Many Indian firms need more leverage

Source: The post is based on an article “Many Indian firms need more leverage” published in Business Standard on 24^th July 2023.

Syllabus: GS 3 – Indian Economy – Growth & Development

Relevance: concerns associated with low debt scenario in India.

News: There has been a decrease in borrowing by India firms. This presents concerns for the Indian economy.

Why is less borrowing by firms not healthy for the Indian economy?

• Debt drives management to work hard, which eventually benefits shareholders and society.
• Borrowing improves return on equity, which is good for shareholders.
• Debt-ridden businesses fail, as part of Schumpeterian creative destruction, fostering a dynamic economy.

What has been the trend in borrowing by the Indian non-financial corporate sector?

Since the early stages of economic reform, the Indian non-financial corporate sector has reduced its borrowing. The debt-equity ratio, which was at its highest of 1.85 in 1991-92, has steadily declined, reaching 0.89 in 2021-22.

Why do Indian corporations follow this trend of low borrowing?

This has been low demand of loans due to – 1) the prevailing macroeconomic environment with low investment, 2) fears of bankruptcy, and 3) low supply of loans due to fear amongst bank employees because of a Supreme Court decision in 2016 over the application of the Prevention of Corruption Act.

Moreover, some see India’s low or nearly zero debt level as a sound basis for long-term growth. However, there are various concerns associated with very low corporate debt.

What are the concerns associated with low levels of debt?

Debt as a disciplining device: There are usually conflicts between the interests of shareholders and the interests of managers. While managers want more money and less effort, shareholders want the firm to do well.

Therefore, in such a scenario, debt acts as a disciplining device for managers to work hard, regardless of whether they have shares in the company or not.

However, when there will be low debt or zero debt, managers will be less motivated to put in the required effort.

Creative destruction: Debt also plays an important role in the failure of the firms, which is essential for a healthy economy.

However, when debt is removed, many low-quality firms can survive indefinitely, leading to governance problems. This lack of a steady pace of firm failure is harmful for economic dynamism.

Return on equity: A successful business achieves a high return on equity by utilizing debt. However, many businesses in India have low debts, leading to poor returns for shareholders.

Therefore, a low rate of firm failures affects the economic dynamism, which ultimately impacts society at large.

Hence, while excessive debt is very harmful, so is zero debt. Therefore, a balance needs to be maintained. 

What can be the way ahead?

Implementing a strategy of moderate debt may encounter constraints due to the ineffective bankruptcy process and its associated costs.

Therefore, in order to reach moderate debt levels, enterprises and group-holding companies’ finance departments will need to have specialized skills in strategizing and implementing borrowing programs.