## 1.   Gross Fixed Capital Formation

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### Introduction and context
- Investment growth in India:
  - Averaged 12 percent per year over the decade ending in 2011/12.
  - Averaged 3½ percent in the five years since.
- Investment-to-GDP ratio:
  - Peak of 33½ percent of GDP recorded in 2007/08.
  - Declined to 27 percent in 2016/17.
- Sectoral patterns:
  - Investment-to-GDP ratio of infrastructure-related industries has fallen by one third.
  - In utilities and manufacturing it has declined by one fourth.
- Corporate balance-sheet dynamics:
  - Financial leverage of Indian firms has been rising and is high relative to other emerging market economies.
  - High leverage is concentrated in metals and mining, construction and engineering, and transportation and infrastructure—industries that have recorded the largest slowdown in investment rates.
- Policy context:
  - Vulnerabilities of corporates have begun to subside, reflecting policy measures to easing supply-side bottlenecks, though leverage levels generally remain high.

### Research question and approach
- Objective:
  - Study drivers of private fixed investment in India over the past twenty years and assess the role of financial frictions versus demand/expectations channels.
- Theoretical framing:
  - Two broad explanations: (i) investment driven by expectations of future demand (Q-theory); (ii) investment affected by financial frictions (debt overhang, costly external finance, agency/asymmetric information).
- Empirical strategy highlights:
  - Firm-level panel analysis using fixed effects as benchmark; two-stage least squares and Arellano and Bond (1991) GMM for robustness.
  - Tests of external-demand channels using export intensity interacted with WorldImportGrowth and a post-GFC dummy (equal to one from 2009 onwards).
  - Tests of financial-friction channels via interactions of leverage with firm age, business-group membership, industry external-finance dependence, and bank-debt composition.
  - Analysis of new projects and project-length using Capex project data.

### Data and descriptive statistics
- Main datasets:
  - Prowess panel database (CMIE): main firm-year sample: 10,974 firms from 1995 to 2015 (financial firms excluded; firms with at least five years of data).
  - Capex database (CMIE): contains 44,584 investment projects from 1995–2015 corresponding to 13,887 firms.
- Project activity and timing:
  - After matching Capex to Prowess at the firm-year level, firms began new investment projects in about 9 percent of the Prowess firm-year sample.
  - Average length of time to complete investment projects is 3.7 years.
  - Average time between project announcement and completion by sector: about 2 years in manufacturing, 3.5 years in the services sector, and about 4 years in the electricity sector.

### Empirical method (benchmark and extensions)
- Benchmark investment specification:
  - Dependent variable: investment rate = expenditure on fixed assets in period t scaled by capital stock at beginning of period (net fixed assets at end of period t-1).
  - Main explanatory variable: leverage ratio = debt to equity ratio (book values).
  - Controls: cash flow to capital stock ratio; sales to capital stock ratio; firm size (log of beginning-of-period capital stock).
- Growth-opportunities and external demand tests:
  - Exporting status/export intensity interacted with WorldImportGrowth (1-period lag) and post-GFC dummy.
  - WorldImportGrowth constructed for 36 product groups matched to firm’s main product group; covers 49 countries accounting for over 90 percent of India’s exports.
- Financial-frictions tests:
  - Interactions of leverage with firm age; membership in a business group; Rajan and Zingales (1998) industry-level measure of dependence on external finance.
  - Bank-debt composition: share of bank debt, share of secured bank debt, share of short-term bank debt.
  - Alternative distress proxy: interest coverage ratio (ICR), including persistence measures (ICR < 1 for several consecutive years).
- New investment and project-length specifications:
  - Dependent variable: Pr{NewProject = 1} if firm announces a new project in year t (from Capex).
  - Also model probability of completing a project and log(project length) to assess composition effects.

### Key empirical findings
- Leverage and aggregate investment effect:
  - A 1 percentage point increase in a company’s debt to equity ratio leads to about a 1 percentage point decline in investment as a share of its capital stock.
- Demand and exporter effects:
  - Exporting firms’ investment rates were 1.9 percent higher than other firms on average through the sample period.
  - Interaction of exporting indicator with post-GFC dummy: coefficient is -0.228 (not statistically significant).
  - Interaction of export intensity with post-GFC dummy: negative but statistically insignificant.
  - WorldImportGrowth main effect: not statistically significant.
  - Interaction WorldImportGrowth × export intensity: exporting firms invest more when external demand is higher.
  - Triple interaction WorldImportGrowth × export intensity × post-GFC: coefficient -0.032 (negative but statistically insignificant).
- Financial-frictions heterogeneity:
  - The negative relationship between investment and leverage is less negative for firms with lower financial constraints: older firms; business-group members; industries less dependent on external finance.
  - Bank debt composition:
    - Firms with a greater share of bank debt have higher investment.
    - Greater share of secured bank debt is associated with lower investment.
    - Higher share of short-term bank debt is associated with lower investment.
  - Interest coverage ratio (ICR) and distress:
    - Firms with one percentage point higher ICRs have higher investment rates, by about 0.13 percent points on average.
    - Firms with ICR < 1 in the previous year have lower investment rates, by about 5 percentage points.
    - Firms with ICR < 1 for five consecutive years have lower investment rates, by about 5 percentage points.
  - Specific bank-debt coefficient evidence:
    - Short-term Bank Debt/Equity (t-1) coefficient is -4.900*** (FE specification).
- New projects, completion, and project length (composition effects):
  - Leverage reduces the likelihood of initiating new investment projects:
    - A 1 percentage point increase in the leverage ratio (from the sample mean) leads to a 3.3 percent decline in the probability of undertaking a new investment project.
    - New investment projects are initiated in 9 percent of the firm-year sample.
  - Leverage reduces the probability of completing investment projects once started:
    - A 1 percentage point increase in the leverage ratio (from the sample mean) leads to an almost 1 percent decline in the probability of completing an investment project.
  - Leverage is associated with shorter projects:
    - The coefficient on leverage of -0.02 indicates that firms with 1 percentage point higher leverage are associated with projects that are one year shorter on average in duration.
- Robustness:
  - Interaction of leverage with cash flow, sales, and size (one-by-one) yields interaction coefficients not statistically significant—suggesting the negative leverage–investment relationship is widespread across firms.
  - Results are not sensitive to inclusion of lagged investment rate or use of IV/GMM estimators.

### Interpretation, policy implications, and institutional context
- Interpretation:
  - Evidence supports that financial frictions (high leverage and financial distress) materially constrain investment in Indian firms, including by reducing the probability of starting projects and by shortening project horizons.
  - External-demand channels affect exporters, but there is no statistically significant evidence that export-sensitivity of investment changed after the global financial crisis.
  - The composition of firm financing and the nature of bank debt (secured, short-term) matter for investment outcomes.
- Policy-relevant observations and recommendations:
  - Measures aimed at reducing corporate leverage and addressing persistent corporate financial distress can help revive investment.
  - Policies improving access to longer-term, less secured financing could support longer-horizon investments.
  - Supply-side and structural measures that ease financing frictions and reduce borrower reliance on secured or short-term debt could increase new project starts and raise investment duration.
- Institutional and ongoing policy context in India:
  - Corporate deleveraging in India has been slow and uneven across sectors; corporate leverage ratios and associated vulnerability indicators continue to be high in comparison to other emerging market economies (IMF, 2017).
  - A multi-pronged approach has been introduced: asset restructuring mechanisms for refinancing, strategic debt restructuring, and debt-to-equity swaps; measures to rehabilitate distressed sectors; a new bankruptcy law to simplify winding-up and debt recovery.
  - Given the bank-centered nature of India’s financial system and the dominant role of public sector banks, rebuilding a healthy banking system is key:
    - The Asset Quality Review initiated by the Reserve Bank of India in December 2015 and completed in March 2017 was instrumental in recognizing distressed bank assets and instigating appropriate loss provisioning.
    - India’s distressed debt markets are underdeveloped; a pragmatic approach is needed, including continued stringent supervision, corporate governance reforms in public sector banks, and ensuring adequate capital at banks, including through capital injections by the Government of India.

*Source: wp17134 (excerpts).*

### 1.   Gross Fixed Capital Formation .....................................................................................

### 1.   Gross Fixed Capital Formation

### Major sections in this content unit
- 1.   Gross Fixed Capital Formation ............................................................................................4
- 2.   Corporates: Median Debt to Equity .....................................................................................4
- 3.   Corporate Sector Vulnerabilities ..........................................................................................4
- 4.   Corporates: Average Investment for Highly Leveraged and Less Leveraged Firms .........11
- 5.   Investment Project Length .................................................................................................11

### Tables included in this content unit
- 1.   Gross Capital Formation by Industry .................................................................................21
- 2.   Summary   Statistics   .............................................................................................................22
- 3.   New Project Announcements  ............................................................................................22
- 4.   Firm Investment – Benchmark Specification ....................................................................23
- 5.   Firm Investment – Exporters and External Demand ..........................................................24
- 6.   Firm Investment – Interaction with Financial Constraints ................................................25
- 7.   Firm Investment – Bank Dependence ................................................................................26
- 8.   Firm Investment – Interest Coverage Ratio .......................................................................27
- 9.   New Investment Projects ...................................................................................................28
- 10. Investment Project Completion ..........................................................................................29
- 11. Investment Project Length .................................................................................................30

*Source: wp17134 - 1.   Gross Fixed Capital Formation (PDF chapter/section)*

### References .............................................................................................................

### wp17134 - References

### Introduction and context
- Investment growth in India:
  - Averaged 12 percent per year over the decade ending in 2011/12.
  - Averaged 3½ percent in the five years since.
- Investment-to-GDP ratio:
  - Peak of 33½ percent of GDP recorded in 2007/08.
  - Declined to 27 percent in 2016/17.
- Sectoral patterns:
  - Investment-to-GDP ratio of infrastructure-related industries has fallen by one third.
  - In utilities and manufacturing it has declined by one fourth.
- Corporate balance-sheet dynamics:
  - Financial leverage of Indian firms has been rising and is high relative to other emerging market economies.
  - High leverage is concentrated in metals and mining, construction and engineering, and transportation and infrastructure—industries that have recorded the largest slowdown in investment rates.
- Policy context:
  - Vulnerabilities of corporates have begun to subside, reflecting policy measures to easing supply-side bottlenecks, though leverage levels generally remain high.

### Research question and approach
- Objective:
  - Study drivers of private fixed investment in India over the past twenty years and assess the role of financial frictions versus demand/expectations channels.
- Theoretical framing:
  - Two broad explanations: (i) investment driven by expectations of future demand (Q-theory); (ii) investment affected by financial frictions (debt overhang, costly external finance, agency/asymmetric information).
  - Relevant theoretical results cited include Tobin (1969), Mussa (1977), Abel (1983), Myers (1977), Steigum (1983), Hennessy (2004), Diamond and He (2014), Aghion et al. (2010).

### Data and descriptive statistics
- Main datasets:
  - Prowess panel database (CMIE): covers approximately 30,000 Indian companies; main firm-year sample: 10,974 firms from 1995 to 2015 (financial firms excluded; firms with at least five years of data).
  - Capex database (CMIE): contains 44,584 investment projects from 1995–2015 corresponding to 13,887 firms.
- Project activity and timing:
  - After matching Capex to Prowess at the firm-year level, firms began new investment projects in about 9 percent of the Prowess firm-year sample.
  - Average length of time to complete investment projects is 3.7 years.
  - Average time between project announcement and completion by sector: about 2 years in manufacturing, 3.5 years in the services sector, and about 4 years in the electricity sector.

### Empirical method
- Benchmark specification (firm-level investment rates):
  - Dependent variable: investment rate = expenditure on fixed assets in period t scaled by capital stock at beginning of period (net fixed assets at end of period t-1).
  - Main explanatory variable: leverage ratio = debt to equity ratio (book values).
  - Controls (X): cash flow to capital stock ratio; sales to capital stock ratio; firm size (log of beginning-of-period capital stock).
  - Estimation: panel fixed effects as benchmark; also two-stage least squares with lags and Arellano and Bond (1991) GMM used for robustness.
- Growth-opportunities and external demand specification:
  - Tests interaction of exporting status/export intensity with growth in volume of world imports by industry (1-period lag) and a post-GFC dummy (equal to one from 2009 onwards).
  - WorldImportGrowth constructed for 36 product groups matched to firm’s main product group; covers 49 countries accounting for over 90 percent of India’s exports.
- Financial frictions specification:
  - Interactions of leverage with proxies for financial constraints: firm age; membership in a business group; Rajan and Zingales (1998) industry-level measure of dependence on external finance.
  - Tests bank-debt composition effects (share of bank debt, share of secured bank debt, share of short-term bank debt).
  - Alternative distress proxy: interest coverage ratio (ICR), including persistence measures (ICR < 1 for several consecutive years).
- New investment and project-length specifications:
  - Dependent variable: Pr{NewProject = 1} if firm announces a new project in year t (from Capex).
  - Also model probability of completing a project and log(project length) as outcome to assess composition effects.

### Key empirical findings
- Leverage and investment (benchmark):
  - A 1 percentage point increase in a company’s debt to equity ratio leads to about a 1 percentage point decline in investment as a share of its capital stock.
  - Sales-to-capital ratio: statistically significant positive effect on investment.
  - Cash-flow-to-capital ratio: positive effect on investment only in some specifications.
  - Larger firms have lower investment rates.
- External demand and exporting firms:
  - Exporting firms’ investment rates were 1.9 percent higher than other firms on average through the sample period.
  - Interaction of exporting indicator with post-GFC dummy: coefficient is -0.228 (not statistically significant), suggesting no significant change in investment at exporting firms after the GFC.
  - Interaction of export intensity with post-GFC dummy: negative but statistically insignificant.
  - WorldImportGrowth main effect: not statistically significant.
  - Interaction WorldImportGrowth × export intensity: exporting firms invest more when external demand is higher.
  - Triple interaction WorldImportGrowth × export intensity × post-GFC: coefficient -0.032 (negative but statistically insignificant), indicating no significant change in export-sensitivity of investment after the crisis.
- Financial frictions and heterogeneity:
  - Interaction results show the negative relationship between investment and leverage is less negative for firms with lower financial constraints (older firms; business-group members; industries less dependent on external finance).
  - Bank debt composition:
    - Firms with a greater share of bank debt have higher investment.
    - Greater share of secured bank debt is associated with lower investment.
    - Higher share of short-term bank debt is associated with lower investment.
  - Interest coverage ratio (ICR) findings:
    - Firms with higher ICRs have higher investment rates.
    - Firms with ICR < 1 in the previous year, or for several consecutive years, have lower investment rates.
- New projects and project length (composition):
  - Leverage negatively affects the likelihood a firm announces a new investment project.
  - Leverage negatively affects the length of investment projects undertaken (consistent with theory that tight credit reduces long-term investment share).
- Robustness:
  - Interaction of leverage with cash flow, sales, and size (one-by-one) yields interaction coefficients not statistically significant—suggesting the negative leverage–investment relationship is widespread across firms regardless of these characteristics.
  - Results are not sensitive to inclusion of lagged investment rate or use of IV/GMM estimators.

### Interpretation and implications
- Evidence supports the view that financial frictions (high leverage and financial distress) materially constrain investment in Indian firms, including by reducing the probability of starting projects and by shortening project horizons.
- External-demand channels affect exporters, but there is no statistically significant evidence that export-sensitivity of investment changed after the global financial crisis.
- The composition of firm financing and the nature of bank debt (secured, short-term) matter for investment outcomes, suggesting that not all bank debt is equally supportive of investment.
- Policy-relevant observations implied by the findings:
  - Measures aimed at reducing corporate leverage and addressing persistent corporate financial distress can help revive investment.
  - Policies improving access to longer-term, less secured financing could support longer-horizon investments.
  - Supply-side and structural measures that ease financing frictions and reduce borrower reliance on secured or short-term debt could increase new project starts and raise investment duration.

*Source: IMF working paper content (wp17134) provided in the source PDF.*

### 0.012 percentage points lower than for the whole sample of firms. The effect of being in a

### VI. CONCLUSIONS

### Main findings on leverage and investment
- Firms with higher financial leverage invest less; the relationship between leverage and investment rates is more negative for firms that are more subject to financial constraints or more dependent on external finance.
- The effect of being in a business group: the relationship between investment and leverage is less negative by almost one percentage point for firms belonging to business groups.
- Firms less able to cover interest expenses invest less:
  - Firms with one percentage point higher ICRs have higher investment rates, by about 0.13 percent points on average.
  - Firms with ICR < 1 in the previous year have lower investment rates, by about 5 percentage points.
  - Firms with ICR < 1 for five consecutive years have lower investment rates, by about 5 percentage points.

### Bank dependence and debt composition
- Firms with a 1 percentage point higher share of bank debt to total debt have marginally higher investment rates, by about 0.034 percentage points.
- The positive effect of bank debt is offset when bank debt is in the form of secured debt: when firms are subject to the loss of collateral, firms that have borrowed from banks do not have higher investment rates.
- Decomposing bank debt:
  - The negative effect on investment comes from the short-term component; short-term bank debt poses a large near-term repayment burden that prevents near-term investment.
  - Table evidence: Short-term Bank Debt/Equity (t-1) coefficient is -4.900*** (FE specification).

### New investment projects, completion, and project length
- Leverage reduces the likelihood of initiating new investment projects:
  - A 1 percentage point increase in the leverage ratio (from the sample mean) leads to a 3.3 percent decline in the probability of undertaking a new investment project. New investment projects are initiated in 9 percent of the firm-year sample.
- Leverage reduces the probability of completing investment projects once started:
  - A 1 percentage point increase in the leverage ratio (from the sample mean) leads to an almost 1 percent decline in the probability of completing an investment project.
- Leverage is associated with shorter projects:
  - The coefficient on leverage of -0.02 indicates that firms with 1 percentage point higher leverage are associated with projects that are one year shorter on average in duration.

### Policy implications and institutional context
- Corporate deleveraging in India has been slow and uneven across sectors, particularly among larger firms; corporate leverage ratios and associated vulnerability indicators continue to be high in comparison to other emerging market economies (IMF, 2017).
- A multi-pronged approach has been introduced to address corporate financial distress:
  - Asset restructuring mechanisms for refinancing, strategic debt restructuring, and debt-to-equity swaps have been introduced.
  - Measures to rehabilitate distressed sectors (road construction, textiles, coal mining) have been implemented.
  - A new bankruptcy law promises to simplify winding-up of failing enterprises and recovery of debts.
- Continued efforts are needed to speed up corporate deleveraging and reduce debt burdens to improve operating performance and encourage an investment revival.
- Given the bank-centered nature of India’s financial system and the dominant role of public sector banks, rebuilding a healthy banking system is key:
  - The Asset Quality Review initiated by the Reserve Bank of India in December 2015 and completed in March 2017 was instrumental in recognizing distressed bank assets and instigating appropriate loss provisioning.
  - India’s distressed debt markets are underdeveloped; a pragmatic approach is needed to preserve banking system health, including continued stringent supervision, corporate governance reforms in public sector banks, and ensuring adequate capital at banks, including through capital injections by the Government of India.

*Source: wp17134 (excerpts).*

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_Source: https://www.imf.org/-/media/files/publications/wp/2017/wp17134.pdf_