Ebook Impact of liquidity constraint on firm’s investment decisions
It has been argued that changes in monetary policy have large impact on real economic variables (Bernanke and Blinder, 1992). The channels through which these effects are transmitted are, however, still a matter of debate. Several channels of transmission have been proposed in the literature. Salient among these include the money channel and the bank lending channel. The former channel argues that a reduction in bank reserves lowers the stock of money, which leads interest rates to rise. Investment and aggregate demand, as a result declines consequent upon the higher cost of capital. The bank lending channel, on the other hand, contends that by lowering reserves, a monetary contraction drains deposits from the banking system and hence, reduces the supply of loans and aggregate spending (Kashyap et al., 1993).
Empirical evidence as the existence of these channels is, at best, mixed. In view of this, several studies have started to explore the possible role played by capital market imperfections in transmitting and amplifying monetary policy shocks and a literature on the broad credit channel has emerged (Hubbard, 1995; Bernanke et al., 1996). According to this view, because of informational asymmetries, lenders are not well informed about the quality of the firm and demand a premium on the debt or stock issued by the firm. As the premium on external finance is inversely related to the borrowers’ financial conditions, such as net worth, an adverse monetary shock which causes the borrower’s financial condition to deteriorate will engender an increase in its cost of external finance and a decrease in its borrowing abilities. Consequently, the borrower’s investment and output will fall.
The paper employs a sample of Indian manufacturing firms for the period 1995?2004 to test whether the effects of the change in monetary policy on firm investment can be transmitted through leverage. This idea can be traced back to Fisher (1933) in explaining the Depression of the 1930s. According to the Fisherian hypothesis, an unanticipated fall in the price level leads to a decline in borrowers’ net worth and an increase in their real debt burdens, which results in a decrease in borrowing and investment.
More recent work on capital market imperfections has shed further light on the role of debt in transmitting monetary shocks. More specifically, because of conflicts of interests and informational asymmetries between lenders and borrowers, debt induces agency problems, which in turn lead to a premium on external funds. Since a highly indebted borrower is more likely to default and has a greater incentive to opt for excessively risky projects, the premium on external finance will be higher for firms with lower net worth or higher leverage. Bernanke and Gertler (1989) show that exogenous shocks, such as decline in production, will lower a firm’s cash flow and boost effective cost of investment. The fall in investment spending will lower the firm’s output and cash flow in subsequent periods, leading to the propagation of the initial shock through credit cycles (Kiyotaki and Moore, 1998).
While there is by now a rapidly expanding literature on the presence of finance constraints on investment decisions of firms for developed countries, limited empirical research has been forthcoming in the context of developing countries for two main reasons. First, until recently, the corporate sector in emerging markets encountered several constraints in accessing equity and debt markets. As a consequence, any research on the interface between capital structure of firms and finance constraint could have been largely constraint driven and hence, less illuminating. Second, several emerging economies, even until the late 1980s, suffered from ‘financial repression’, with negative real rates of interest as well as high levels of statutory pre?emption. This could have meant restricted play of market forces for resource allocation.
Issues regarding the interaction between financing constraint and corporate finance have, however, gained prominence in recent years, especially in the context of the fast changing institutional framework in these countries. Several emerging economies have introduced market?oriented reforms in the financial sector. More importantly, the institutional set?up within which corporate houses operated in the regulated era has undergone substantial transformation since the 1990s. The move towards market?driven allocation of resources, coupled with the widening and deepening of financial markets, have provided greater scope for corporate houses to determine their capital structure.
The rest of the paper unfolds as follows. Section II discusses the institutional context to contextualize the present study. Section III explains the methodology and the data employed in the paper. Section IV presents the results and discusses robustness check followed by the concluding remarks in the final section.
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