In recent years the corporate debt landscape in emerging markets has changed substantially. Debt in emerging economies climbed to a record high of $55 trillion in 2018, illustrating the largest and fastest surge in the last five decades. In addition, according to the International Monetary Fund (IMF) 2015 report, the mean ratio of corporate debt to GDP grew by 26 percent. These recent developments are important and have raised broad concerns because emerging economies account for 60 percent of the global GDP.

High levels of leverage could either constrain or accelerate firm growth. In addition, high corporate debt could lead to either underinvestment or overinvestment. For instance, managers in leveraged firms may forgo projects that enhance shareholder wealth in order to avoid transferring the benefits of their investments to creditors. This leads to underinvestment. Overinvestment, by contrast, is related to excess free cash flows that managers allocate to negative net-present-value projects to derive personal benefits from enlarging the firm (e.g., power, status, bonuses). Overinvestment is especially prevalent in low-growth firms as they have poorer investment choices, which could lead to negative value investments.

In our recent paper, we investigate whether the increase in corporate debt in recent years constrains or stimulates firm growth in 22 emerging economies. Our study represents the main markets in Asia, Latin America, Eastern Europe, and South Africa. Thus, it includes a large degree of variation in both institutional environments and ownership structures, which allows us to examine how different institutional and ownership characteristics affect the relationship between leverage and investment.

Different countries exhibit systematic differences in size, ownership structure, and institutional environment, which could determine how leverage affects investment. For example, environments with low-quality institutions feature weaker judicial systems, higher corruption, less transparency, and less available information, which can lead to an increased need for monitoring through leverage. Different countries also exhibit various levels of ownership concentration, which may affect firm leverage and the need for monitoring through leverage. Specifically, high ownership concentration can act as a monitoring tool in countries with low investor protection. This is because investors are more prone to keep their shares and thereby voting power to ensure that increased monitoring in the firm can cover for weak legal protection.

Our empirical analysis points to three key findings. First, we show a negative relation between leverage and investment in emerging countries. This relationship is in line with the debt overhang issue, indicating that the increased leverage in emerging economies imposes constraints on investment. More specifically, we show that on average a $100 increase in leverage decreases investment by $2.70. However, in line with the overinvestment hypothesis, we further find that this increased leverage reduces managers’ opportunistic behavior to overinvest or misuse funds and thus has a disciplinary effect on overinvestment.

Second, by digging deeper into the impact of varying institutional environments on the relationship between leverage and investment, we find that the monitoring effect of leverage on investment is stronger for firms that operate in emerging countries with high corruption and weak regulation such as Colombia, Egypt, Indonesia, Thailand, and Turkey. This finding shows that firms that operate in economies that suffer from greater information asymmetry, lower investor protection, and weaker regulatory systems have greater need for monitoring through leverage. A potential interpretation is that firms that operate in emerging countries with better institutional quality (e.g., Greece, Hungary, Poland, South Korea, United Arab Emirates) already operate in a transparent environment with less asymmetrical information, which reduces the need for monitoring through leverage. Third, when investigating the role of varying degrees of ownership concentration, we find that the negative relationship between investment and leverage is stronger in firms with higher levels of ownership concentration. This finding indicates that the monitoring effect induced by ownership concentration complements the monitoring effect of leverage on investment.

Our results suggest that the increased debt levels reported in emerging markets in recent years reduce investment but also guard against overinvestment, especially in countries with weak institutional environments that have a greater need for monitoring. Our findings have important implications for investors and policy makers and implicitly for our society and economy in providing an understanding of the significance of leverage on corporate investment, as well as the role of leverage in monitoring investment across countries with different ownership structures and institutional environments.

This post comes to us from Tiago Loncan, a lecturer in finance at King’s College London; Styliani Panetsidou, an assistant professor of finance in the Centre for Financial and Corporate Integrity at Coventry University, and Angelos Synapis, an assistant professor of finance in the Centre for Financial and Corporate Integrity at Coventry University. It is based on the recent paper, “Leverage, Investment and Institutional Environments: Evidence from Emerging Markets,” available here.