Many Indian firms need more leverage
Business Standard, 24 July 2023
Borrowing by large Indian firms has greatly subsided. While this makes managers of firms feel safe, it is not healthy for the Indian economy. Debt is a disciplining device, and it helps ensure that managers run hard, which is good for shareholders and society. Borrowing improves return on equity, which is good for shareholders. Indebted firms go bankrupt, which is part of Schumpeterian creative destruction. An economy where large firms have little debt runs the risk of being less dynamic. Shareholders and boards need to reopen the discussion on optimal firm leverage.
The big decline in firm borrowing
From the early days of economic reform, the Indian non-financial corporate sector has retreated from borrowing. Their debt-equity ratio was highest at 1.85 in 1991-92. In the latest data, for 2021-22 it stood at 0.89 and it is likely to have dropped further in the following year. It generally makes sense to represent the balance sheet on market-value terms. In this, the re-pricing of debt yields little change, and net worth is re-priced at market capitalisation. Once this re-pricing is made, the magnitude of debt that is now present is minuscule. When we look into the industry structure of the debt, it is really found in only a few industries like electricity: Leverage in most industries is at astonishingly low levels.
There has been much discussion about why this grand phenomenon took place. Explanations include: Low demand owing to the macroeconomic environment with low investment, low demand owing to fears of bankruptcy costs, and low supply owing to fears of bank employees (which spread from public-sector to private-sector bankers through a Supreme Court ruling in 2016 about the scope of the Prevention of Corruption Act). It can be argued that firms are recoiling from the problems that were experienced with high leverage. It must be noted that the peak leverage seen (debt:equity ratio of 1.85) was a while ago (1991-92) and any extremes of short-term responses should have subsided.
Some view low or near-zero debt as a healthy foundation for sustained growth in India. When difficulties were faced with high leverage strategies, is the answer to go to zero debt? Is zero debt the optimal design for an Indian business? What do very low levels of corporate debt imply for economic dynamism? Three problems can be identified.
- Debt as a disciplining device
- A fundamental feature of corporations is the principal-agent conflict, between the interests of shareholders and the interests of managers. Managers want more money and less effort, and they want to constrain the strategy of the firm to stay within their capabilities so as to sustain their power. Shareholders want the firm to do well. In this conflict, loading up on debt is good for the shareholders. In a low-debt firm, the managers can slack off. When debt is present, managers are under pressure to create the cash required for debt servicing. Debt makes managers run harder. This creates economic dynamism.
And -- a greater presence of debt forces them to work harder regardless of whether they have shares or not. This tool is particularly important in India, given the fact that one main institution that should demand accountability from managers -- the board -- does not work much. Under Indian conditions of boards that do not drive managers, the optimal level of debt is higher.
- Creative destruction
- A healthy economy is one in which there is a steady flow of firm failure. A critical path to failure lies in the presence of debt and then in debt default. Once debt is mostly removed from the picture, a variety of low-quality firms can survive indefinitely. This is related to the governance problem described above: Once boards work poorly and debt is absent, managers get a peaceful ride. This lack of a steady pace of firm failure is harmful for economic dynamism.
- Return on equity
- In the standard corporate finance toolkit, a successful business achieves supercharged return on equity by adding debt. Many a business in India is inefficiently geared: The shareholders are left with poor return because there is not enough debt.
For shareholders, inadequate debt harms return on equity and reduces the pressure upon managers to run harder. For society at large, economic dynamism is hampered when managers do not run hard and when there is a low rate of firm exit. The biggest beneficiaries of this low-debt environment are the managers who control the firm. They have an easy time, in the context of Indian boards, which mostly do not hold them accountable.
Everyone in the Indian business world knows the dangers of excessive leverage. The main point here is to also draw attention to the problems associated with zero leverage. The truth lies in between, in moderate and wise levels of leverage.
How can things change
Solving this problem is primarily up to the dominant shareholders of firms and the boards that represent them. This reasoning needs to feed into the better working of boards. When boards do not exert their oversight on corporate financial structure, there will be a bias in favour of inefficient levels of gearing. There are now myriad situations in India where the chief executive officer is not a dominant shareholder. In such situations, the shareholders and board members need to push in favour of non-zero leverage.
Implementing such a strategy will face constraints. The bankruptcy process works poorly and imposes an unreasonable level of costs. These factors suggest the optimal level of debt is moderate and not high. Against the backdrop outside each firm, there is an array of difficulties in the supply side of debt. Banks, the bond market, foreign borrowing: All these pathways are hampered by weaknesses of financial economic policy. For the typical non-financial firm, going from low debt to moderate debt will be hard. The finance department of firms and of group-holding companies will have to develop special expertise in strategising and implementing the borrowing programme.
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