WPS Ir46 POLICY RESEARCH WORKING PAPER 1746 The Role of Long-Term It appears that firms grow faster and are mnore Finance productive when more Icng- term finance is available to them. Governmert subsidies Theory and Evidence do riot produce the szme effects and a8re in some cises Gerard Caprio, Jr. associated with educed Asl1 Demirgiiu-Kunt productivity aid qrcwth. The World Bank Policy Research Department Finance and Private Sector Development Division April 1997 POLICY RESEARCH WORKING PAPER 1746 Summary findings Caprio and Demirgiiu-Kunt review the literature on term developing countries in terms of firm characteristics, finance to place the research in context and discuss its macro factors, and - most important - government implications for World Bank operations. Their project subsidies, the country's level of financial development, investigated whether industrial firms in developing and legal and institutional factors. countries suffer from a shortage of long-term credit and They conclude that more long-term finance tends to be whether that shortage affects the firm's investment, associated with higher productivity. productivity, and growth. Cross-country analysis of firm-level data also indicates Both issues are important in designing the World that when there is an active stock market and when Bank's industrial lending policy because the development creditors and debtors are better able to enter into long- community is reevaluating mechanisms to make more term contracts, firms seem to be able to grow faster than term finance available or to lessen the constraints they could by relying only on internal resources and imposed by its absence. short-term credit. Using both cross-country empirical analysis and Another important finding: Government subsidies country case studies, researchers found that developing around the world have increased firms' long-term country firms use significantly less long-term debt than indebtedness, but there is no evidence connecting these their industrial country counterparts, even after subsidies with the firms' ability to grow faster. Indeed, in controlling for firm characteristics. They explain the some cases subsidies were associated with lower difference in debt composition of industrial and productivity. This paper - a product of the Finance and Private Sector Development Division, Policy Research Department - summarizes the results of a recently completed Bank project on term finance. The study was funded by the Bank's Research Support Budget under the research project "Term Finance: Theory and Evidence" (RPO 679-62). Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Paulina Sintim-Aboagye, room N9-030, telephone 202-473-8526, fax 202-522-1155, Internet address psintimaboagye@worldbank.org. April 1997. (31 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is toget the findings outquickly, even if the presentationsare less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Produced by the Policy Research Dissemination Center T'he Role of Long Term Finance: Theory and Evidence Gerard Caprio, Jr. and Aslh Demirgu9-Kunt Policy Research Department The World Bank 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. 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 str ucture of a firm's debt.' 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 1 980s many DFIs were experiencing significant portfolio problems.2 Many of the moderate problems became severe later in See for example work by Berglof and von Thadden (1993), Diamond (1991,1993) and Rajan (1992). 2 A 1974 study of delinquency rates in agricultural lending institutions reported that the average arrears rate was 41 per cent, while a 1983 report indicated that 39 percent of the DFIs were experiencing serious portfolio problems while another 53 percent were experiencing moderate problems (World Bank, 1974, and Siraj, 1983). 2 the 1980s, and a wave of failures of DFIs or, at best, severe financial distress, was the result.3 Furthermore, directed credit, often long term, in many cases failed to reach its intended beneficiaries (Atiyas, 1991 and World Bank, 1989). Once established, governments found it politically very difficult to reduce support for these programs, regardless of their cost and inefficiency. Prompted by these problems and following the issuance of an internal review of financial sector lending (World Bank, 1989), the World Bank adopted new guidelines governing lending to DFIs, and Bank lending to these institutions dropped dramatically: DFI loans fell from 11 percent of new credits extended by the Bank in FY 1989 to only 2.4 percent of new loans in FY 1993. Still, controversy over the Bank's efforts to channel long term credit to the private sector continue. Both the Bank and the development community at large presently are re-evaluating mechanisms aimed at increasing the availability of term finance or lessening the constraints imposed by its absence, though the assumptions that term finance is scarce in developing countries, that its absence deleteriously affects firm performance, and that countries would be better off subsidizing its provision, remain prevalent, at least in the development community.4 Unfortunately, relatively little effort, until now, has been devoted to investigating the factors behind this imperfection and whether and how it affects economic growth. Although aggregate data and anecdotal evidence suggest that there often is less long-term credit in developing countries, even those with low or moderate inflation rates, no attempts had -- until quite recently -- been made to examine the evidence more 3 Although the potential for many of these problems might be traced to the origin of DFIs, it is likely that the strength of real commodity prices in the 1970s and their deterioration in the 1980s explains the timing of the recognition of the situation. 4For 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 rolling over of 3-year loans. 3 Ysystematically and in particular to see if any scarcity merely reflected the different 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 5 These studies are part of the World Bank Research Project (RPO 679-62) and were presented at the World Bank Conference "Tern Finance: Does It Matter?" held in Washington D.C., June 14, 1996. 4 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 6Being aware of adverse selection and moral hazard problems, there of course are some borrowers to whom banks will not provide credit at any price. 5 there may be a potential correction that could rectify this problem.7 To be sure, any correction may be difficult. For example, it is argued (and confirmed below) that a leading reason for the absence of long term finance is high inflation and unstable macro policies (the first source, above). Attempts to increase the supply of long term credit without addressing the inflation problem could easily prove to be short-lived or costly. Similarly, high real interest rates may reduce the effective demand for credit -- entrepreneurs will say they want more credit, but not at the market price. If the yield curve is upward sloping (long term interest rates above short term rates), then the demand for long term credit will tend to suffer most in this situation. Again, addressing the factors that account for high real interest rates (see Brock, 1996) may in the long run pay off more than attempts to force banks to lend long. In the 1980s, Chile succeeded both in tackling the underlying factors behind high real rates -- an overvalued exchange rate and insolvent banks -- and by moving to a fully-funded pension system, created a natural source of long term finance without interfering in credit and investment decisions. The firm level studies reviewed below finesse this issue by examining term finance in countries with relatively stable macro environments. Long term credit may well be scarce because of institutional factors (the second source, above) in developing country financial markets. Institutional factors generally affect borrowers only until funds are disbursed; these factors are crucial during all phases of a credit relationship for providers of funds, who are concerned about the return on their in vestment. An important emphasis in the finance literature is that banks will use short term credit as a way to control borrowers (Diamond, 1991), and that they will tend to 7 Of course, industrial country capital markets might also be characterized by imperfections. But this approach is taking, for better or worse, industrial country capital markets as the best that could be attained, at least in some medium run. 6 want to use this instrument more the less developed is financial infrastructure, such as 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 lb 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 7 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 cornpetition (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 8 rolling over of these loans is easier to exercise, and a more credible near-term threat, than with long term credit. Importantly for policymakers intent on intervening to influence the supply of long term credit is the key recent finding (Hart-Moore) that the faster the returns to investment arrive, the shorter the optimal payment structure will be. In other words, firms will tend to match the maturity of their assets and liabilities; only firms with long term assets will tend to have a longer debt maturity structure. If this tendency is born out in developing country experience, it suggests that attempts to interfere with the market allocation of credit need to take account of a number of factors, including the structure of the assets of firms; a program to extend long term credit to firms with short term assets may not be welcomed, as it is inconsistent with firms' desire to balance the maturity of assets and liabilities. Firm size is another key variable, and indeed a justification for a number of credit market interventions is the desire to get more credit, particularly long term credit, to small firms. In general, there tends to be less information about small firms, not only because some of them will be new but also because it is costly to obtain such information. Thus, even in the most developed financial systems, small and medium size enterprises tend to get a larger part of their external financing in the forn of bank debt. Banks overcome some information problems by developing long term relationships with smaller firms. A variety of other firm characteristics and their expected effect on the maturity structure of debt are summarized in Table 1. The key point is that firns in developing countries may have less long term debt than firms in developed countries simply because they have different characteristics, rather than necessarily implying a deficiency in the 9 Table 1. Theoretical determinants of maturity choice Increase in: Leads to Source Asset Maturity Firms will tend to match the maturity of assets and Hart and Moore (1995) liabilities Growth opportunities Reduced reliance on long term debt Myers(1977) Size of project Reduced reliance on long term debt Bergloff and von Thadden (1993) Observable credit Increased reliance on long term debt Diamond (1991) and Rajan (1992) quality of low credit quality firms Reduced reliance on long term debt because the possibility of being wrongly liquidated are decreasing. Flannery (1986) and Diamond(l 991) Observable credit quality of high credit or quality firms Increased reliance on long term debt because the monitoring benefits of short term debt are less Myers(1977) and Rajan(1992) important. May make it possible for low quality firms to issue short Diamond (1991) term debt even if they cannot issue long term debt. No Liquidation value impact on other firms. Decreases reliance on long term debt Rajan (1992) The lower the market power of incumbent lenders, the Rajan (1992) Contestability less the reliance on long term debt. Firm Size Greater problem with asymmetric information, more Myers (1977), Barclay-Smith (1995) reliance on bank debt, often have greater growth opportunities, leading to less reliance on long term debt. credit market. It also means that comparisons of debt maturity structures in different 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-tern 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 8 See Harris and Raviv (1990) for a review of empirical and theoretical capital structure literature. 10 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.1I 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). 9 T he correlation between access to long term credit and firm size was also seen in Ecuador in a separate data set (1984-92). 10 IBerger and Udell (1995) found that among small U.S. firms, it was important to have a long relationship with a bank. The longer this relationship, the lower the amount of collateral needed and the greater the availability of long term credit. 11 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 a major factor in firms' choice of capital structure is the reduction of the cost of contracting between firms and their providers of capital. These costs depend not just on the characteristics of firms but especially on the institutional environment in which the contracting takes place. It is the institutions in the economy - legal or financial- that facilitate monitoring and enforcement of financial contracts. For example, when the legal system is inefficient or costly to use, short-term debt is more likely to be employed than long-term debt, as in recent work by Hart and Moore (1995) and Bolton and Scharfstein (1996). Diamond (1991, 1993) also emphasizes the importance of contract enforcement. As he has argued, short-term financing may reduce the expropriation of creditors by borrowers. Short maturity limits the period during which an opportunistic firm can exploit its creditors without being in default. It allows the creditors to review the firm's decisions frequently and, if necessary, to vary the terms of the financing before sufficient losses have accumulated to make default by the borrower optimal. This also implies that if complicated loan covenants (trying to anticipate a variety of future outcomes) could be enforced at a lower cost, the supply of long term debt by the institutions would be greater. Financial institutions also play a very important role. Two types of institutions, financial intermediaries and stock-markets, directly influence the financial structure choices of firms. A prime function of financial intermediaries, such as banks, is that of monitoring borrowers. As Diamond (1984) argues, intermediaries have economies of scale in obtaining information. Intermediaries may also have greater incentives to use the 12 collected information to discipline borrowers than small investors subject to free-rider problems. By collecting information, monitoring borrowers and exerting corporate 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 imay be an important determinant of the capital structure of firrms."I Atiyas (1991) and World Bank (1989) provide evidence that directed credit often failed to reach its intended beneficiaries. 13 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 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 Demirgiuc-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 (Demirgiiu-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 12 The data set consists of financial statement data for the largest publicly traded corporations in manufacturing in thirty countries. 14 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 and large firms, even after controlling for firm characteristics (Demirgiiu-Kunt and Maksimovic, 1996b). In this data set developed countries' firms clearly have more long term debt and greater proportion of their total debt is held as long term debt (Figure 1). Also, large firms have more long-term debt - as a proportion of total assets and debt - compared to smaller firms (Figure 2). Importantly, this lack of term finance in developing countries persists even after controlling for firm characteristics. The authors explain this differential by institutional differences, such as the extent of government subsidies, different level of development of stock markets and banks, and differences in the 0.50 0.45 0.40 0.35 0.30 0.25 0.20- 0.15 0.10 N m o > X ' m -D *-lom