Financial Liberalisation and Corporate Capital Structure Choice - Evidence from Stationary Panel Data and Dynamic Simultaneous Equations Models M.Phil/Ph.D. Student: Prayagsing Chakeel Coomar FSSH ID:

Introduction and Motivation Corporate capital structure basically defines the way that a company is financed. However, this is a much deeper issue, as equity financing leads to agency costs and principle-agent problems while debt financing results in bankruptcy costs. Studies on capital structure, which has basically focused on general trends in leverage, the impact of capital structure on stock prices, firm and industry characteristics on capital structure and the impact of corporate strategy on financing decisions, have generated much interest among researchers in both developed and developing countries. Yet, most studies are focused mainly on the industrialized countries and very few conflicting and puzzling results are available in developing countries (see Prasad et. al., (2001), Pandey (2001), Jogernsen and Terra (2003)).

Ironically, Singh and Hamid (1992) argued that firms in developing countries made significantly more use of external financing, particular equities, to finance their growth. There are still no clear-cut answers to the determinants of corporate capital structure in Small Island Developing States like Mauritius. An urgent need for such a study in Mauritius, especially following the various efforts by the authorities to liberalise and develop the system, especially with the development of the stock market. An often over-looked consideration in the corporate finance literature. Moreover, we test for a joint interaction between firm investment, liquidity and leverage under asymmetric financial markets and liberalized finance, which is estimated via a dynamic panel data model with the Generalised Method of Moment (GMM) estimates.

LITERATURE REVIEW Durand (1959): traditional Net Income Approach Net Operating Income Approach Traditional View Modigliani and Miller (1958, 1963) Static Trade-Off theory Pecking Order Hypothesis of Capital Structure Agency theories of capital structure Market-timing hypothesis Signaling theory of capital structure Legal Environment theory

Empirical Literature General studies Singh and Hamid (1992) argued that firms made significantly more use of external finance, particularly equities, to finance their growth, than is typically the case in the industrial countries. Krasker (1986) and Narayanan (1988) found strong evidence for the POH, while it was rejected by Brennan and Kraus (1987). Corbett and Jenkinson (1996) examined corporate capital structures at aggregate level in Japan, Germany, UK and USA for the period and found that internal funds as the main source of finance in all countries. Mayer (1988) reported similar results for France, Japan, Germany, the UK and USA for the period where, regardless of whether market-based or bank- based capital structure was observed, retentions were the dominant source of finance for firms in the main industrial countries. Abar (2008) compared the capital structures of public quoted firms, large unquoted firms and SME’s in Ghana using panel data regression model, as well as in a sample of three different groups. He showed that quoted and large unquoted firms exhibited significantly higher debt ratios than SME’s. However, short-term debt constituted a relatively high proportion of total debt of all the sample groups.

Studies on financial sector development and capital structure Sundarajan (1987) examined the linkages among interest rates, debt/equity ratios, cost of capital, savings, investment and growth in Korea from 1963 to 1981 and found dynamic interaction among the variables. In a series of paper, Demirgue-Kunt and Maksimovic (1992, 1994, 1995), by using indicators of financial sector development and stock market development, showed that stock market development did not lead to lesser leverage and firms increased their borrowings in the external market. Loeveer (2006) found a positively significant relationship between stock market development and leverage for a sample of 9 European countries over the period Bakpin and Isshaq (2008) examined the impact of stock market development on the financing choices of listed firms in Ghana, using data from 1991 to They regressed debt-equity ratios on market size and market liquidity variables using ARIMA models. Stock market development did not lead to the substitution of equity for debt. Moreover the market liquidity variables showed a mixed impact on the debt/equity ratios, showing the insignificant impact of the stock market on financial choices.

Critical appraisal of current literature and contribution of the present study The upshot of the above issues clearly shows that most research has focused in developed countries and scarcely for a small island developing economy like Mauritius, which we undertake in this chapter. some empirical results on corporate capital structure are puzzling and conflicting with each other. Very little knowledge is available on the impact of financial sector liberalisation and development on financing decisions of firms. Some authors have attempted to model the impact of stock market development and banking sector development but have missed the financial liberalization variable and other indicators of financial sector development. We test the impact of external financing explicitly on capital structure models, using a unique data set of companies in Mauritius in 8 different sub- samples: banking, insurance, leasing, hotel, oil, retail/distributive trade and the construction industry, listed firms and unlisted firms, those belonging in corporate groups and those with good corporate governance practices financial liberalization or financial sector development that affects capital structure decisions of firms, besides the firm specific and market specific factors.

Determinants of capital structure choice Ranjan and Zingales (1995) identified three important determinants of corporate leverage: asset tangibility, firm profitability and firm size. Other research include Ferris and James (1979), Titman and Wessels (1988), Friend and Land (1988) Based on the above determinants, we consider the hybrid model of capital structure as follows: LEV it =  1 TANG it +  2 PROF it +  3 SIZE it +  4 LIQUIDITY it +  5 AGE it +  6 NDTS it +  7 RISKS it +  8 GROWTH it + e it (1) where LEV is a measure of corporate leverage, TANG measures asset tangibility, PROF is a measure of firm profitability, SIZE measures the relative sizes of firms, LIQUIDITY measures firms’ internal cash flow, AGE measures the relative age of firms, NDTS measures the amount of non-debt tax shields, RISKS measures firms’ risks, GROWTH measures the growth opportunities of firms and e is the random error term. i measures company element while t is the time dimension ranging from 1994 to 2007.

Augmented model: LEV it =  1 TANG it +  2 PROF it +  3 SIZE it +  4 LIQUIDITY it +  5 AGE it +  6 NDTS it +  7 RISKS it +  8 GROWTH it +  9 FINLIB it +  10 FINDEV it + e it (2) We augment model 1 above to include macroeconomic variables, more specifically financial variables. As a novelty in this study, we differentiate between financial liberalization and financial sector development. We differentiate between the index of Money Market Liberalisation (IMML), the index of Capital Account Liberalisation (ICAL) and the Overall index of Liberalisation. Financial Sector Development definitely impacts on corporate leverage. We also disaggregate the impact of banking financial sector development and non-bank financial sector development on corporate leverage.

Empirical strategy For a more comprehensive analysis of debt/equity choices of firms in Mauritius, we undertake sensitivity analysis in different sub-samples. We have collected data from an unbalanced sample of 298 firms across different sectors and classified them according to good corporate governance, poor corporate governance, those in group structure v/s independent companies, international and domestic enterprises and listed v/s unlisted companies. We further sub-divided the sample into the top 100 companies and ‘other companies’. To conduct a sectoral analysis, we undertake the study in the banking, insurance, hotels, manufacturing, construction, leasing, retail/distributive trade and oil industry.

Methodology Panel Data Models Panel Unit Root Test Interaction between investment, liquidity and leverage under asymmetric financial markets and liberalized finance LIQ it =  0 +  1 LIIQ it-1 +  2 L it +  3 L it-1 +  4 INV it +  5 INV it-1 +  6 PROF it +  7i PROF t-1 +  8 FILIB it +  9 FLIB it-1 +  10 FINDEV it +  11 FINDEV it-1 + e it (A) L it =  0 +  1 LIQ it +  2 LIQ it-1 +  3 PROF it-1 +  4 INV it +  5 INV it-1 +  6 SIZE it +  7 FILIB it +  8 FLIB it-1 +  9 FINDEV it +  10 FINDEV it-1 + v it (B) INV it =  0 +  1 LIQ it +  2 LIQ it-1 +  3 L it +  4 L it-1 +  5 PROF it +  6 PROF it- 1 +  7 FILIB it +  8 FLIB it-1 +  9 FINDEV it +  10 FINDEV it-1 + u it

CONCLUSION This chapter has provided additional evidence on the relationship between financial liberalization and development on corporate capital structures. We have divided the sample of firms differently, as well as across different sectors and used an improved measure of internal liquidity. Results from a stationary panel data from an augmented capital structure model, with macroeconomic financial variables have shown different results. The main determinants of corporate leverage are asset tangibility, firm size, firm growth, age, growth, risks, profitability and liquidity. However, the relative impact of each of these variables varies across the different sub- samples. Firms in groups and international companies operate an internal financial market and easily obtain finance. This is also the case for those with good banking ties. Further results have shown a nil effect of financial liberalization on capital structure decisions, unlike financial sector development. It has also been proved that the stock market does not influence capital structure choice, results contrary to what Hamid and Singh (1992) found for developing countries. We found that subsidized Government financing increases corporate leverage but other institutions such as private venture capitalists, insurance companies and leasing companies cannot explain leverage

Results from a simultaneous dynamic panel data model comprising of a leverage equation, a liquidity equation and investment equation confirmed joint interaction between these parameters firms retain profits in terms of internal cash flow (liquidity) in order to finance investment. They also borrow less in the market. Myers (1984) PO hypothesis is thus reinforced and we have an indirect proof that firms also curtail dividend payments in order to finance current investment projects.