Foreign borrowing by Indian firms: Implications for growth and macroeconomic stability

This project will analyse the pattern of external borrowing by Indian firms, an exercise that has as yet not been carried out. We will identify possible drivers of such borrowing. Most importantly, we will analyse the impacts of foreign borrowing on the performance of firms that do so, and compare them to the performance of firms that do not borrow. Finally, we will assess the macroeconomic risks that may be associated with external borrowing by Indian firms, and the implicit risk-reward trade-off of growth vs. macroeconomic stability.

India’s policymakers face two simultaneous challenges – a significant growth slowdown and potential macroeconomic instability (inflation, rapid currency depreciation, capital outflows). In the short run, policy measures must focus on averting a crisis, but the most important issue is how to boost growth in the medium term. The Indian finance minister has been making a case for policies to encourage foreign investment into India, including direct investment and portfolio flows. The goal of our project is to provide policymakers with a clearer sense of the risk-reward trade-off of external borrowing by firms, and therefore its position in the foreign investment menu of possibilities. The project will also contribute to the academic literature on firm financing and borrowing decisions, and to the understanding of industrial dynamics in India.

We will use the Prowess database of the Centre for Monitoring Indian  Economy, which provides data for 27000 Indian firms, with coverage from 1989-90 to the present. This database contains extensive financial and operating information for a diverse set of firms, thus giving us a representative sample of Indian firms for our study. We will first document the types of firms that borrow abroad, by age, size, industry, financial structure, international trade engagement, etc. We will particularly examine the impact of regulatory changes on borrowing decisions. Next, we will analyse the impact of foreign debt on growth, which is still an unresolved debate.  We will study this foreign debt and growth linkage using firm level data.  The large panel of firm level data will allow us to study the impact of foreign borrowing on firm growth. The methodology we will follow is propensity score matching, augmented with probit analysis of firms’ overall financing decisions. This methodology gives us a clean experimental design to study the impact of foreign borrowing.

Macroeconomic risks will be qualitatively assessed, building up from the estimated tail risks of the sample firms, i.e., we will use the balance sheet and performance data to estimate default probabilities in different scenarios (e.g., currency depreciation or slower growth), and aggregate to obtain possible total contingent liabilities for firms that borrow abroad. The third part of the study will examine the impact of policy changes on financing constraints. We can study whether access to the foreign borrowing channel caused any change in the firms’ financing constraints. We will use propensity score matching for this as well. Finally, we will go to the aggregate stage and exploit unanticipated foreign shocks as an exogenous variation whose impact on Indian firms, and through them on money market funds and the financial sector more generally, can be analysed more fully.