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Determinants of Private Corporate Sector Savings: An Empirical Study

The private corporate sector, characterised by a stagnant savings rate until 2002-03, has recently emerged as the category experiencing the most rapid growth of savings in the country. This has contributed to the increase in India's overall savings rate. Using firm level data of public limited companies for the period 1998-99 to 2006-07, this paper employs a random effects model to study the determinants of private corporate sector savings. The empirical results of the panel regression indicate that corporate tax rate, availability of external funds, cost of borrowings, interest burden and value of production as a percentage of manufacturing expenses are the major determinants of corporate savings during the period. Dividing the sample into large and small firms based on their sales in 2006-07, we find that the significance of determinants varies considerably between these two firm groups.

SPECIAL ARTICLE

Determinants of Private Corporate Sector Savings: An Empirical Study

Ramesh Jangili, Sharad Kumar

The private corporate sector, characterised by a stagnant savings rate until 2002-03, has recently emerged as the category experiencing the most rapid growth of savings in the country. This has contributed to the increase in India’s overall savings rate. Using firm level data of public limited companies for the period 1998-99 to 2006-07, this paper employs a random effects model to study the determinants of private corporate sector savings. The empirical results of the panel regression indicate that corporate tax rate, availability of external funds, cost of borrowings, interest burden and value of production as a percentage of manufacturing expenses are the major determinants of corporate savings during the period. Dividing the sample into large and small firms based on their sales in 2006-07, we find that the significance of determinants varies considerably between these two firm groups.

The views expressed in this paper are strictly personal.

Ramesh Jangili (rjangili@rbi.org.in) and Sharad Kumar are at the Department of Statistics and Information Management, Reserve Bank of India, Mumbai.

T
he growing optimism about the Indian economy in recent years has led to a resurgence of interest in economic growth in India. Empirical literature has consistently shown that the rate of savings is an important determinant of economic growth. More importantly, many studies have provided evidence that in developing countries, private savings plays a greater role than public savings in determining economic growth. According to Mohan (2008):

…The secular uptrend in domestic growth is clearly associated with the consistent trends of increasing domestic savings and investment over the decades… A very significant feature of these trends in savings and investment rates is that Indian economic growth has been financed predominantly by domestic savings.

Similarly, the Economist (2006) affirmed, “Demography, it is argued, will help raise the level of private savings from about 29% of GDP now to 34% over the next five to seven years. I nvestment will follow, so GDP will continue to grow at 8%.” Clearly, the presumption is that a growth in savings now will lead to a growth in the gross domestic product (GDP) in future through higher i nvestments.

The total national savings comprises public savings and private savings. The latter is further divided into household savings and corporate savings. Corporate savings is defined in stock terms as change in real wealth – net worth at the end of the period less net worth at the beginning of the period. Savings then would be change in resources available for future consumption. While this change is certainly an important variable worthy of serious investigation, unexpected wealth changes also influence it, which should not be included in the savings. Alternatively and more customarily, savings is defined in flow terms as current income less current expenditure.

Gross corporate savings in the National Accounts Statistics (NAS) equals undistributed corporate profits, while net savings equals undistributed (retained) profits less capital consumption (depreciation). Since capital consumption should be treated as an expense of doing business, this paper focuses primarily on net savings, which are retained profits, those profits which are ploughed back into business after making commitments in the form of interest payments, tax provisions, dividend, etc, and after making depreciation provision for the various fixed assets.

A high level of corporate savings is essential and desirable not only because of its macro-implications, but also because of its many advantages at the micro level, i e, availability of finance for the companies themselves. In terms of risk and cost, own savings are the best source of finance for the companies.

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There are no transaction and bankruptcy costs associated with the retained profits of companies. Internal finance has the advantage of easy availability, and it effectively brings about infusion of additional equity capital. The use of retained earnings, in contrast to external equity, eliminates issue costs and losses on account of underpricing.

Sorting out the significant determinants of corporate savings is important for two broad questions in economics. First, is the c yclical behaviour of corporate savings an important stabiliser? This question involves a study not only of the marginal relationship between changes in planned corporate savings and corporate income but also of the interdependence between planned corporate savings and planned corporate investment. Second, does the behaviour of corporate savings in our society adversely affect the allocation of economic resources? This question is important for the position one takes on whether or not government policy should be designed to increase the distribution of corporate income and thus to increase the channelling of new corporate funds through the capital market.

This paper is organised in five sections. Section 1 covers a brief review of literature relating to the determinants of corporate savings. Section 2 presents the trends in domestic savings and the performance of the private corporate sector. Section 3 discusses the data and empirical model used in this study. Section 4 presents the empirical analysis and the concluding observations are presented in Section 5.

1 Review of Literature

In economics, the theory of savings has traditionally focused on private savings, and the division of private savings between corporate and household has been left indeterminate, even though e mpirical tests of the theory have generally been on data of p ersonal savings rather than on data of private savings.

In an empirical study of companies in the United States (US), Lintner (1956) suggested the existence of systematic relationships between dividends and other variables such as corporate income. The explanation for this observed relationship appears to be based on treatment of the corporation as an economic unit with special behavioural characteristics that are not typically recognised in economic theory. Thus, Lintner suggests that directors usually set a target dividend pay-out ratio for the long run and adjust dividends slowly towards this target as income changes. He, therefore, treats dividends and corporate savings as a f unction of current income and dividends of the previous period.

Smith (1963) argued that the proportion saved out of corporate income in a given period would depend on both the previous level of dividends and on demand and supply conditions for corporate funds. For Canadian firms he concluded that in addition to income, previous dividend levels play a very important role in the short run in influencing corporate savings, and the indicator for the demand for investment funds had a smaller impact.

In a study of the relationship between tax policy and corporate savings, Poterba et al (1987) explained how tax policy effectively influences the allocation of profits into dividends and corporate savings. In this study, the major conclusion was that a higher corporate tax rate provides a device for extracting free cash flow

50 from firms and tightens the external capital market’s control on new corporate investments. But tax policies that limit the availability of internal finance exacerbate pre-existing capital market distortions (ibid: 503).

For medium and large non-financial non-government Indian public limited companies during the period 1951-52 to 1973-74, Kishor (1980) identified net income, reserve requirements, expansion requirements, and dividend requirements as the determinants of corporate savings. It was observed in this study that the lagged dividend variable had an inverse relationship with retentions, i e, an increase in dividends in any year should reduce retentions in the next year. Net income emerged as the next most important variable influencing retentions. Need for expansion measured by incremental operating assets as a percentage of the volume of operating assets at the beginning of the period, turns out to be a relatively weaker explanatory variable with a small coefficient and a very large standard error.

In a study of South African companies, Aron and Muellbauer (2000) examined the determinants of annual net corporate savings relative to national income for the period 1966-97, by disaggregating this ratio into two components, and investigated the determinants separately for net corporate savings with respect to net corporate income and for gross corporate profits relative to national income. The major findings from the profit equation were that the share of profits in national income increased with the ratio of wholesale prices to unit labour costs, the gold terms of trade, the difference between the highest tax rate on individuals and the rate of corporation tax and capacity utilisation, but declined with the ratio of company taxes to profits and with import tariffs. From the corporate savings equation, the authors found that the rise in the inflation rate between the late 1960s and late 1980s was an important factor in explaining the rise in the share of corporate savings in net profits; while with the d ecline of inflation in the 1990s, the corporate savings rate has been b olstered by high real interest rates and financial liberalisation in consumer credit markets. It was also concluded in the study that changes in personal tax rates on dividends play no role in explaining the rise in the corporate savings rate out of net profits.

Bhole and Mahakud (2005) studied the trends and determinants of private corporate savings in India using panel data pertaining to 330 public limited companies for the period 1966-67 to 2000-01. This was divided into three time periods and studied individually, i e, 1987-88 to 1999-2000, 1987-88 to 1991-92 and 1995-96 to 1999-2000. The authors employed the generalised method of moments technique for the estimation. They found profit after tax, investment opportunities, availability of external funds, cost of borrowings, and cost of equity to be the major d eterminants of corporate savings in India as evidenced from the empirical results of the panel data model. They also found that retention ratio of the companies was positively related with profit after tax ratio, level of investment, cost of borrowing, and the growth rate of the firm, and negatively related with external sources of funds, corporate tax rate, and cost of equity.

The review of literature indicates that private corporate sector savings plays an important role in economic development. While some studies have analysed the necessity of savings for a firm,

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others have been concerned with the fundamentals or the main determinants of savings behaviour of the private corporate

Figure 1: Trends inDomestic Saving Rate

Saving as a percentage of GDP atCurrent Market Prices

35

25

15

5 0 -5

Savings rate Household sector Private Sector Public Sector

1951 1957 1963 1969 1975 1981 1987 1993 1999 2005 2008 Source: RBI (2010).

sector. More specifically, studies have shown that profits after tax, dividend policy, tax policy, investment opportunities, reserve requirement, expansion requirement, availability of external funds, cost of borrowing and cost of equity are the major factors which determine private corporate savings in India.

2 Private Corporate Sector: Performance and Trends

While India’s savings rate has steadily increased over time, its composition has undergone considerable change. Savings rate of both the private corporate sector and the public sector has gone up, offsetting the decline witnessed in the household sector (Figure 1). The share of public sector savings in the total savings has increased to 4% in recent years from -1% in 1999-2000. The private corporate sector, which had a stagnant savings rate till 2002-03, has only recently emerged as the sector with the most rapidly rising savings rate in the country. Its contribution to the overall savings rate has been increasing and comprised 25% of total domestic savings in recent years.

Recognising the importance of corporate savings for economic growth, policymakers worldwide have become increasingly interested in developing effective strategies for stimulating thrift. Concerns over low level of savings have led to a variety of policy proposals designed to stimulate thrift through the tax system, ranging from narrowly focused tax deferred savings accounts to broad-based consumption taxation. Economic research has played an important role in the resulting public policy debates, and economists have weighed in on virtually all sides of the pertinent issues.

The corporate sector has responded well to the increased global competition by improving its productivity and efficiency through increased application of technology and better financial and human resource management. The economic reforms process has helped greatly in making the policy environment more conducive for efficient entrepreneurial activity. The corporate tax rate was steadily reduced from 45% in 1992-93 to 30% in 2005-06 and was kept stable thereafter. Monetary policy has contributed to the sustained moderation in inflation leading to a r eduction in nominal interest rates. Financial restructuring of firms has also led to the reduction in overall debt equity ratios in the corporate sector. The substantial reduction in debt servicing costs has thereby added to the corporate sector’s competitiveness and profitability.

Profits after tax recorded an annual growth of 26% in 2007-08 (Table 1). Profit margins have recorded large gains, while the i nterest burden has witnessed a significant decline. In fact, the

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ratio of interest expenditure to sales revenues fell from around 6% in the 1990s to about 2% in 2007-08, thereby contributing greatly to the enhanced profit growth (Table 2). The profit after tax (PAT) to net worth ratio, after declining from 14.4% in 1995-96 to 5.1% in 2001-02, increased to 17.5% in 2007-08. Another notable feature of the performance of the corporate sector in the recent period is the progressive increase in retained profits, which as a share of PAT, increased from 30.9% in 2001-02 to 79.9% in 2007-08, which directly contributed to the corporate savings. The improved profitability, reflecting improved productivity and l owering of tax rates, enabled corporates to deleverage their balance sheets. This was reflected in the sharp decline in the debtequity ratio. The improved corporate financial performance resulted in a more than doubling of the private corporate sector savings rate as a percentage of GDP (from 3.4% in 2001-02 to 8.8% in 2007-08), which has also contributed to the pick-up in the overall savings rate.

Table 1: Corporate Financial Performance: Select Growth Rates (in %)

Sales Expenditure Depreciation Provision Gross Profits Interest Payments Profits after Tax
1991-92 19.0 19.2 18.2 22.2 28.7 6.5
1992-93 12.1 14.5 16.3 3.7 21.6 -5.1
1993-94 15.4 10.3 -2.6 22.5 3.1 68.6
1994-95 20.5 20.7 15.9 31.7 8.1 59.2
1995-96 23.7 24.0 23.3 31.0 25.0 23.9
1996-97 10.4 11.4 28.6 -1.9 25.7 -26.6
1997-98 7.5 10.6 25.6 -2.8 12.5 -13.7
1998-99 6.1 6.7 14.4 -3.2 11.1 -20.9
1999-00 11.2 11.9 15.8 9.0 6.7 14.7
2000-01 9.9 9.6 7.1 5.8 7.1 8.3
2001-02 -1.3 -3.3 9.6 3.0 -5.1 -17.8
2002-03 8.5 8.7 4.9 9.8 -9.8 76.2
2003-04 16.0 13.2 6.0 25.0 -11.9 59.8
2004-05 24.1 21.9 11.2 32.5 -5.8 51.2
2005-06 17.9 18.1 11.6 20.5 1.7 28.2
2006-07 26.5 24.4 17.2 44.7 24.9 44.0
2007-08 18.6 19.6 15.7 24.9 29.4 26.0
Source: RBI, various years.
Table 2: Corporate Financial Performance: Select Ratios (in %)

Gross Profits Interest Interest Interest Debt to Internal Bank Profits Profits

Profits to after Coverage to Sales toTotal Equity Sources of Borrowings after Tax Retained Sales Tax to Ratio Expenditure Funds to toTotal to Net to Profits Sales (number) Total Sources Borrowings Worth after Tax

of Funds

1991-92 11.9 3.9 1.9 6.4 6.3 99.5 28.1 32.1 12.0 62.2
1992-93 11.0 3.3 1.6 6.9 6.8 90.4 26.1 32.0 8.7 53.9
1993-94 11.9 5.5 2.0 5.9 6.1 74.9 28.9 27.5 12.0 67.6
1994-95 13.0 7.3 2.4 5.3 5.5 65.5 28.8 29.8 14.0 72.2
1995-96 14.2 7.8 2.7 5.3 5.4 58.7 36.6 35.0 14.4 73.6
1996-97 12.6 5.2 2.1 6.0 6.1 61.6 35.1 33.4 9.5 64.0
1997-98 11.6 4.4 1.9 6.2 6.3 63.0 34.3 32.1 7.6 63.0
1998-99 10.6 3.3 1.6 6.5 6.5 68.2 37.8 31.8 5.6 52.3
1999-00 10.5 3.4 1.7 6.2 6.2 68.4 40.3 33.8 6.3 47.6
2000-01 10.1 3.4 1.7 6.1 6.1 67.0 59.6 34.4 6.5 48.8
2001-02 10.2 2.6 1.7 5.9 6.1 70.5 65.3 37.4 5.1 30.9
2002-03 10.3 4.2 2.1 4.9 5.0 64.7 64.9 43.5 8.7 56.3
2003-04 11.1 5.9 3.3 3.4 3.6 58.6 53.5 48.0 13.2 59.8
2004-05 11.9 7.2 4.6 2.6 2.8 52.7 55.5 51.7 16.8 71.7
2005-06 12.4 8.4 5.4 2.3 2.4 46.8 42.6 57.7 16.7 74.2
2006-07 14.2 9.6 6.2 2.3 2.4 47.3 35.9 60.5 18.8 78.9
2007-08 14.9 9.8 5.9 2.5 2.7 44.4 36.9 62.6 17.5 79.9
Source: RBI, various years.
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From the long-term perspective, it is interesting to observe that the rate of savings of the private corporate sector has increased from around 1% in the 1950s, 1.7% in the 1980s and 3.8% in the 1990s, to almost 9% now. Higher retained profits, availability of greater credit from the banking sector, lower financing requirement of the government and the increased access to the domestic and international capital markets have led to a sharp increase in the investment rate of the corporate sector from 5.4% of GDP in 2001-02 to 15.9% in 2007-08. Thus, despite the increased savings rate, the savings-investment gap of the corporate sector widened from 2.1% of GDP in 2001-02 to 7.1% in 2007-08.

3 Data and Empirical Model

Besides the published data of yearly studies on the finances of public limited companies, the data set used in this study is firmlevel data from Company Finances Studies of the Reserve Bank of India (RBI). The RBI collects annual data from audited annual a ccounts of private sector companies operating in India. From the standpoint of coverage, the RBI collects data on nearly 3,000 companies, representing approximately 30% in terms of the p opulation paid-up capital.

To construct the panel used in this study, several modifications to the original sample were made. The RBI systematically covers data on large firms, but its coverage of smaller firms is sporadic. As such, “entries” and “exits” in and out of the sample tend to be smaller firms that do not submit data rather than actual entries and exits. We eliminated most of the sporadic entries and exits by restricting our sample to common firms included during the whole time period (1998-99 to 2006-07).

The literature review suggests a number of factors that may influence the corporate savings. Here we assume a linear relationship between corporate savings and its determinants. That is,

k RRit = Ȉ‰kXkit + —L + İLW N

where RR = retention ratio, firms are represented by subscript i=1, 2,…,n and time by t=1,2,…,T. K represents the number of explanatory variables. X represents the explanatory variable

—L= firm specific effects, and İLW=disturbance term having the properties, E (İLW and Var (İLW ı2.

3.1 Possible Determinants and Nature of Relationship

Retention ratio is considered as an endogenous variable and is measured as profits retained by a corporate, either in the form of reserves or in the form of credit balance in the balance sheet, as a percentage of profits after tax.

Profits after tax ratio is measured as the profits after tax as a percentage of sales income of the firm. A higher level of net income for a firm would increase its capacity to save and hence,

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the net income or the profit after tax of a firm is expected to be positively related with profits retained. The use of external funds involves cash outflows in the form of either interest or dividend payments; retained profits as the internal funds would reduce the firm’s dependence on external funds. All these considerations suggest a positive relationship between the retention ratio and profit after tax ratio.

Corporate tax rate is measured as the ratio of total tax payments to total profits after tax. The taxation policy of the government negatively affects the retained profits of the firm. The high corporate tax rate increases the total tax payments of the firm and reduces its net income, which in turn reduces the retained profits of the firm. The corporate tax rate is expected to be negatively related with the retention ratio.

External sources of funds ratio is measured as the ratio of total borrowings and share capital to total assets. It is argued that the availability of external funds would be negatively associated with the retained profits of the firm due to cash outflow in the form of dividend and interest. Further, the easy availability of external funds may enable firms to distribute higher dividends to keep certain shareholders happy. However, with the availability of external funds, firms can expand their business activities and enhance their profits, which may boost their savings capacity.

Cost of borrowing is measured as the ratio of interest payments to total outstanding borrowings of the firm. When the cost of borrowing increases, the outgo in the form of interest payments increases. As a result, the retention ratio is expected to have a negative relationship with the cost of borrowing.

Capital formation ratio is measured as the ratio of fixed assets and inventory to total assets of the firm. Capital may increase either from internal funds in the form of retained profits or from external funds in the form of borrowings. The sign is expected to be positive.

Interest burden is measured as the ratio of interest payments to gross profits of the firm. Interest burden may be softened either by an increase in profits or due to a sustained reduction in inflation and domestic and foreign interest rates. If the decrease in interest burden is purely due to higher profits, it may have a positive relationship with retained earnings; however, if the decrease is due to reduction in inflation and interest rates, it may have a negative relationship with retained earnings.

Depreciation ratio is measured as the ratio of depreciation to total assets of the firm. Companies will provide depreciation on various fixed assets and will be used as internal funds. Hence, the retention ratio is expected to have a negative relationship with depreciation ratio.

Value of production ratio is measured as the ratio of value of production to manufacturing expenses of the firm. When the ratio increases, there is a high propensity to get more profits and hence retained profits will improve. As a result, the retention ratio is expected to have a positive relationship with the value of production ratio.

Inventory to sales ratio is measured as the ratio of stock in trade to sales of the firm. When the stock in trade increases, there is a tendency to drop profits and hence retained profits will

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m oderate. Thus the retention ratio is expected to have a negative relationship with the inventory to sales ratio.

The basic statistical properties of the variable used in our model are presented in Table 3. The mean value of the retention

Table 3: Statistical Properties of the Variables

1998-99 2002-03 2006-07
Mean Standard Mean Standard Mean Standard
Deviation Deviation Deviation
Retention ratio 80.0 35.7 83.5 34.5 81.8 47.9
Profits after tax ratio -2.2 34.3 11.1 329.9 3.5 145.1
Corporate tax rate 15.7 20.4 16.9 43.6 21.3 52.1
External sources of funds ratio 52.4 40.6 54.4 49.9 54.8 130.1
Cost of borrowings 15.1 9.0 17.0 77.9 10.5 21.3
Capital formation ratio 85.6 30.5 94.0 36.2 91.2 43.5
Interest burden 41.1 589.1 56.6 832.3 -141.9 4,746.2
Depreciation ratio 24.4 22.3 34.5 26.1 35.0 32.9
Value of production ratio 14.1 177.5 12.5 203.3 9.1 107.3
Inventory to sales ratio 1.5 21.8 -0.2 8.7 6.8 122.6

ratio increased from 80% in 1998-99 to 83.5% in 2002-03 and then it moderated to 81.8% in 2006-07. Average profits after tax ratio improved to 11.1% in 2002-03 from -2.2% in 1998-99 and then declined to 3.5% in 2006-07. Though the corporate tax rate was steadily reduced from 45% in 1992-93 to 30% in 2005-06 and was kept stable thereafter, average corporate tax as a percentage of profits before tax improved from 15.9% in 1998-99 to 16.9% in 2002-03 and then to 21.3% in 2006-07. The external sources of funds ratio, on the average, improved over the years suggesting that corporates are more dependent on external funds than i nternal funds. Though average cost of borrowing was higher in 2002-03 compared to 1998-99, it declined significantly in s ubsequent years.

4 Empirical Results
4.1 Estimation Issues

The model of corporate savings has been estimated using a balanced sample of 785 firms, i e, common firms which have data for the entire period from 1998-99 to 2006-07. The sample was divided into large firms and small firms based on their sales. A firm is classified as large if the sales are more than Rs 100 crore in 200607; otherwise it is classified as small. Thus, 359 large and 426 small firms constituted the total sample for the study. Results for the entire sample (large firms and small firms) are presented in the next section.

The model of savings can be estimated in several ways. The appropriate technique depends upon the structure of the error term İLW, and the correlation between the components of the error term and the observed determinants of savings. Unobservable effects can be accommodated using one of two techniques. First, the unobservable effects can be included in the error term. The v ariance-covariance matrix of the resulting non-spherical errors must be transformed to obtain consistent estimates of the standard errors. In this case, the random effects estimator is appropriate (Wooldridge 2002).

However, a problem arises with the random effects estimator if the unobservable effects, which have been included in the error term, are correlated with some or all of the regressors. This

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s imultaneity would make the random effects estimator inconsist-covariance matrices of the two models, then the correlations of ent. As a consistent alternative to the random effects estimator, a the random effects with the regressors are statistically insignifidummy variable can be included for each firm. This estimation cant. The Hausman test is a kind of Wald Ȥ2 test with k degrees of approach, known as fixed effects, yields consistent estimates re-freedom (where k=number of regressors) on the difference magardless of correlation between firm-specific error components trix between the variance-covariance of the fixed effects model and the regressors. However, it is less efficient than the random with that of the random effects model. There is no evidence to effects estimator. The inefficiency arises because the fixed effects reject the hypothesis that random effects would be consistent estimator requires a separate pa-

Table 5: Estimates of the Regression Model for Different Set of Firms

rameter to be estimated for each All Firms Large Firms Small Firms
firm in the sample in place of the Number of Firms/ 785 359 426
Independent Variables Coefficient Robust Standard Error Coefficient Robust Standard Error Coefficient Robust Standard Error
single variance estimate that is Profits after tax ratio 0.000273 0.000324 0.000188 0.000195 0.000468 0.000595
required for the random effects Corporate tax ratio -0.222572* 0.001746 -0.410281* 0.043438 -0.222479* 0.001683
estimator. External sources of funds ratio 0.213385# 0.122141 0.131584* 0.038768 0.218822 0.162910
The two alternative specifica- Cost of borrowings -0.000112* 0.000052 -0.000096* 0.000036 -0.024775 0.032567
tions of the model differ in their Capital formation ratio 0.095135 0.107254 0.024250 0.092497 0.158747 0.136525
treatment of the firm specific ef- Interest burden 0.000851@ 0.000543 0.000059 0.000223 0.000924 0.000741
fect — L. The fixed effects model Depreciation ratio -0.584539 0.611978 -0.060663 0.157149 -0.805707 0.778851
treats — L as a fixed but unknown Value of production ratio 0.000028* 0.000011 0.000005 0.000007 0.000034* 0.000017
constant differing across firms, Inventory to sales ratio -0.000370 0.001480 -0.091261@ 0.061858 -0.000872 0.001669
*, # and @ show the 5%, 10% and 15% level of significance respectively.
whereas the random effects

model (or variance component model) assumes that —Lis drawn from an independently and identically distributed distribution —L a N (0, ı2 ), and is uncorrelated both with the İLWand Xit.

—

We use the Hausman (1978) specification test, which is the classical test to determine whether the fixed or random effects model should be used. The question is whether there is any significant correlation between the unobserved firm-specific random effects and the regressors. If there is no such correlation,

Table 4: Hausman Test for Fixed Effects versus Random Effects

Test Statistic Statistic Distribution P-Value Model Selected
Entire sample Large firms Small firms 7.31 8.51 5.29 Ȥ Ȥ Ȥ2 9 0.6961 0.5788 0.8710 Random effects model Random effects model Random effects model

then the random effects model may be more powerful and p arsimonious. If correlation exists, the random effects model would be inconsistently estimated and the fixed effects model would be preferred.

The Hausman test is a test of H0: random effects would be consistent and efficient, versus H1: random effects would be i nconsistent (note that fixed effects would certainly be consistent). If there is no statistically significant difference between the and efficient at the 5% level of significance for the entire sample as well as for large firms and small firms (Table 4). As a result, we prefer to focus on the random effects estimates.

4.2 Estimation Results

Results of the panel regression model (random effects) for the three sets of companies – entire sample firms, large firms and small firms, are presented in Table 5. It may be observed that corporate tax rate, cost of borrowings, depreciation ratio and inventory to sales ratio are negatively associated with retained earnings of the firm. Other ratios such as profits after tax ratio, external sources of funds ratio, capital formation ratio, interest burden and value of production ratio are positively associated with retained earnings. According to the previous empirical works, external sources of funds ratio was expected to have a negative association with retention ratio; however, we empirically found a positive association for the period 1998-99 to 2006-07. This indicates that companies expanded their business by deploying external funds and hence generated more profits, which in turn led to high retained profits during the period under study. The study by Bhole and Mahakud (2005) for the period 1987-1999, found a negative association between availability of

THE VERDICT ON AYODHYA

December 11, 2010

Dissecting the Ayodhya Judgment – Anupam Gupta Secularism and the Indian Judiciary – P A Sebastian Idols in Law – Gautam Patel Issues of Faith – Kumkum Roy Was There a Temple under the Babri Masjid? Reading the Archaeological ‘Evidence’ – Supriya Varma, Jaya Menon

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FEBRuary 19, 2011 vol xlvi no 8

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external funds and retained profits. They argued that retained profits and the availability of external funds are substitutable for each other. Their findings, however, have been contradicted in our study. It is maybe due to the fact that with the availability of external funds, companies could expand their business and e nhance their profits.

The other coefficients are in line with the previous empirical studies on the subject. We found that corporate tax rate, availability of external funds, cost of borrowings, interest burden and value of production as a percentage of manufacturing expenses are the major determinants of corporate savings for the period 1998-99 to 2006-07.

Though the signs of the estimated coefficients for large firms and small firms are similar to those for the entire sample, the significant determinants are different. For large firms, corporate tax rate, availability of external sources of funds, cost of borrowings and inventory to sales ratio were found to be significant determinants. It appears that inventory to sales ratio, which is significant for large firms, is insignificant for the entire sample. I nterest burden was significant for the entire sample, but insignificant in case of large firms. For small firms, the signs of coefficients are in line with the entire sample and large firms. However, only corporate tax rate and value of production ratio turns out to be significant, indicating that only tax policy and value of production to manufacturing expenses ratio can influence the r etained profits of small firms.

The estimated coefficient of corporate tax rate is negative and is significantly different from zero across different set of firms. Though availability of external funds is significant in case of entire sample firms as well as in case of large firms, it turns out to be insignificant in case of small firms. This may be because of creditworthiness of the small firms. Funds available in the market may be utilised by larger companies and as a consequence smaller firms are unable to obtain funds for their business expansion. It is also clearly evident that retained profits of small firms are not significantly affected by cost of borrowing, whereas, for larger firms and for entire set of firms it is significant. It appears that small firms do not have liberal access to borrowings.

The estimated coefficient of value of production ratio is significant in case of entire set of firms and small firms, whereas, it is insignificant in case of large firms indicating that input costs do not influence the retained profits of large firms. This may be due to their large base. The estimated coefficient of interest burden is significant at 15% level of significance for the entire set of firms indicating that interest outgo influences the retained profits of the firms. The coefficient of inventory to sales ratio for large firms is significant at 15% level of significance indicating that inventory management is crucial for large firms as they may get orders in bulk.

5 Summary and Conclusions

In this paper we have studied the determinants of private corporate savings in India using a panel regression model. We used firm level data of public limited companies, which contribute a major proportion of corporate savings in India. Though gross corporate savings in the NAS equals undistributed corporate profits, we primarily focused on net savings, which is retained profits. The productivity and efficiency of the private corporate sector has improved in recent years through increased application of technology. The liberal policy environment has unleashed entrepreneurship and improved efficiency of firms. Monetary policy has contributed to sustained moderation in inflation, reducing nominal interest rates, which further leads to reduction in debt servicing costs and a higher profitability of the firms. The gross profitability improved to 14.2% in 2006-07 with gross profits growing at 44.7% in the same year. The improved corporate financial p erformance has resulted in a more than doubling of the private corporate sector savings rate, which has also contributed to the pick-up in the overall savings rate.

The empirical results of the panel regression model showed that corporate tax rate, cost of borrowings, depreciation ratio and inventory to sales ratio are negatively associated with retained earnings of the firm, whereas, profits after tax ratio, external sources of funds ratio, capital formation ratio, interest burden and value of production ratio are positively associated with retained earnings. It is observed from the model that corporate tax rate, availability of external funds, cost of borrowings, interest burden and value of production as a percentage of manufacturing expenses are the major determinants of the corporate savings for the period 1998-99 to 2006-07.

Dividing our sample into large and small firms based on their sales we found that the signs of coefficients in these sets of firms are the same, though their significance varied considerably. Corporate tax rate, availability of external sources of funds, cost of borrowings and inventory to sales ratio were found to be significant determinants in case of large firms, whereas corporate tax rate and value of production ratio were significant in case of small firms.

Our results show that reduction in corporate tax rate would boost corporate savings, and making funds available in the s ystem with moderate interest rates would encourage firms to develop their business activities and raise higher profits and more savings.

References

Aron, Janine and John Muellbauer (2000): “Personal and Corporate Savings in South Africa”, World Bank Economic Review, Vol 14, No 3, 509-44.

Bhole, L M and Jitendra Mahakud (2005): “Trends and Determinants of Private Corporate Sector Savings in India”, Economic Political Weekly, Vol 40, No 39, 24-30 September, 4243-50.

Hausman, J A (1978): “Specification Tests in Econometrics”, Econometrica, Vol 46, No 6, November, 1251-71.

Kishor, Braj (1980): “Corporate Internal Finance: A

Economic Political Weekly FEBRuary 19, 2011

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Study of Overall Trends and Retentions”, Vikalpa, Vol 5, No 3, July, 185-207.

Linter, John (1956): “Distribution of Incomes of Corporations among Dividends, Retained Earnings and Taxes”, The American Economic Review, Vol 46, No 2, May, 97-113.

Mohan, Rakesh (2008): “Growth Record of the Indian Economy, 1950-2008: A Story of Sustained Savings and Investment”, Economic Political Weekly, Vol 43, No 19, 10 May, 61-71.

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vol xlvi no 8

Brookings Papers on Economic Activity, Vol 1987, No 2, 455-515.

Reserve Bank of India (2010): Handbook of Statistics on the Indian Economy, 15 September.

Smith, David C (1963): “Corporate Savings Behaviour”, The Canadian Journal of E conomics and Political Science, Vol XXIX, No 3, August, 297-310.

The Economist (2006): “Business in India: Can India Fly?”, 1 June (Special Section).

Wooldridge, Jeffrey M (2002): Econometric Analysis of Cross Section and Panel Data (Cambridge: MIT Press).

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