the concern for drop in government receipts by developing credit markets may not be realized practically. With sound availability of credit, firms would increase their investments and hence their operating incomes proportionately. Higher operating income would in turn provide higher tax receipts to the government exchequer again. Raising tax revenue this way will be more organic and aligned to welfare in the long run. This collectively might resolve the issue of drop in government receipts from corporate taxes and would also stimulate the investment climate in the country. This in turn will improve the status quo of Indian firms vis-a-vis foreign players. Fiscal deficits will now be more sustainable and 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 its expenditure, provided it wishes to bring in sustainability to the fiscal deficit position in India. While, bringing in sustainability is desired, a strong political will is required for developing credit markets in India.

Notes

(1.) 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) for several determinants of capital structures.

(6.) See Scott (1972) and Kraus and Litzenberg (1973) for the initial literature on "static tradeoff theory" relating tax savings and financial distress by increased probability of failure for firms. Also See Graham (2003) for a review of the literature on the influence of taxes on capital 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 and Pindado (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, transport and 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 in India with regard to institutional investors' participation.

(17.) Retail Debt market segment was formally launched at NSE in 2003, with a view that initially trading be allowed in government securities and subsequently in phase wise development trading would be allowed in other securities. Despite of the fact that number of trade reported in 2003-04 was 912, trading is eventually evaporated from this segment as there was no trade reported in the fiscal 2011-12.

(18.) No trade being reported in Interest rate futures for six out of first eight months for year 2012 at 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 government of India.

(21.) Fiscal deficit here is measured as difference between total government receipts and expenditures.

References

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GAURAV SINGH CHAUHAN, Indian Institute of Management Indore, Prabandh Shikhar, Rau-Pithampur Road, Indore - 453331, MP (India), E-Mail: gauraus@iimidr.ac.in; s.gaurav.c@gmail.com

Table 1
Corporate income tax rates *

Country               Corporate Income
                      Tax Rates (2012)

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

Source: KPMG (#) includes duties, surcharges and additional cess