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The Role of Long Term Finance: Theory and Evidence
Gerard Caprio, Jr. and Aslï Demirgüç-Kunt
Policy Research Department
The World Bank
February 1997
We would like to thank Stijn Claessens, Harry Huizinga, Vojislav Maksimovic, Fabio Schiantarelli and Mary Shirley for helpful comments. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent.
The Role of Long Term Finance: Theory and Evidence "Almost without exception DFC project appraisal reports take the position that in developing countries there is an inadequate supply of long-term (and foreign exchange) financing for the industrial sector. Most appraisal reports are focused on the solution to the term-financing problem, however, not on the analysis of the extent of the problem or its consequences." (Long, 1983)
A popular view, seen in the above quotation from 1983, is that financial markets in developing economies are highly imperfect and, in particular, that the alleged scarcity of long term finance is a key impediment to greater investment and growth. Indeed, a significant part of World Bank and other multilateral development bank lending was aimed at attempting to correct for the dearth of term credit through the creation and encouragement of DFIs (Development Finance Intermediaries), later through financial intermediary loans (FILs) extended through DFIs and commercial banks, and recently by extending guarantees to lengthen the maturity of loans. On the other hand, a recent strand of the finance literature has been studying the forces which determine the maturity structure of a firm’s debt.^1 In those models, long term debt is not necessary for acquiring physical capital and indeed performance of firms may improve by decreasing reliance on long term debt. Thus, policy-induced changes in the term structure of finance generally, if not uniformly, would be viewed at best with great skepticism by these analysts. Notwithstanding the difference of views, attempts to cure this ‘market imperfection’ -- the alleged scarcity of long-term credit in developing countries -- have been plentiful and expensive. By the early 1980s many DFIs were experiencing significant portfolio problems.^2 Many of the moderate problems became severe later in the 1980s, and a wave of failures of DFIs or, at best, severe financial distress, was the
(^12) See for example work by Berglof and von Thadden (1993), Diamond (1991,1993) and Rajan (1992). was 41 per cent, while a 1983 report indicated that 39 percent of the DFIs were experiencing seriousA 1974 study of delinquency rates in agricultural lending institutions reported that the average arrears rate
characteristics of firms in poorer economies. This lacuna was understandable even five years ago, because the data to test whether or not there was a shortage of long-term credit and whether the availability of such credit affected firm performance were not available. Recently, this gap has been filled in two ways: first, by the availability of firm-level data in emerging markets for the top tier of firms listed on stock exchanges, and second, by various surveys of listed (and in some cases unlisted) firms in selected countries, prompted by governments’ attempts to understand the impact of a variety of policies on firm behavior. Armed with this data, a variety of studies from a World Bank research project on term finance have appeared in the last year to evaluate the empirical properties of long term credit and, as a result, we now have answers to fill an important part of the aforementioned gap in our knowledge.^5 The present paper reviews these findings and discusses why policy makers should care about this issue. Section I investigates the issue of the availability of long term credit in developing countries, while Section II reviews evidence about the relationship of long term credit and firm performance. Section III concludes with lessons for policy makers and bilateral and multilateral agencies, as well as directions for future research.
I. Firm Financing Decisions and Debt Maturity Choice The starting point for any policy decision to encourage more long term credit should be that it is both scarce and important for goals of concern to developing country policy makers. This section examines the scarcity issue, discussing what it means and reviewing
(^4) For example, a recent World Bank loan to Argentina uses Bank resources to provide a backup facility -- much like a revolving underwriting facility (RUF a 1980s financial innovation in industrial countries) for the rollingover of 3-year loans. (^5) These studies are part of the World Bank Research Project (RPO 679-62) and were presented at the World Bank Conference “Term Finance: Does It Matter?” held in Washington D.C., June 14, 1996.
evidence, both within countries and among them, leaving the importance (or performance) issue to section II. What does it mean to say that long term credit is scarce? A typical way this question has been answered is by surveying firms to see what are important constraints on their operations; credit, usually long term credit, regularly is at or near the top of the list. However, such an approach is unsatisfactory, not least because it often is unclear what survey respondents imagine they will pay for credit. Moreover, it is unclear under what type of financial system they would be able to obtain short or long term credit. Even the most advanced financial system will find some borrowers uncreditworthy or would grant them much less credit than they might desire or at higher interest rates than they would like. Given riskier than average firms, loans at average market rates are attractive to these borrowers precisely because they convey a subsidy in the form of a lower risk premium than the market would grant them.^6 Whenever there are many firms whose expansion is constrained by the lack of long-term credit, there are three potential sources of this constraint: first, macroeconomic factors limiting the supply side; second, institutional factors specific to the financial sector (often dubbed market imperfections); and third, the characteristics of the firms, or classes of firms, in the country. One way to interpret scarcity then is by the relative access to credit, i.e., to say that there is scarcity to the extent developing country firms find it more difficult to gain access to long term credit in comparison with similar firms in developed countries. In this relative sense if there is a scarcity or limited access in developing countries, then there
(^6) Being aware of adverse selection and moral hazard problems, there of course are some borrowers to whom banks will not provide credit at any price.
information systems or contract enforcement mechanisms. Thus, if accounting and auditing are underdeveloped or if it is difficult or expensive to enforce loan covenants, bankers will prefer short term credit. Ignoring this deficiency and establishing government banks to lend long term certainly is faster, less difficult, and likely cheaper than trying to address the information or contract enforcement problems, but these banks will have to cope with the same issues that private banks would confront, and may have additional incentive problems as well. Finally, the maturity structure of finance in an economy will depend on the characteristics of the firms there as well. Section Ib will review how all three factors interact to yield different patterns of maturity structure across countries. But first, the next part reviews how access to long term finance can differ within an economy by highlighting the importance of firm specific factors.
a. Differential Access Within Countries: Relevance of Firm Characteristics In the aftermath of the seminal Modigliani-Miller article, which found that the value of a firm was invariant to its mix of financing, the study of financing choices by firms initially received little attention. As economists and finance experts have repealed the simplifying assumptions of this classic framework, however, they have developed a literature on the maturity structure of firm financing, stressing the different roles played by long and short term finance. This literature emphasizes that short term debt permits loans to be repriced to reflect new information, increases efficiency by allowing uneconomic projects to be terminated, and gives manager/owners strong incentives to avoid bad outcomes. In contrast, long term debt protects the firm from liquidation by
at least in some medium run.
imperfectly informed creditors and prevents opportunistic creditors from using the threat of liquidation to expropriate the profits of healthy firms. The optimal mix of long and short term debt is determined by a number of parameters including the firm's observable credit quality (i.e. its credit rating), its portfolio of growth opportunities, the profitability of the project, the ability to fund the project through retained earnings, the liquidation value of the assets, the perceived accuracy of financial information, the firm’s size and age, and the level of banking competition (Table 1). According to Myers’ (1977) seminal article, just as workers possess firm-specific capital, firms’ owner/managers possess future investment opportunities that are like call options. These investment opportunities usually are important in determining the market value of the firm; if so much of the benefit of future investment accrues to debtholders that the owners -- stockholders -- cannot capture enough of the benefits, then the owners may underinvest. The greater the growth options that a firm has, the greater the possibility of a conflict between stock and bond holders, with the outcome being ‘underinvestment.’ As Myers notes, the firm can limit this problem by having less debt, by including restrictive covenants in its debt contracts, or by having more short term debt (since if the debt matures before the investment option expires, it is easy to show that there is no conflict). In developing countries, one might expect to find more firms with growth opportunities, meaning that this underinvestment problem could be significant there. Moreover, since both share issuance (one way to lower debt-equity ratios) is difficult in lower income countries and contract enforcement mechanisms (needed to enforce covenants) typically less developed, firms there can be expected to use more short term and less long term debt. By using a series of short-term loans, bankers retain greater control over their clients because the option to halt the
countries are more likely to be informative if researchers control for these parameters, as we show below. While numerous empirical papers tested the implications of capital structure models, attention recently has turned to empirical determinants of debt maturity.^8 Titman and Wessels (1988) show that firms with higher leverage issue both more long term debt and more short term debt, but do not provide a clear picture of how the mix of long term and short term debt varies with firm characteristics. Barclay and Smith (1995) find that firms that have few growth options and large firms have more long term debt. Stohs and Mauer (1996) find that larger, less risky firms, with longer-term asset maturities use longer-term debt. These studies all used U.S. data. In the World Bank research project, empirical studies using developing country data generally confirmed their results, with some interesting exceptions. The link that stands up most clearly is that for the matching of firm assets and liabilities. This finding is quite robust in Italy and the United Kingdom (Schiantarelli and Srivastava, 1996), where it is also clear that firms with higher profits get access to more long term credit. Maturity matching also is evident in Colombia (Calomiris, Halouva, and Ospina, 1996), India (Schiantarelli and Sembenelli, 1996), and Ecuador (Jaramillo and Schiantarelli, 1996). This finding is important for policy, in that as maturity matching represents a tendency in both industrial and developing country markets, attempts to stimulate long term finance may prove to be excessive -- firms may resist taking on long term debt if it does not fit their balance sheet structure, and indeed may only do so if long term debt is subsidized, meaning a lower risk premium than they would get from the market. Also, these country studies showed that financial markets, where free from government intervention, provide more long term finance to better
quality firms, and attempt to monitor lower quality firms more closely by using short term debt. Whether or not governments even should want to intervene should depend on the link between long term credit and firm performance (below), as well as on equity considerations and dynamic arguments. For example, it is possible that small firms find it excessively difficult to obtain long term credit, as in Ecuador, where only 11% of micro firms and 17% of small firms had long term debt every year (1984-88), compared with 58% of all large firms.^9 This correlation likely reflects the role of collateral, with large firms having more collateralizable assets, as well as age.^10 Moreover, larger firms in Ecuador tended to be more profitable, suggesting that the allocation of credit favored firms with the more solid balance sheet positions. Finally, it could also reflect the greater economic and political bargaining power of large firms in obtaining directed credit. A disturbing fact was that, given firm size, past profits had no relationship with the amount of long term credit obtained. Whether this latter finding reflects a market failure, the limits of banking (bankers can pick the class or industry, but not individual winners and losers) or excessive intervention is not clear (a substantial portion of long term debt was subsidized).
b. Differential Access Across Countries: Relevance of Institutional Factors In addition to firm specific factors, the relative amount of long term credit will also depend on a variety of institutional factors. As noted above, financial theory suggests that
(^89) See Harris and Raviv (1990) for a review of empirical and theoretical capital structure literature. data set (1984-92).The correlation between access to long term credit and firm size was also seen in Ecuador in a separate
control, a developed banking sector can facilitate access to external finance and especially long term finance, particularly among smaller firms which have limited access to alternative means of financing due to information costs. Large stock markets provide opportunities for diversification by entrepreneurs. Thus, in countries with developed stock markets there may be an incentive for firms to substitute from long-term debt to equity. However, stock markets also transmit information that is useful to creditors. Prices quoted in financial markets at least partially reveal information that more informed investors possess, as demonstrated by Grossman (1976) and Grossman and Stiglitz (1980). This revelation of information may make lending to a publicly quoted firm less risky. As a result, the existence of active stock markets may increase the ability of firms to obtain long-term credit. Finally, governments seek to increase the availability and use of long term debt -- which they think may be undersupplied due to informational costs, enforcement problems and financial market imperfections-- through adopting policies that direct or subsidize long-term financing to favored firms or sectors. Directed credit policies include preferential discount lines from the central bank, portfolio restrictions on private commercial banks, guaranteed credit for public enterprises, and credit lines through development banks. These programs need not always involve financial subsidies, but they frequently do. The degree of these distortions varies from country to country and may be an important determinant of the capital structure of firms. 11 Several studies have explored the effect of the institutional environment on firm financing choices in specific countries. Hoshi, Kashyap and Scharfstein (1990) show that membership in industrial groups linked to banks reduces financial constraints on Japanese
availability of long term credit.
firms. Schiantarelli and Sembenelli (1996) provide evidence that Italian firms that are members of large national groups face less severe financial constraints than independent firms. Calomiris (1993) examines the effect of differences between the banking systems of the United States and Germany on firm financing in the pre-World War era and argues that regulatory limitations on the scale and scope of US banks hampered financial coordination and increased the cost of capital for industrialization. Rajan and Zingales (1995) and Demirg -Kunt and Maksimovic (1995) compare and contrast capital structure decisions of firms in five developed countries and ten developing countries, respectively. Both studies conclude that institutional differences are crucial in understanding determinants of capital structure. However systematic cross-country comparisons are needed to illustrate fully the effect of financial and legal institutions on financing decisions of firms, since the institutions within a particular country tend to evolve very slowly over time. In the past, cross-country empirical studies of this nature have been few and recent due to data constraints. One of the recent World Bank studies (Demirg -Kunt and Maksimovic, 1996a) focuses on the impact of stock market development on firm financing decisions. Analyzing firm-level debt-equity ratios in 30 developed and developing countries they find that existence of active stock markets increases the ability of firms to borrow, especially in countries with developing financial markets.^12 They also compare and explain firm debt maturity choices across countries and they find systematic differences in the use of long term debt between developed and developing countries, as well as small
(^11) Atiyas (1991) and World Bank (1989) provide evidence that directed credit often failed to reach its intended beneficiaries. (^12) The data set consists of financial statement data for the largest publicly traded corporations in manufacturing in thirty countries.
LTD/TA STD/TA TD/TA LTD/TD
SmallMedium LargeVery Large
(LTD/TA), short-term debt to asset (STD/TA), total debt to total asset (TD/TA) and long-term debt to total debt^ Figure 2. Debt Ratios: Small vs. Large Firms.^ The figure presents the average long-term debt to asset (LTD/TD) ratios across thirty countries by firm size.total assets, and the average debt ratios of each quartile, calculated across countries, is reported. The firms in each country are divided into quartiles by value of Countries in the sample are: Australia, Austria, Belgium, Brazil, Canada, Germany, Finland, France, Hong Kong, India, Italy, Jordan,Japan, Korea, Malaysia, Mexico, Netherlands, Norway, New Zealand, Pakistan, Singapore, Spain, Switzerland, Sweden, Thailand, Turkey, United Kingdom, United States, South Africa, and Zimbabwe. Source: DemirgMaksimovic (1996b). -Kunt and
underlying legal infrastructure. Their results indicate that while policies that help develop legal and financial infrastructure of countries are effective in increasing the access of firms to long term debt, different policies would be necessary to lengthen the debt maturity of large and small firms. A key result is that improvements in the legal system’s effectiveness seems to benefit all firms, although this result is less significant for the smallest firms, which have limited access to the legal system. Moreover, policies that would help improve the functioning and liquidity of stock markets would benefit mostly the large firms. In contrast however, policies that would lead to improvements in the development of the banking system would improve the access of smaller firms to long term credit.
II. Firm Performance and Debt Maturity Choice In recent years theorists have been studying the forces which determine the maturity structure of a firm’s debt.^13 This literature provides an interesting perspective on the implications of debt maturity for firm performance by emphasizing the different control and incentive properties of long and short term debt. In most of these models, long term debt is not a technological necessity for acquiring physical capital, but rather one of a number of financial claims that a firm may issue. Indeed, these models highlight a number of undesirable effects of relying on long term debt. First, firm efficiency may be maximized by adopting a capital structure which excludes long term debt. Reliance on long term debt leads to greater distortions in the owner/manager’s risk preferences than does short term debt (Myers, 1977). As noted earlier, when investment is financed through debt, this creates an incentive problem because the return of the project has to be split between shareholders and bondholders. Stockholders may not capture enough of the return, so they may pass up positive net present value projects. This conflict between shareholders and bondholders is greater, the greater the investment opportunities of the firm and it can be mitigated by decreasing the overall degree of leverage, or the maturity of debt. Second, short term debt may also increase firm’s efficiency because of its role as a discipline device (Jensen, 1986). Because of the more continuous scrutiny of a firm’s operations and the threat of liquidation it brings, short term debt may lead to a reduction in wasteful activities by managers and a greater level of efficiency in a firm’s operations.
(^13) In addition to the articles cited in table I see Brick and Ravid (1985), Diamond (1993), Hart and Moore (1989), and Kale and Noe (1990).
returns arrive, the shorter the optimal payment structure will be. This provides a rationale for the firms with long term assets to have a longer debt maturity structure (Hart and Moore, 1995). If financial markets undersupply long term credit because banks are unable to internalize the full benefits of monitoring the firm,^14 because nontransferable control rents account for a major portion of the project returns,^15 or because few people participate in financial markets,^16 firms with a longer asset maturity may be disadvantaged. While all these models have interesting implications both for empirical studies of the links between term finance and firm performance and for policy discussions about the necessity and means for providing subsidized finance to the industrial sector, taken as a whole, the theoretical literature is inconclusive on how the maturity structure a firm’s debt affects its performance. Notwithstanding data problems, empirical analysis in this area is difficult since it is not appropriate to draw conclusions about performance by simply treating maturity structure variables as independent, given that theory tells us that expected growth and profitability also affect maturity choice. The recent empirical literature attempts to avoid this simultaneity problem by focusing on performance indicators that should not play a role in “causing” maturity choice such as efficiency measures, or using instruments for maturity choice such as legal efficiency indicators that measure the ability to enter into long-term contracts. This literature provides some interesting answers, which we discuss below.
a. Evidence From Country Cases
(^1415) See Mayer (1988) and Calomiris and Himmelberg (1993). 16 See Diamond (1991).Diamond (1996) develops a model that predicts that there would be a small supply of long-term claims in countries where limited numbers participate in financial markets.
Most of the empirical work on this area has been on firm growth and external financing. Starting with the seminal paper by Fazzari, Hubbard and Petersen (1988), there has been a large amount of work on the effect of financial constraints on firms’ investment. 17 On the links between debt maturity and performance, however, there has been surprisingly little work. Gilson, John, and Lang (1990) find that the more long term debt a firm has, the more likely it will be to reorganize successfully. However, Hall (1992) finds that when the ratio of long term debt to physical capital increases, physical investment and research and development expenditures are reduced. Atiyas (1991) investigates the impact of Colombian directed credit programs on firm productivity and finds a negative relationship between long-term indebtedness and efficiency. More recently, a number of case-studies were conducted including both developed and developing countries, using firm-level information for a large number of firms in each country.^18 In general, these studies find that there is no support in the data for any role played by short term debt in boosting efficiency and growth. Moreover, the conventional wisdom that more long term debt may actually lead to productivity improvements is confirmed in Ecuador, Italy and the U.K. However, echoing the earlier findings for Colombia, in the case of Italy, the positive effect of long term debt is substantially reduced and even reversed if debt is subsidized (Schiantarelli and Sembenelli, 1996). And also interesting is what was not found: even though many directed credit programs are established to increase investment, there was no evidence that the quantity of capital was sensitive to the amount of long term credit.
(^17) Fazzari, Hubbard, and Peterson showed that investment of US firms is sensitive to cash flow. In later work, again analyzing US data, Calomiris and Hubbard (1995), Calomiris, Himmelberg and Wachtel(1995), Carpenter, Fazzari and Petersen (1994), and Calomiris and Himmelberg (1996) argued that high- shadow cost of external finance will show itself most clearly in the cash flow sensitivity of inventories. (^18) These are Schiantarelli and Sembenelli (1996), using data from UK and Italy; Jaramillo and Schiantarelli (1996), analyzing data from Ecuador; Calomiris, Halouva and Ospina (1996), using Colombian data; and Schiantarelli andSrivastava (1996) analyzing Indian firm level data.
