South Asian Journal of Global Business Research

Credit supply and corporate capital structure: evidence from Pakistan

Amjad Iqbal Tanveer Ahsan Xianzhi Zhang
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Amjad Iqbal Tanveer Ahsan Xianzhi Zhang , (2016),"Credit supply and corporate capital structure:
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SAJGBR
5,2
Credit supply and corporate
capital structure: evidence
from Pakistan
250 Amjad Iqbal, Tanveer Ahsan and Xianzhi Zhang
Received 29 March 2015
School of Accounting, Dongbei University of Finance and Economics,
Revised 18 June 2015 Dalian, China
8 October 2015
19 November 2015
Accepted 19 January 2016 Abstract
Purpose The purpose of this paper is to investigate the relevance of credit supply for corporate
capital structure decisions of manufacturing firms in Pakistan.
Design/methodology/approach The implicit assumption in much of the work on capital structure
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is that for a firm, the availability of incremental capital depends solely on its characteristics. However,
the capital market frictions suggest that suppliers of credit may also affect firms ability to borrow. The
authors investigated this intuition by employing dynamic panel data estimators using 8,984 firm-year
observations for the period 1990-2010.
Findings The results show that short-term debt is a major source of financing in these firms.
Further, credit supply plays a significant role in these firms capital structure decisions and hence, they
increase their short-term debt (main financing source) with an increase in credit supply in the market
while payoff their long-term debt with internal funds.
Practical implications The findings of this study can enhance the practitioners and analysts
understanding of capital structure of manufacturing firms in a bank dominated financial system, like
Pakistan. Also, it can provide them more insight in understanding the alternative choices of financing
and the reasons why firms prefer one over the other.
Originality/value To the authors best knowledge, this is the first study in Pakistan that
considers both supply-side as well as demand-side factors of capital structure and applies dynamic
panel data techniques.
Keywords Pakistan, Capital structure, Dynamic panel data models, Credit supply
Paper type Research paper

South Asian Journal of Global
Business Research
Vol. 5 No. 2, 2016
pp. 250-267
Emerald Group Publishing Limited
2045-4457
DOI 10.1108/SAJGBR-03-2015-0029
1. Introduction
After the seminal work of Modigliani and Miller (1958) regarding the role of capital
structure decisions for firm value, in the last six decades, researchers from almost every
part of the world have contributed to capital structure literature. In the beginning,
researchers investigated the role of firm level determinants of corporate capital
structure (Myers, 1977; Titman and Wessels, 1988). Further on, they incorporated
industry effects (Mackay and Phillips, 2005) and then macroeconomic conditions
( Jeveer, 2013). However, very recently the supply-side of capital structure has
captured greater attention by researchers. Empirical research has provided
considerable evidence regarding the role of credit supply for capital structure
decisions and its influence on firms choice of lenders (Graham and Harvey, 2001;
Faulkender and Petersen, 2006). This new strand of capital structure research proposes
that the credit supply conditions as well as the capital market segmentation strongly
influence a firms financing pattern (Faulkender and Petersen, 2006; Leary, 2009;
Voutsinas and Werner, 2011). Moreover, the studies incorporating the role of credit
supply for capital structure decisions have been conducted in developed economies,
namely, the USA, the UK, and Japan. While following in the footsteps of these seminal
 papers, this study investigates the role of credit supply in corporate capital structure Credit supply
decisions in Pakistan, a developing economy. and corporate
Pakistan is an emerging economy with developing financial and legal systems.
According to Worldwide Governance Indicators; Pakistan is suffering from political
capital
instability, poor rule-of-law, and high corruption level. Moreover, an empirical study structure
carried out in Pakistan shows that politically connected firms borrow 45 percent more
and their default rate is also 50 percent higher than other firms (Khwaja and Mian, 251
2005). In addition, the debt market is more developed than the equity market as
depicted by a higher mean (0.7823) for the total leverage ratio (TLEVit) in Table III.
A higher mean (0.5690) for short-term leverage ratio (SLEVit) as compared to the mean
(0.2044) for long-term leverage ratio (LLEVit) depicts that Pakistani firms mostly rely
on short term financing (Table III). All these factors make Pakistan an interesting case
for the purpose of empirical research in the field of corporate finance.
Previous research on capital structure in Pakistan focusses only on demand-side
determinants (Sheikh and Qureshi, 2014; Qureshi, 2009). This study explains the
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financial behavior of Pakistani manufacturing firms by focussing on supply-side as

well as demand-side determinants of corporate capital structure. Demand-side
variables are important to avoid alternative explanations. We apply dynamic panel
data analysis on 8,984 firm-year observations for the period 1990-2010 (State Bank of
Pakistan (SBP) 1990-2010).
The findings from our study confirm earlier works which show manufacturing
firms in Pakistan prefer retained earnings to finance their projects and follow a mix of
pecking-order theory (POT) and trade-off theory (TOT) (Qureshi, 2009; Sheikh and
Wang, 2010). We contribute to the literature on credit supply and capital structure
decisions in different ways. First, we provide a theoretical reasoning based on credit
supply and capital structure literature, thus hypothesizing a positive relationship
between credit supply and leverage ratios. We argue that increased credit supply make
it easy for firms to raise debt. Using Pakistani data, we put the argument to empirical
test and confirm a positive relationship between credit supply and short-term leverage.
Second, against the theory and empirical evidence we find a negative relationship
between credit supply and long-term leverage. We argue that increased credit supply
in the market decreases the cost of short-term debt and increases profitability as
well as liquidity (positive relationship of credit supply with profitability and liquidity,
Table IV). Accordingly, firms payoff their long-term debt with internal funds.
In the very next section, we review empirical research regarding the role of credit
supply in shaping corporate capital structure policies, starting with a brief introduction
to basic capital structure theories. In Section 3 we describe our data and methodology,
definition and measurement of our variables, econometric models of the study, and our
choice of econometric techniques for estimation purpose. We report and discuss in
detail the results from our analysis in Section 4 and conclude the study in Section 5.
References are available at the end.

2. Literature review: credit supply and corporate capital structure

Most of the studies regarding capital structure interpret their results in light of the two
competing theories; the POT and the TOT. The pecking-order hypothesis, proposed by
Myers and Majluf (1984), reflects that funding of companies follows the path of least
resistance and prefers internal sources to external sources, instead of following
theoretical rules. According to this hypothesis, in order to fulfill their financing needs,
companies give preference to retained earnings, then debt, and lastly equity issuance.
 SAJGBR Thus, there is no particular capital structure target by managers. The alternative
5,2 theory is the TOT where the firms managers set target leverage by optimally
balancing the associated benefits and costs of debt (e.g. tax benefits, palliated
management-ownership agency costs, shareholder-bondholder agency costs, financial
distress costs). These theories have been endorsed as well as challenged in empirical
studies. Each theory has succeeded in explaining part of the heterogeneity in leverage
252 ratios, such as the relation between various firm characteristics and capital structure,
but they fail to account for the overall heterogeneity in the observed leverage ratios.
According to Gaud et al. (2006), even after 40 years of research in the field of capital
structure, no universal theory has been developed that can explain all the decisions
regarding financial policy.
Most of the capital structure studies revolve around the determinants of capital
structure and have mainly focussed on the demand-side factors, while completely
ignoring the supply-side factors (Rajan and Zingales, 1995; Booth et al., 2001; Sheikh
and Qureshi, 2014). In agreement with Modigliani and Miller (1958) a great deal of
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extant literature on capital structure has assumed that supply of different forms of
capital is perfectly elastic. This notion indicates that a firms capital structure is solely
determined by its demand for debt. However, recent studies have led toward a new
string of capital structure literature by proposing that credit supply conditions as well
as capital market segmentation strongly influence a firms financing pattern
(Faulkender and Petersen, 2006; Leary, 2009; Voutsinas and Werner, 2011; Becker
and Ivashina, 2014).
A majority of these studies mainly focus on capital market segmentation based on
firms with access to arms-length lenders (e.g. bond markets) and firms which are bank
dependent. Faulkender and Petersen (2006) investigate the impact of access to public
debt markets on corporate capital structure. They use a firms credit rating as a proxy
for measuring its access to the public debt market, and find that the leverage ratios are
significantly larger (i.e. 35 percent) for firms with a credit rating than those without.
This suggests that firms having a credit rating can get cheaper capital from the bond
market, whereas firms without a credit rating (which are small and riskier) have limited
or no access to the bond market, and rely mostly on financial intermediaries for their
financing needs. Sufi (2009) examines the effect of introducing rating for syndicated
bank loans, and documents that these ratings lead to more debt issuance and more
investment especially by riskier borrowers. In a similar study, Tang (2009) shows that
firms who are facing refinement upgrading in their credit rating are increasing their
long-term debt as opposed to those who are facing downgrading. Saretto and Tookes
(2013) document a direct association between firms trading Certificates of Deposit (CDs)
and their leverage level as CDs trading on a firm increases its access to credit supplier.
Other studies have observed the relationship between credit supply shocks and
corporate capital structure in addition to examining their access to the external sources
of capital. Leary (2009) explores the impact of bank loan supply shocks on corporate
financing decisions in the USA. He uses two events of bank loan supply shocks, the
1961 loosening event of interest caused by the introduction of CDs, and the 1966
tightening event known as the credit crunch. He argues that in the expansionary
period as the bank loan supply increases, bank-dependent firms significantly increases
their leverage ratios relative to firms with public market access and vice versa. In other
words, for positive (negative) loan supply shocks the leverage ratios of small and bank-
dependent firms experience a significant increase (decrease) relative to large firms with
public market access. Furthermore, Leary (2009) expands the sample period from 1965
 to 2000 covering a period of 35 years in order to analyze the leverage difference with Credit supply
and without access to the public debt market and finds that this difference becomes and corporate
greater in periods of tighter credit markets and reduced loan supply. In their recent
study Voutsinas and Werner (2011) investigate how credit supply fluctuations affect
capital
the corporate financing decisions in Japanese listed firms. They use two events of structure
extreme credit supply fluctuations, the 1980s asset bubble and late 1990s credit crunch.
Their panel data analysis shows that monetary conditions significantly influence 253
corporate capital structure decisions. Furthermore, they argued that during economic
downturns, small-sized firms as compared to the large-sized firms face severe financial
constraints and hence an ultimate reduction in their leverage ratios. Also, Choi et al.
(2010) in their study of convertible bond arbitrageurs observe clear evidence of supply
effects in the convertible bond market.
In addition to the studies discussed above, there are also studies that consider size of
the firm and availability of alternative sources of financing while investigating the role
of credit supply in corporate capital structure decisions. Gertler and Gilchrist (1993)
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classify their sample into small and big firms and report a higher effect of tight
monetary conditions for small firms capital structure as compared to their large
counterparts. Similar results were reported by Mateut et al. (2006). Monetary policy
impacts a firm capital structure through the balance sheet channel and through the
bank lending channel and these effects are more prominent for small firms which
have limited access to capital markets (Bernanke and Gertler, 1995; Gertler and
Gilchrist, 1994). A tight monetary policy leads to a reduction in banks lending capacity,
and as small firms are more bank dependent, this in turn affects their financing mix
adversely (Bernanke et al., 1996; Kashyap et al., 1994). Moreover, small firms are
associated with higher risk and higher information asymmetry. Also, these firms have
limited financing sources and most of their short term financing needs are satisfied
from banks. More than half of the short-term finance of small firms comes from banks
(Guariglia and Mateut, 2010). This implies the bank-dependency of small firms, and
thus in the case of any kind of credit shortage that reduces banks lending capacity,
small firms are more affected as compared to their large counterparts (Holmstrom and
Tirole, 1997). Similarly, Becker and Ivashina (2014) and Akiyoshi and Kobayashi (2010)
also argue that when banking system suffers from financial shocks, the effects of such
shocks are realized more severely by small and unrated firms as these firms do not
have access to other sources of financing.
In contrast to the arguments presented above there also are some studies suggesting
a negligible impact of credit supply shocks on corporate financing policies. Lin and
Paravisini (2010), for example report an insignificant association between credit
contraction and firms capital structure. Similarly, Lemmon and Roberts (2010)
document a minute effect of credit shortage for firms leverage levels. Other studies
(Kahle and Stulz, 2010; Iyer et al., 2014) find no evidence of credit shortage to small
firms in the 2007-2009 financial crisis. Furthermore, they argued that from the third
quarter of 2007 (i.e. the start of financial crisis) to the first quarter of 2009 (i.e. the peak
of financial crisis), no evidence of credit contraction was found for either investment-
grade or large manufacturing firms.
Summarizing the above arguments, it seems that credit supply is a significant factor
in determining a firms financing behavior. Also, this is evident that the role of credit
supply has been investigated during tight monetary policy regimes as well as in the
crisis periods. Furthermore, the aforementioned studies regarding credit supply and
corporate capital structure mostly cover developed countries including the USA,
 SAJGBR the UK, and Japan, where there are developed bond markets as well as equity markets,
5,2 and there also exist events of extreme credit supply fluctuations either caused by
monetary policy or crisis. However, there may be certain economies especially the
developing ones, where the nature of credit supply fluctuations is not as extreme but
they still need to be investigated. This study considers Pakistan as a sample for such
economies. Figure 1 explains credit growth and leverage patterns over the period under
254 study. The figure shows that although there are fluctuations in credit growth over the
period, these fluctuations are not extreme enough to categorize this time period into
credit expansion or contraction events. Further, leverage patterns depict that these
fluctuations in credit growth do not hurt leverage ratios severely. By incorporating
supply-side information in the traditional capital structure models, this study
contributes to the literature on capital structure especially from a developing economy
perspective, i.e. Pakistan.
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3. Data and methodology

3.1 Dataset
The firm level data for demand-side determinants are taken from the SBP website and
annual reports of companies included in the sample, while the credit growth data are
derived from the IMF International Financial Statistics. Our dataset comprising
13 sectors and 612 listed manufacturing firms for the period 1990-2010 gives us 8,984
firm-year observations. Non-manufacturing firms, such as insurance, utility, and banks
were excluded from the sample as in most capital structure studies (Faulkender and
Petersen, 2006; Leary, 2009; Voutsinas and Werner, 2011). We summarized our dataset
in Table II. As demonstrated in Table I, textile sector is the biggest sector with
229 firms and 3,531 firm-year observations and tobacco is the smallest sector having
five firms and 81 firm-year observations.

3.2 Variables definition and measurement

Leverage. Leverage is the dependent variable in this study and following similar
studies in Pakistani context (Ahsan et al., 2016a, b) we measure it using three proxies:
short-term leverage (SLEVit) measured as short-term liabilities over total assets;
long-term leverage (LLEVit) measured as long-term liabilities over total assets; and
total leverage (TLEVit) measured as total liabilities over total assets.

0.9000
0.8000
0.7000
0.6000
0.5000
0.4000
0.3000
0.2000
0.1000
Figure 1. 0.0000
Credit growth and
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010

leverage patterns
stl ltl tl cg
 Number Number of Percentage of number Cumulative number
Credit supply
Sl. no. Sector of firms observations of observations of observations and corporate
capital
1. Cement 28 396 4.408 396
2. Chemical 52 701 7.803 1,097 structure
3. Engineering 56 871 9.695 1,968
4. Fuel and energy 35 420 4.675 2,388
5. Jute 08 134 1.492 2,522 255
6. Miscellaneous 79 1,124 12.511 3,646
7. Paper and board 13 224 2.493 3,870
8. Sugar 41 720 8.014 4,590
9. Textile 229 3,531 39.303 8,121
10. Textile ancillary
products 33 431 4.797 8,552
11. Tobacco 05 81 0.902 8,633 Table I.
12. Transport and Sector-wise number
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communications 16 150 1.670 8,783 of firms and

13. Vanaspati 17 201 2.237 8,984 observations

Credit supply. Credit supply is the main independent variable of this study and is
defined as bank lending to public and private sectors, plus bank lending in domestic
currency overseas. Most of the previous studies have used credit supply to categorize a
time period into different events such as financial crisis, credit expansion, and credit
contraction (Voutsinas and Werner, 2011; Becker and Ivashina, 2014). Figure 1 explains
credit growth and leverage patterns over the period under study. The figure shows that
although there are fluctuations in credit growth over the period under study, these
fluctuations are not extreme enough to categorize the period into credit expansion or
contraction events. Further, leverage patterns indicate that these fluctuations in credit
growth do not hurt leverage ratios severely. Furthermore, descriptive statistics in
Table IV explains a mean value of 0.1490 for credit growth with standard deviation of
0.0852, indicating that variations in credit growth are not high enough. Accordingly, in
this study we use credit supply as an explanatory variable to measure its impact on
leverage and use credit growth as a proxy for credit supply as employed by the
previous studies such as Leary (2009) and Voutsinas and Werner (2011). However, the
absence of extreme fluctuations as evident from Figure 1, do not allow us to categorize
the time period into different events such as credit expansion and credit contraction.
Thus, unlike these studies we use credit growth as a direct measure of credit supply.
This treatment of credit growth, instead of showing the relevance of credit supply for
corporate capital structure decision in specific events of extreme fluctuations, captures
the response of corporate financing behavior to credit supply over the period.
We also consider the demand-side control variables in our model in order to avoid
alternative explanations. Control variables of this study include tax shield, non-debt
tax shield (NDTS), business risk, growth, agency cost, profitability, past profitability,
liquidity, asset tangibility, firm size, and firm age. These variables are explained one by
one as follows.
Tax shield and NDTS. According to the TOT, given the tax-shield benefit, profitable
firms are expected to be highly levered as they have plenty of income to shield.
Consistent with the TOT many empirical studies have reported a positive tax-shield
effect on firms leverage, however this effect can vary from country to country due to
 SAJGBR differences in institutions and tax policies (Booth et al., 2001). Opposite to this, there are
5,2 also non-debt tax shield (NDTS) benefits such as tax deduction for depreciation,
amortization, long-term deferred expenditures, and investment tax credits. Deangelo
and Mesulis (1980) argue that NDTS are substitutes for the tax-shield benefits and
firms with larger NDTS are expected to use less debt. Accordingly, a negative
relationship is expected between NDTS and leverage. Empirical studies report mixed
256 findings regarding the relationship between NDTS and leverage. Bradley et al. (1984)
find a positive relationship between NDTS and leverage. However, Chaplinsky and
Niehaus (1993) as well as Wald (1999) report a significant negative correlation between
NDTS and leverage. Based on theoretical as well as empirical support discussed above
this study expects a positive relationship between tax shield and leverage, and a
negative relationship between NDTS and leverage. Following previous studies, this
study measures tax shield as the ratio of tax payments to gross profit, while NDTS as
depreciation expenses scaled by total assets.
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Business risk, agency costs, and growth. It is argued that due to the higher probability
of default of riskier firms, debt is available for them, but with higher interest rates.
Moreover, debt involves a commitment of periodic future payments and financially weak
firms may not have the ability to timely fulfill these commitments, so a negative
relationship is expected between business risk and leverage. Opposite to this, according
to the theory of agency costs; firms having limited liability may invest in projects with
very high risk. Success of these projects may make profit for equity-holders and failures
will be faced by debt-holders ( Jensen and Meckling, 1976). Therefore, a positive
relationship is also expected between business risk and leverage. Further, the probability
to invest in highly risky projects is greater for growing firms because these firms have
more investment opportunities. Therefore, a positive relationship is also expected
between growth and leverage. Furthermore, debt is also considered as a tool to reduce
agency conflicts (management vs shareholders) which arise due to the inefficient use of
the firms resources by the management, because it involves periodic repayments ( Jensen
and Meckling, 1976). Therefore, a positive relationship is expected between agency costs
and leverage. Following previous studies we choose Altmans Z-score[1] to measure risk
(Gomariz and Ballesta, 2014), percentage change in total assets to measure growth
(Bayrakdarolu et al., 2013), and expense ratio (operating expenses/sales) to measure
agency cost (Pantzalis and Park, 2014). Empirical results provide mixed evidence such as,
negative relationship by Qureshi et al. (2012) and positive by Chen and Strange (2005) for
risk and positive (Bayrakdarolu et al., 2013) as well as insignificant (Titman and
Wessels, 1988, Sheikh and Wang, 2011) for growth.
Profitability. Alternative explanations provided by both POT and TOT make
profitability one of the most controversial determinants of capital structure. According
to the pecking-order hypothesis, financial managers always prefer the use of internal
funds over external funds (Myers and Majluf, 1984). As a result, POT expects a
negative relationship between profitability and leverage. On the other hand, TOT
asserts that as profitable firms have much income to shield, so they will go for debt
financing to avail the maximum tax-shield benefit, and thus a positive relationship is
expected between profitability and leverage. However, almost all the empirical research
carried out internationally (Bokpin, 2009; Bayrakdarolu et al., 2013) as well as in
Pakistan (Qureshi, 2009; Qureshi et al., 2012) report a negative relationship between
profitability and leverage. Similar to other studies (Degryse et al., 2012; Qureshi, 2009)
we use ROA as a proxy for profitability. In addition to current profitability, this study
 also uses past profitability (retained earnings) as a robustness measure. Retained Credit supply
earnings is a more direct measure of a firms availability of internal funds, and is also a and corporate
direct test for the validity of pecking-order hypothesis. We use retained earnings over
total assets as a proxy for past profitability.
capital
Liquidity. The pecking-order hypothesis postulates that firms with higher liquidity structure
ratios will prefer internal financing, thus suggesting a negative relationship between
liquidity and leverage. Ozkan (2001) consistent with the pecking-order hypothesis 257
suggests a negative impact of liquidity on leverage by arguing that firms with higher
liquidity ratios use them for financing their monetary needs. However, according to
TOT, as firms with higher liquidity ratios have more ability to fulfill their contractual
obligations on time, thus they may do more debt financing. This theory, contrary to the
pecking-order hypothesis, suggests a positive relationship between liquidity and
leverage. Given these different arguments, we cannot hypothesize the exact
relationship between liquidity and leverage. This study uses the ratio of current
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assets to current liabilities as a measure of liquidity.

Asset tangibility. Theories in general state a positive relationship between asset
tangibility and leverage. Jensen and Meckling (1976) suggest that there exist some
agency costs of debt in the event of the firms debt issuance. However, the firms
tangible assets if used as collateral to make the debt more secured, then such agency
costs of debt can be reduced. Issuing secured debt reduces the cost of selling securities,
thus it is beneficial for a firm to issue/sell secured debt. So, higher leverage is expected
to be associated with higher level of tangibility. Williamson (1988) documents that
tangibility increases a firms liquidation value, and higher liquidation value suggests a
firm should increase its debt level, thus showing a positive relationship between
tangibility and leverage. This kind of relationship is also confirmed by Harris and
Raviv (1991). This study expects a positive relationship between asset tangibility and
leverage as reported by most of the empirical studies (Rajan and Zingales, 1995; Titman
and Wessels, 1988; Wald, 1999). Similar to previous empirical studies this study
measures tangibility as net fixed assets scaled by total assets.
Firm size. According to TOT, larger firms have stable cash flows and tend to be
diversified, so they should have higher leverage as compared to smaller firms. On the
other hand, according to the pecking-order hypothesis, larger firms face less
information asymmetry problems so they have the ability to issue equity securities,
hence suggesting a negative relationship between firm size and leverage. Much of the
international evidence finds a positive relationship between firm size and leverage
(Bayrakdarolu et al., 2013; Jeveer, 2013). However in Pakistan, studies find positive
(Qureshi et al., 2012) as well as a mix of positive/negative relationships for different
proxies of leverage (Sheikh and Qureshi, 2014). Following previous international as
well as local studies, we use natural logarithm of total assets as a proxy of firm size.
Age. POT states that older or experienced firms do have enough internal funds
available to finance their projects internally. The availability of internal funds with
older and experienced firms reduces their dependence for external funds. Accordingly,
a negative relationship is expected between firm age and leverage. On the other hand,
TOT states that older or experienced firms due to their creditability and soundness are
considered as less risky as compared to new and small firms. Therefore, debt is also
easily available for them. Accordingly, a positive relationship is expected between firm
age and leverage. Empirical studies have used natural logarithm of number of years a
firm is listed as a proxy for business age (Chen and Strange, 2005; Rocca et al., 2011)
 SAJGBR and found positive (Chen and Strange, 2005) as well as negative (Qureshi et al., 2012)
5,2 relationships between firm age and leverage.
Table II lists all the variables of this study, and also describes the expected
relationships of explanatory as well as control variables with leverage.

3.3 Estimation technique and econometric models of the study

258 The literature suggests that capital structure decisions may also depend upon their
past values (Getzmann et al., 2014), therefore, we choose to apply dynamic panel data
techniques for the purpose of our analysis. Dynamic panel data techniques control for
endogeneity created by the presence of lagged dependent variables and as such are
best suited for our analysis (Roodman, 2009).
For a more thorough investigation of capital structure policy, we categorize leverage
into total, long term, and short term. The econometric models used in this study are
given below.
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Model 1:
TLEV it b0 b1 TLEV i;t1 b2 CGRt b3 TAX it b4 RSK it
b5 N DTS it b6 GRit b7 AC it b8 CPRit b9 PPRit
b10 LQit b11 TAN it b12 SZ it b13 AGit eit
Model 2:
LLEV it b0 b1 LLEV i;t1 b2 CGRt b3 TAX it b4 RSK it
b5 N DTS it b6 GRit b7 AC it b8 CPRit b9 PPRit
b10 LQit b11 TAN it b12 SZ it b13 AGit eit
Model 3:
SLEV it b0 b1 SLEV i;t1 b2 CGRt b3 TAX it b4 RSK it
b5 N DTS it b6 GRit b7 AC it b8 CPRit b9 PPRit
b10 LQit b11 TAN it b12 SZ it b13 AGit eit

Variable name Model name Proxy Effect on debt (+//?)

Credit supply CGRt Credit growth rate +

Tax shield TAXit Tax payments/gross profit +
Risk RSKit Altmans Z-score +/
Non-debt tax shield NDTSit Depreciation expenses/total assets
Growth GRit % change in total assets +/
Agency cost ACit Operating expenses/sales +
Table II. Current profitability CPRit Net profit before tax/total assets +/
Independent Past profitability PPRit Retained earnings/total assets +/
variables, their Liquidity LQit Current assets/current liabilities +/
description, and Tangibility TANit Net fixed assets /total assets +
expected relationship Firm size SZit Ln (total assets) +/
with leverage Age of business AGit Ln (Number of years since listing) +/
 where subscript i denotes the cross-sectional dimension; t represents the time-series Credit supply
dimension; 0 is the intercept for the ith firm; TLEVit is total leverage ratio of ith firm at and corporate
time t; TLEVit1 is one year lagged total leverage ratio; LLEVit is long-term leverage ratio
of ith firm at time t; LLEVit1 is one year lagged long-term leverage ratio; SLEVit is short-
capital
term leverage ratio of ith firm at time t; SLEVit1 is one year lagged short-term leverage structure
ratio; CGRt is credit growth rate at time t; TAXit is tax shield of ith firm at time t; RSKit is
the risk of ith firm at time t; NDTSit is non-debt tax shield of ith firm at time t; GRit is 259
growth rate of ith firm at time t; ACit is agency cost of ith firm at time t; CPRit is current
profitability of ith firm at time t; PPRit is past profitability of ith firm at time t; LQit is
liquidity of ith firm at time t; TANit is tangibility of ith firm at time t; SZit is size of ith firm at
time t; AGit is age of ith firm at time t and; it is the error component for the ith firm at time t.

4. Empirical results and their discussion

This section starts with descriptive statistics, an initial analysis of the dataset used in
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this study. Then it is followed by a critical discussion of the findings derived from the
main empirical analysis of this study.

4.1 Descriptive statistics

Table IV presents descriptive statistics for dependent and independent variables.
The mean short-term leverage of 56.90 percent as compared to mean long-term leverage
of 20.44 percent suggests that short-term debt financing is the main source of financing
for manufacturing firms in Pakistan. This finding also confirms earlier studies conducted
in Pakistan (Qureshi, 2009; Sheikh and Qureshi, 2014; Ahsan et al., 2016a, b) (Table III).
A mean value of 0.1490 for credit growth rate with a standard deviation of 0.0852
explains a low and fluctuating credit growth rate but the fluctuations are not extreme.

Variable Obs. Mean SD Min. Max.

SLEVita 8,984 0.5690 0.4547 0.0868 2.9814

LLEVit 8,984 0.2044 0.2297 0.0000 1.1843
TLEVit 8,984 0.7823 0.5283 0.1348 3.5393
CGRt 20 0.1490 0.0852 0.0073 0.3137
TAXit 8,984 0.0724 0.1197 0.2010 0.6460
RSKit 8,984 1.5535 2.5441 8.0259 8.1999
NDTSit 8,984 0.0410 0.0236 0.0000 0.1016
GRit 8,984 0.1053 0.2518 0.3557 1.2686
ACit 8,984 0.5132 0.7043 0.0000 4.5895
CPRit 8,984 0.0210 0.1278 0.3853 0.3859
PPRit 8,984 0.0229 0.6650 3.6428 0.7081
LQit 8,984 1.1179 0.8827 0.0511 5.3309
TANit 8,984 0.5335 0.2361 0.0466 0.9619
SZit 8,984 6.3393 1.6157 1.6019 10.5088
AGit 8,984 2.5953 0.9232 0.0000 4.1271
Notes: SLEVit, short-term liabilities over total assets; LLEVit, long-term liabilities over total assets;
TLEVit, total liabilities over total assets; CGRt, credit growth rate; TAXit, gross profit over total assets;
RSKit, Altmans Z-score; NDTSit, depreciation expense over total assets; GRit, percentage change in
total assets; ACit, operating expenses over sales; CPRit, net profit before tax over total assets; PPRit,
retained earnings over total assets; LQit, current assets over current liabilities; TANit, net fixed assets
over total assets; SZit, natural logarithm of total assets; AGit, natural logarithm of number of year since Table III.
a firm is listed. aAccounts payable are negligible Descriptive statistics
 SAJGBR A mean value of 0.0724 for tax shield with a standard deviation of 0.1197 indicates quite
5,2 low as well as stagnant tax payments. The highest variation of SD 2.5441 in risk
suggests that Pakistani firms are facing quite a volatile business environment, but still
Pakistani firms have enjoyed a very good growth rate with a mean of 10.53 percent over
the study period. A mean value of 0.0210 and 0.0229 for current and past profitability,
respectively indicates low profitability and moreover their standard deviations (SD of
260 0.1278 for current profitability, SD of 0.6650 for past profitability) show high variability,
but these firms maintain higher liquidity with a mean value of 1.1179.

4.2 Robustness
First of all we investigate multicollinearity issue and find out highest variance inflation
factor of 7.18 (Table IV) therefore multicollinearity is not an issue (Nachane, 2006).
Further, we use robust standard errors adjusted for heteroskedasticity. Furthermore,
Wald 2 (Table V) validates the joint significance of both the models used in the study.
Moreover, Arellano-Bond test for autocorrelation (Table V) finds no autocorrelation
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problem in either model used. The results of both of the models (GMM-Difference,
GMM-System) used are consistent with each other and validates the robustness of the
results of our study.

4.3 Overall results and their discussion

We present the results of dynamic panel data models (GMM-Difference and GMM-
System) in Table V using 8,984 firm-year observations for all three proxies of leverage.
GMM-System reduces total number of firm-year observations to 8,234 due to the use of
one year lagged dependent variable and GMM-Difference also reduces total number of
firm-year observations to 7,524 due to the use of one year lagged dependent variable as
well as the use of first difference.
The significance of one year lagged dependent variable for all the three leverage ratios
explains that financial leverage ratios also depend upon their past values. Further,
confirming the theoretical reasoning of positive relationship, both the models find
positive association between credit growth rate and short-term leverage. This
relationship explains that with an increase in credit supply Pakistani manufacturing
firms increase their short-term debt financing (main financing source). But against the
theory, both the models find a negative relationship between credit supply and long-term
leverage. We argue that increased credit supply in the market decreases the cost of short-
term debt and increases profitability as well as liquidity (positive relationship of credit
supply with profitability and liquidity, Table IV). Accordingly, firms payoff their long-
term debt with internal funds as depicted by negative association between short-term
and long-term leverage in Table IV. These results also validate the correlation matrix in
Table IV where we find positive correlation between credit growth rate and short-term
leverage while a negative correlation between credit growth rate and long-term leverage.
Further, we argue that due to uncertain conditions in Pakistan (higher inflation rate, low
economic growth and fluctuating exchange rates as depicted by World Development
Indicators (WDI)), investment opportunities seem to be short-lived, therefore these firms
try to take benefit of the available opportunities on an urgent basis and go for short-term
debt financing. Moreover on supply-side, banks being the supplier of debt in a bank-
based capital market shy away from long-term debt due to higher default rate and weak
legal system of Pakistan (Sheikh and Qureshi, 2014). Furthermore, both the models find
insignificant relationship between credit growth rate and total leverage. The plausible
reason may be the fact that total leverage is a combination of short-term plus long-term
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SLEVit LLEVit TLEVit CGRt TAXit RSKit NDTSit GRit ACit CPRit PPRit LQit TANit SZit AGit VIF

SLEVita 1.000
LLEVit 0.071 1.000
TLEVit 0.869 0.401 1.000
CGRt 0.023 0.037 0.006 1.000 1.06
TAXit 0.130 0.189 0.205 0.019 1.000 1.16
RSKit 0.687 0.423 0.821 0.006 0.319 1.000 7.18
NDTSit 0.034 0.205 0.059 0.062 0.093 0.125 1.000 1.31
GRit 0.145 0.073 0.165 0.123 0.091 0.167 0.212 1.000 1.15
ACit 0.226 0.074 0.231 0.190 0.120 0.305 0.011 0.129 1.000 1.20
CPRit 0.173 0.174 0.085 0.030 0.120 0.087 0.209 0.038 0.065 1.000 2.01
PPRit 0.353 0.320 0.464 0.015 0.299 0.668 0.124 0.209 0.229 0.081 1.000 4.38
LQit 0.819 0.355 0.936 0.001 0.221 0.823 0.092 0.212 0.275 0.002 0.462 1.000 2.01
TANit 0.428 0.261 0.487 0.008 0.219 0.640 0.245 0.084 0.123 0.067 0.425 0.427 1.000 1.68
SZit 0.108 0.497 0.119 0.017 0.231 0.381 0.406 0.090 0.104 0.249 0.302 0.154 0.475 1.000 1.38
AGit 0.359 0.024 0.345 0.056 0.168 0.292 0.088 0.229 0.189 0.101 0.245 0.440 0.102 0.006 1.000 1.14
Notes: SLEVit, short-term liabilities over total assets; LLEVit, long-term liabilities over total assets; TLEVit, total liabilities over total assets; CGRt, credit
growth rate; TAXit, gross profit over total assets; RSKit, Altmans Z-score; NDTSit, depreciation expense over total assets; GRit, percentage change in total
assets; ACit, operating expenses over sales; CPRit, net profit before tax over total assets; PPRit, retained earnings over total assets; LQit, current assets over
current liabilities; TANit, net fixed assets over total assets; SZit, natural logarithm of total assets; AGit, natural logarithm of number of year since a firm is listed.
a
Accounts payable are negligible
structure
capital
and corporate

along with variance

Credit supply

inflation factor (VIF)

Correlation matrix
Table IV.
261
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5,2

262

Pakistan
Table V.
SAJGBR

Credit supply and

leverage behavior in
SLEVit LLEVit TLEVit
GMM-Difference GMM-System GMM-Difference GMM-System GMM-Difference GMM-System
Variables Coef. Prob. Coef. Prob. Coef. Prob. Coef. Prob. Coef. Prob. Coef. Prob.

Leveragei,t1 0.269 0.000 0.341 0.000 0.480 0.000 0.569 0.000 0.093 0.011 0.190 0.000
CGRt 0.064 0.028 0.052 0.066 0.051 0.018 0.039 0.071 0.008 0.568 0.003 0.852
TAXit 0.019 0.311 0.019 0.384 0.012 0.447 0.016 0.335 0.017 0.091 0.031 0.008
RSKit 0.065 0.000 0.070 0.000 0.023 0.004 0.023 0.006 0.025 0.000 0.025 0.000
NDTSit 0.471 0.018 0.573 0.005 0.010 0.957 0.247 0.255 0.355 0.000 0.289 0.010
GRit 0.028 0.003 0.039 0.000 0.007 0.412 0.005 0.567 0.005 0.385 0.008 0.195
ACit 0.012 0.213 0.010 0.299 0.016 0.019 0.014 0.054 0.002 0.534 0.001 0.773
CPRit 0.133 0.026 0.125 0.051 0.192 0.000 0.221 0.000 0.007 0.825 0.047 0.245
PPRit 0.268 0.000 0.234 0.000 0.239 0.000 0.237 0.000 0.671 0.000 0.652 0.000
LQit 0.114 0.000 0.120 0.000 0.086 0.000 0.091 0.000 0.028 0.000 0.031 0.000
TANit 0.605 0.000 0.646 0.000 0.349 0.000 0.360 0.000 0.196 0.000 0.196 0.000
SZit 0.001 0.971 0.002 0.889 0.093 0.000 0.083 0.000 0.080 0.000 0.068 0.000
AGit 0.028 0.105 0.008 0.657 0.109 0.000 0.084 0.000 0.057 0.000 0.059 0.000
Constant 0.870 0.000 0.900 0.000 0.519 0.000 0.539 0.000 0.499 0.000 0.513 0.000
2
Wald 1,488.63 0.000 2,209.21 0.000 779.39 0.000 1,180.54 0.000 3,657.00 0.000 5,610.19 0.000
AR 0.363 0.717 0.139 0.889 0.245 0.807 0.036 0.971 1.213 0.225 1.221 0.222
No. of obs. 7,524 8,234 7,524 8,234 7,524 8,234
No. of firms 587 607 587 607 587 607
Notes: SLEVit, short-term liabilities over total assets; LLEVit, long-term liabilities over total assets; TLEVit, total liabilities over total assets; Leveragei,t1,
lagged value of leverage ratios; CGRt, credit growth rate; TAXit, gross profit over total assets; RSKit, Altmans Z-score; NDTSit, depreciation expense over total
assets; GRit, percentage change in total assets; ACit, operating expenses over sales; CPRit, net profit before tax over total assets; PPRit, retained earnings over
total assets;, LQit, current assets over current liabilities; TANit, net fixed assets over total assets; SZit, natural logarithm of total assets; AGit, natural logarithm
of number of year since a firm is listed. The table represents the results of dynamic panel data regression models (GMM-Difference and GMM-System) for three
leverage ratios, separately. Wald 2 is a test for joint significance of the variables included in the regression models while AR (Arellano-Bond) is a test for
autocorrelation
 leverage and short-term leverage has positive association while long-term leverage has Credit supply
negative association with credit growth rate. The opposite direction of association of and corporate
short-term and long-term leverage with credit growth rate cancel out each others impact
and leave the relationship of total leverage insignificant with credit growth rate.
capital
Regarding the demand-side control variables used in this study, we find a significant structure
positive relationship of tax shield with total leverage of Pakistani manufacturing firms in
line with TOT, whereas this relationship is insignificant with long-term as well as short- 263
term leverage. The negative association of risk with short-term as well as total leverage
indicates that the firms having relatively lower risk (higher Z-score) have enough
resources to finance short-term business activities internally in line with POT. On the
other hand, the positive association of risk with long-term leverage explains that firms
with lower risk (higher Z-score) can raise cheaper long-term debt. The positive association
of NDTS with short-term as well as total leverage indicates that Pakistani manufacturing
firms use depreciation as a stable source of cash flow to crowd-out debt. These results
also confirm the results of an earlier study in Pakistan (Sheikh and Qureshi, 2014).
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We find a negative relationship of growth with short-term leverage explaining that

growing firms do have enough internal funds to finance their short-term business
activities. Further, we find a positive association between agency cost and long-term
leverage only, explaining that Pakistani firms use long-term debt to manage their agency
problems. We also find a universal negative relationship of past profitability with all three
proxies of leverage in line with the earlier studies in Pakistani context (Sheikh and Wang,
2011; Qureshi et al., 2012; Qureshi, 2009). However, for current profitability; we find
positive association with short-term and negative with long-term leverage suggesting
that profitable Pakistani manufacturing firms use their profitability to payoff their long-
term debt and use it as a positive signal to raise short-term financing. On the other hand,
we find a negative association between liquidity and short-term as well as total leverage
whereas this association becomes positive with long-term leverage suggesting that liquid
Pakistani manufacturing firms use their liquidity to payoff their short-term debt and use
it as a positive signal to raise long-term financing. A positive relationship between
tangibility and long-term leverage suggests that higher tangibility lowers the agency cost
of long-term debt (Frank and Goyal, 2009) which is very important to the creditors
(banks) in Pakistan to minimize the possibility of their long-term credit being written-off.
Contrary, the relationship between tangibility and short-term as well as total leverage is
negative. POT argues that higher tangibility reduces the cost of equity for these firms
because of their lesser information asymmetry (Harris and Raviv, 1991) thus resulting in
a negative relationship between tangibility and leverage. Following TOT we find that
firm size is positively associated with long-term as well as total leverage, indicating that
bigger firms are considered more diversified and have lesser default risk. Opposite to this,
a negative relationship of age with long-term as well as total leverage suggests that older
firms that have been around longer and which are better known in the market have
enough internal resources to finance long-term business projects.

5. Conclusion and policy implications

As discussed earlier in the introductory section of this study, the majority of capital
structure studies have considered only the demand-side explanatory factors, thus
assuming that the managers choices are bound to become reality. The two major
competing theories, namely, the TOT and the POT have been derived for providing
alternative explanations. The former is based on agency costs and tax savings, while
the latter is based on information asymmetry.
 SAJGBR Failing to provide a sufficient explanation regarding corporate financial decision
5,2 making, these theories have led to a new approach in investigating corporate capital
structure. More specifically, by incorporating the supply-side factors in the study of
capital structure, Faulkender and Petersen (2006), Leary (2009), and Voutsinas and
Werner (2011) have proved that firms face financial constraints thus leading to a new
strand of capital structure literature. Following in the footsteps of these aforementioned
264 studies while gathering evidence from Pakistan, this study attempts to explain the
supply-side as well as demand-side factors of capital structure. Also, to the authors
best knowledge, in Pakistan this is the first study on capital structure in light of the
financial constraints faced by firms.
This study applies panel data analysis on 8,984 firm-year observations of Pakistani
manufacturing firms for the period 1990-2010 (SBP 1990-2010). The empirical results
confirm earlier studies by finding that these firms prefer retained earnings to finance
their projects and follow a mix of POT and TOT (Qureshi, 2009; Qureshi et al., 2012;
Sheikh and Wang, 2010). Furthermore, the mean short-term leverage of 56.90 percent as
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compared to mean long-term leverage of 20.44 percent suggests that short-term finance
is the main source of financing in these firms. Moreover, the study explains that these
firms increase their short-term debt with an increase in credit supply in line with
theory. Opposite to theory, this study finds a negative relationship between long-term
debt and credit supply. We argue that these firms payoff their long-term debt with
internal funds as credit supply is positively correlated with profitability and liquidity.
Further, indirect correlation between short-term and long-term debt also strengthens
our argument by explaining that these firms reduce their long-term debt dependence
with an increase in short-term debt financing.
Summarizing the results explained above, we conclude that credit supply has serious
effects on corporate financing decisions. The reasons: first, the equity market of Pakistan
is under developed; second, banks are reluctant to issue long-term debt due to the weak
legal system (Sheikh and Qureshi, 2014); third, the operating business environment is
uncertain (WDI) and as a result firms try to grab short-term opportunities. As a policy
implication, controlling for all forces which are causing uncertainty (whether political or
institutional failures) and developing the equity as well as the bond market can bring
versatility in corporate financing patterns and more financing choices at hand. For future
research, it is necessary to consider both the demand-side as well as the supply-side
determinants of capital structure along with the macroeconomic conditions.

Note
1. Z-score 1.2 (Working capital/Total assets) + 1.4 (Retained earnings/Total assets)
+ 3.3 (Earnings before interest and taxes/Total assets) + 0.6 (Market value of equity/
Book value of total liabilities) + 0.999 (Sales/Total assets).

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About the authors

Amjad Iqbal holds a Masters Degree in Finance and is currently pursuing his PhD in Financial
Management from the Dongbei University of Finance and Economics, School of Accounting,
Dalian, China. He has published several papers on capital structure, corporate governance,
financial reporting, and behavioral finance. Amjad Iqbal is the corresponding author and can be
contacted at: amjadiqbal1987@yahoo.com
Tanveer Ahsan holds a Masters Degree in Finance and is presently a PhD Student with
Financial Management major at the Dongbei University of Finance and Economics, School of
Accounting, Dalian, China. He has published several papers on capital structure.
Xianzhi Zhang is a Professor of Accounting at the School of Accounting, Dongbei University
of Finance and Economics, Dalian, China. He has published extensively in good journals, with
several papers and books on Accounting and Management Control System in China.

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