Macroeconomic risk and firms financing decision: An empirical panel data investigation using system GMM

This paper investigates the effect of macroeconomic risk on the capital structure decisions of the non-financial Indian firms over a period of 2002-2014, using a panel robust two-step system-GMM estimator as given in Blundell and Bond (1998) to address the problem of endogeneity. Macroeconomic risk (conditional volatility) is estimated by fitting EGARCH (1, 1) model to India’s real exchange rate, and inflation rate. The results indicate that foreign exchange risk and inflation risk have the sizable and statistically significant negative impact on firms’ leverage decision. Profitability of firms has negative relation with the leverage decision hence proving pecking order theory in Indian markets. Further, firms are divided into two groups based on their sensitivities to foreign exchange and inflation. It is found that there is significant difference in leverage ratio of the firms that are affected by foreign exchange or inflation risk and those which are not affected by foreign exchange or inflation risk. The firms sensitive to foreign exchange and inflation risk have a lower percentage of total assets financed by debt. This study will be useful to managers in designing their financing strategy and derivative usage strategy.