The cyclicality of debt finance: Evidence from Taiwan

Over the past few decades, a considerable number of studies have been made on the external financing behavior of firms. Financing decisions of firms are usually affected by investment opportunities as well as macroeconomic conditions. As addressed by Minsky’s Financial Instability Hypothesis (1982, 1986), firms tend to overleverage under speculative atmospheres, thus making the financial system more fragile. This implies that leverage is procyclical. However, there is no consensus among empirical literatures on the macroeconomic condition’s effect on firm leverage. Moreover, in studies on the theory of capital structure, since economic expansions tend to lower firms’ equity costs and hence their leverage, the correlation between macroeconomic conditions and leverage appears to be negative (Marsh, 1982;Asquith and Mullins, 1986;Levy and Hennessy, 2007).

This paper sheds light on these different theories of firm behavior by researching the leverage of firms over the business cycles. We focus on publicly listed firms in Taiwan during the years 1986 through 2013 and employ the panel regression of Covas and den Haan (2011) to explore this issue. We improve upon Covas and den Haan (2011) on two fronts: First, besides GDP, we also consider the Industrial Production Index and Stock Price Index, which is related to firm equity financing costs, as macroeconomic variables. Second, since the cyclical behavior of debt financing could be affected by firm’s financial constraints and bankruptcy costs, we simultaneously use both the firm’s size and the amount of tangible assets to classify the ability of obtaining debts. In addition to debt, we also examine the changes in equity financing throughout business cycles and compare them with the cyclicality of debt financing since equity financing is a way for firms to raise funds, and has a substitute relationship with debt financing. Our findings support that debt financing is procyclical for most firms, and this procyclicality is more prominent for larger firms with higher tangible assets,where finance constraint and bankruptcy costs are low.