I am among those investors who wonder what has happened to the investment pattern of leading Indian industries who roared with huge financial leverage( It is defined as financial borrowing to generate income to overcome its cost of acquisition) after Indian economy skyrocketing during the past decade, and why no suitable income generated for the investor? Yes, RBI with its latest study of financial leverage vs Investment as per the following web would answer the question after a study of nearly 2 decades of experience:


The study was undertaken by distinguished Mr. Avdhesh Kumar Shukla who is Director in the Department of Economic Policy and Research, Reserve Bank of India (RBI), and Mr. Tara Shankar Shaw who is an Associate Professor at Indian Institute of Technology, Bombay, Mumbai.

With no emotion attached as an investor with ardor, let me decrypt the study with simple explanations.

The preamble nails the truth, however unpleasant it may be.

“The GDP growth during 2012-2020 was characterized by a significant slowdown in capital formation. The literature provides evidence that the slowdown in investment growth was driven by the lower capital formation in the private sector ————–.

The decline in investment growth was particularly noticeable in manufacturing, electricity, and other utilities, construction, transport, and communication services. The private sector firms in these sectors recorded a significant increase in leverage after the global financial crisis (GFC).”

We mean leverage as financial leverage in all our discussions.

Therefore, this study attempts to explore whether the firms’ leverage, which increased sharply after the GFC, has affected investment behavior in India. The literature suggests that capital structure and debt overhang in balance sheets of non-financial firms, after the GFC, have played an important role in capital formation slowdown in many economic jurisdictions.

The scholars start with their hypothesis as under and their study continues to prove these statements.

“We test two key hypotheses as outlined below.

i. Firm leverage affects physical investment negatively; and

ii. Relationship between physical investment and leverage is non-linear, i.e. at lower levels of leverage it has either positive or no impact, while at higher levels it negatively affects investment”.

Their study is based on following pattern.( as described in the study)

  • Theoretical underpinnings relating to firms’ physical investment and capital structure are covered in Section II.
  • Data sources and methodology are outlined in Section III.
  • Section IV covers stylized facts about India’s economic growth, capital formation, and other relevant macro and micro-economic variables.
  • The results of econometric analysis and key findings are discussed in Section V.
  • Section VI concludes the paper.

What was the economic situation abroad on the combination of leverage and investment pattern?

International experience

I may explain the international experience of capital expenditure and financial leverage. (from pages 6 and 7 of the main report.)

Statement of facts

  • “In a study of a group of five peripheral euro area countries for the period 2005 to 2014, Gebauer, Setzer, and Westphal (2018) find a negative relationship between corporate leverage and their capital expenditure.
  • In an analysis of the Brazilian economy, Krznar and Matheson (2018) show the role of high leverage in restricting new investments by firms.
  • A similar study on the impact of leverage on investment at the firm level for Canadian enterprises shows that a higher level of debt reduces investment in low growth firms, as benefits are expropriated by the bondholders rather than the shareholders and management (Aivazian, Ge, and Qiu, 2005).
  • The theory of agency cost of debt by Jensen and Meckling (1976) suggests that at a lower level, debt has a disciplining effect on firm managers, but at higher levels, it increases the probability of bankruptcy and misallocation of resources.
  • Therefore, the literature suggests a non-linear relationship between the leverage and the firm’s investment.
  • In the case of Spain, Hernando and Martı ́nez-Carrascal (2008) find non-linearity between leverage and firm’s investment.
  • This was reiterated by Gebauer, Setzer, and Westphal (2018) in their study of five peripheral euro area economies.
  • They find that the negative impact of leverage on investment is higher when the debt-asset ratio is above 90 percent.

My explanation

Our understanding of the above information indicates that a higher level of debt reduces investment in low growth firms since the benefits flow towards bondholders than shareholders and management. Debt which controls the firm managers at low levels fails to dampen the efforts of the probability of tilt towards bankruptcy and misallocation of resources. The saddest part was that in India, as an investor for the past 4 decades the fruits of development or fall thereof resulted in less return for his investment.

Let us go in for a detailed analysis of the study in India.

The key variables used in the study are listed in Table 1. Firm-level data are obtained from the CMIE Prowess database. The data cover the period 2004-2017.

Data on 5,779 firms providing 54,354 firm-year observations are available in Table 1 at page 8. Macroeconomic data have been sourced from the Database on the Indian Economy of the Reserve Bank of India. Data relating to policy uncertainty was obtained from the web portal www.policyuncertainty.com.

Table 1 on page 8 is explained below:

Table 1: Firm-level and macroeconomic variables used in the study

Firm-level variables

Investment rate:  Annual change in net total fixed assets plus depreciation (in %)

Leverage:  Ratio of financial debt to equity, with financial debt including loans, securities, and other current liabilities

Debt to asset ratio: Ratio of financial debt to total assets (%)

Growth of debt:  Annual growth of borrowing (%)

 Interest rate burden/ interest coverage ratio:

 Ratio of earnings before interest, taxes, depreciation, and amortizations (EBITDA) to interest payments (times)

Profitability (RoA):  Ratio of earnings before interest, taxes, depreciation, and amortizations (EBITDA) to total assets (%)

Growth in profits:  Annual growth in EBITDA (%)

Size of the firm:  Log of total assets

Price to book ratio: Ratio of equity prices to per-share book value of a firm. It represents the growth opportunity of the firm.

Macroeconomic variables

Effective policy rate: A weighted average of the repo and reverse repo rates (weights are assigned on the basis of liquidity conditions in the Liquidity Adjustment Facility Window)

Policy uncertainty index: Baker, Bloom, and Davis uncertainty index http://www.policyuncertainty.com/about.html

Stylized facts relating to investment and firms’ capital structure

The following facts related to investment and capital structure present a bleak picture.

Let us view the data more closely.

  • The growth rate of real investment decelerated sharply after 2011-12. Strangely, the share of capital formation during the period 2011-19 was less than one-fourth in contrast to around two-third during high growth phases, viz., 2003-08, and 2009-11.
  • Within gross capital formation (GCF), the contribution of gross fixed capital formation (GFCF) during the period 2014-19, at around 25 percent, in fact, was significantly lower than the level of 51.3.

Table 2 on page 10 indicates that the mean rate of capital formation (ratio of annual change in gross fixed assets to gross fixed assets at the end of the previous year) by non-financial firms peaked in 2008-09. It recorded a secular decline across sectors thereafter. Let us table it for a clear understanding.

Table 2 Investment rate of all non- financial firms

Year No of firms Mean Median
2004-05 2980 7.7 4.0
2005-06 3166 9.5  5.2
2008-09 4088    14.8 8.8
2009-10 4271 13.3 7.6
2012-13 4430 11.0 6.0
2015-16 3988 6.5 3.1
2017-18 3025 6.9 3.8

Though I may be inclined to include similar figures for the debt-equity ratio, it is also important to say that the” Debt-equity ratio, a key proxy for firms’ leverage, increased considerably after 2008, though it showed some signs of easing in 2017 (Table 3). The average debt-equity ratio of firms is significantly higher than median values indicating right skewness in the data. Average debt to equity ratio during the period 2011-17 was 1.5 as against 1.3 during the period 2004-11. “(Table 3 appears on page 11)

The main details from Table 3 (page 11) are as under:

Table 3: Debt-Equity ratio

Year No of firms Mean Median
2004-05 2980 1.30 0.77
2005-06 3166 1.30 0.81
2008-09 4088 1.34 0.87
2009-10 4271 1.43 0.92
2012-13 4430   1.43 0.89
2015-16 3988 1.50 0.81
2017-18 3025   1.32 0.67

I would like to quote from the main study the following statement:

“In line with the rise in debt-equity ratio, firms witnessed a general deterioration in their debt repayment ability as measured by the interest coverage ratio (Table 4). Unlike the debt-equity ratio, deterioration in the interest coverage ratio was more pronounced for construction sector firms. In 2017-18, the interest coverage ratio of manufacturing and metals sectors witnessed an improvement, while firms in the construction sector did not show signs of improvement.”

Table 4 appearing on page No. 12 contains the following figures:

Table 4: Interest coverage ratio

Year No of firms Median
2004-05 2853 4.54
2005-06 3009 5.28
2008-09  3918 4.60
2009-10 4082  3.78
2012-13  4240 3.46
2015-16 3831  3.21
2017-18 2911 4.10

Some may be interested to know the technical tables for a deeper understanding of the study.

  • Table 5: Regression analysis of firm-level investment equation
  • Table 6: Sector-wise regression of basic investment equation
  • Table 7: Regression results – Impact of leverage over firms’ capital expenditure
  • Table 8: Regression results in quadratic and cubic functional forms


The main conclusion of the study may be given as under:

“By analyzing the experience of the Indian economy, our study fills an important gap in the context of emerging market economies. We empirically demonstrate that heightened corporate leverage, through adverse impact on investment activity, aggravated the economic slowdown in the Indian economy.”

Is it so simple to conclude?

Expectedly, high leveraged firms had an adverse impact on their capital expenditure. The relationship between leverage and the firm’s investment was also non-linear in nature. With their high leverage, with a poor balance sheet, any firm is loathing to approach external sources for investment purposes. Obviously, equity shareholders were not interested to contribute when the financial leverage at record high levels stymied their expectations. If one has to go through the behavior of even rich public sector banks, even SBI never offered even once a bonus share during the last 30 years. Even many Tata group of companies never failed to garner huge financial leverage but did not adequately compensate the equity shareholders.

I do agree with the major finding of the paper that the initiatives to clean up balance sheets of banks and deleveraging by non-financial corporates should help in the revival of the investment cycle. Virtual silent statements from the Chairman of many successful on investment plans cast a gloomy shade on the expectations of genuine investors.

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