Interaction Impact of Monetary Policy and Inflation on Corporate Debt in Developing Nations

Research Question: Several firms in developing countries are increasing debt capital to take advantage of debt interest tax-shield but they are also exposed to bankruptcy, especially during this recent coronavirus pandemic period. Motivation: After 60 years of scholarly research, the determination of firms’ capital structure is still a puzzle and is unending. Modigliani and Miller (1963) theory incorporates taxes and it allows for usage of 100 percent debt capital because of absence of bankruptcy costs; but Myers (1984) theory argues for the existence of an optimal capital structure that maximize firms’ value. This study provides empirical validation to the effectiveness of monetary policy to lower corporate debt in the firms’ capital structure. Idea: The article examines the moderating role of monetary policy on the relationship between corporate debt ratios and inflation rate in developing countries, and the moderating role of monetary policy on the relationship between corporate debt ratios and interest rate. Data: Monetary policy rate data are obtained from the official website of each country and from the Economics Trading Websites. Other macroeconomic data are obtained from the World Bank Databases. Institutional quality data are obtained from World Governance Indicators. The firm-level data are obtained from the Datastream databases. We use a total of 3,827 listed firms covering 2007 to 2015 periods. Method/Tools: The study applies the two-step system generalized method of moments which mitigate endogeneity problem. Findings: The findings reveal that monetary policy weakens the positive effect of inflation rate on corporate debt ratios. Conversely, monetary policy strengthens the negative effect of interest rates on corporate debt ratios. These findings suggest that that monetary policy appears effective to lower corporate debt ratios. Moreover, firms should take monetary policy signals into consideration when formulating capital structure decisions. Contributions: First, the article extends earlier studies by introducing new variable – the money market rate as a proxy for monetary policy and examine the issue of whether monetary policy moderate the relationship between inflation rate and corporate debt. Second, the article examines the issue of the moderating role of monetary policy on the relationship between interest rate and corporate debt.