National Academy of Development and Strategy, Renmin University of China; Development Strategy and Regional Economic Research Department, Development Research Center of the State Council; Zheshang Bank Corporation; National School of Development, Peking University
Summary:
The literature on corporate finance has traditionally categorized studies on firm leverage under capital structure. However, macroeconomists have begun to study the topic of firm leverage since the 2008 global financial crisis. Macroeconomic studies have argued that changes in leverage are related to a contraction or expansion of credit, i.e. the credit cycle, or an additional business cycle overall. Another category of studies have argued that the differences in leverage are tied to structural differences in firm characteristics, including ownership, firm size, and financing constraints. The two types of studies have advanced our understanding of macroeconomic fluctuations, although they have left some gaps in the literature. The first type has argued that changes in credit cycle and firm leverage are causes of economic fluctuations. However, the question remains, what leads to the cyclical fluctuations in leverage？ The second type, in contrast, has failed to explain the observed fluctuations. For instance, they have shown that ownership affects firm leverage, but they have failed to explain the structural and cyclical changes in firm leverage. The motivation of this paper is to examine the fundamental mechanism behind the cyclical changes in firm leverage. This paper focuses on one dominant determinant for the firm's investment, the firm's expectation for the future. The firm's decision to borrow to finance an investment is a risky intertemporal decision. The increase in leverage can significantly raise the return on assets during a boom period, but the decision can lead to great loss in an economic recession. Following this argument, an enterprise's choice of leverage ratio should be pro-cyclical if the expectation of a representative agent in the economy is optimistic in times of economic prosperity (i.e. increasing risk preference) and pessimistic (i.e. decreasing risk preference) in times of economic recession. In this paper, we concentrate on the firm's most direct operating risks, measured by the standard deviation of ROA within the “year*city*2-digit industry” cell. This study uses data from the Industrial Enterprise Database (1998-2013). We find that the firm's operating decisions become more conservative as the firm's operating risks increase, as demonstrated by a decline in leverage. We decompose leverage as a “liability-asset” to show that assets and liabilities both drop in times of rising operating risks. The decrease in liability is larger than that in assets, which leads to a downward slope in leverage. Moreover, we show that the key mechanism is the contraction in investment, suggesting that the process of de-leveraging is equivalent to a decrease in investment. After separating liabilities by long-and short-(current) term liabilities, we find that the decrease in current liabilities is prioritized when firms are dealing with increasing risks. Grouped by ownership, non-state-owned enterprises (non-SOE) are most sensitive to the changes in operating risks, while SOEs are much more stable. These findings may be explained by the differences in their financing capacity, industry characteristics, and operating objectives. This paper makes the following contributions. First, it advances the literature on firm leverage cycles. Studies on credit cycles have focused on the role of financial intermediates as credit suppliers. This paper, in contrast, focuses on the role of credit demand to show the pro-cyclical pattern that exacerbates economic fluctuations. Second, we examine the changes in liabilities based on duration, ownership, and possible mechanism. Third, the firm's decision is used as a framework to examine the leverage cycle, which results in policy implications. Specifically, credit cycle theorists have argued that credit should be eased in an economic recession. However, this study shows that while credit easing may alleviate the liquidity risks in the financial market, it fails to stimulate the real economy if the firms have a negative outlook for the future. It also indicates that monetary easing prior to a recovery in the firm's expectation will divert finances out of the real economy. Furthermore, credit easing does not stabilize the real economy if the high-yielding firms are more conservative. Rather, it may aggravate the problem of adverse selection and financial risks. This paper suggests that a more effective method would be to apply expansionary fiscal policies to stabilize the firms' demand and strengthen their confidence, then apply credit easing as a complementary tool.
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