The Consequences of Easy Credit Policy, High Gearing, and Firms' Profitability in Pakistan's Textile Sector: A Panel Data Analysis

By Hussain, Ijaz | The Lahore Journal of Economics, Summer 2012 | Go to article overview

The Consequences of Easy Credit Policy, High Gearing, and Firms' Profitability in Pakistan's Textile Sector: A Panel Data Analysis


Hussain, Ijaz, The Lahore Journal of Economics


Abstract

This study uses panel data on 75 textile firms for the period 2000-09 to examine the consequences of an easy credit policy followed by high gearing, increased financing costs, and other determinants of corporate profitability. Five out of nine explanatory variables-including gearing, financing costs, inflation, tax provisions, and the industry's capacity utilization ratio-have a negative impact, while the remaining four variables-working capital management, asset turnover, exports, competitiveness, and devaluation-have a positive impact on firms' profitability.

Keywords: Easy credit, energy crisis, corporate profitability, textile sector, panel data, Pakistan.

JEL Classification: L78, L69, F14.

(ProQuest: ... denotes formulae omitted.)

1. Introduction

Both the nonfinancial corporate sector (private and public enterprises) and financial sector play a critical role in a country's economic growth, because they produce goods and services for local as well as foreign markets, create job opportunities, contribute to government tax revenues to finance public expenditure on economic and social infrastructure, and sometimes also to foreign exchange reserves, thus playing an important part in the forward and backward linkages of the value chain.

Figure 1 shows that the profitability of Pakistan's textile sector has varied substantially across firms and over time, declining from almost 10 percent in 2000 to near 0 percent in 2009. This study examines the factors responsible for the variability of firms' profitability in the country's textile sector during this period.

As Figure 2 shows, the sector's gearing ratio peaked in 2005 due to the negative real interest rate followed by an explosion in its financing costs, which, along with the removal of the textile quota and acute energy crisis, later hampered the sector's profitability and ability to repay its debt and financing costs.

The State Bank of Pakistan (2010, December) reports loans of PKR 705.2 billion to the textile sector by the end of 2009, of which nonperforming loans accounted for PKR 171.5 billion, which constituted 31.3 percent of all total nonperforming loans. The gravity of the situation is evident from the fact that there were 189 textile firms in existence in 2004, which number fell to 164 in 2010 with the closure of 25 companies. This makes it important to understand the consequences of an easy credit policy followed by high gearing, increased financing costs, and other determinants of corporate profitability for textile firms in Pakistan.

The paper is organized as follows: Section 2 provides a review of the literature. Section 3 describes the data sources used, variables, and methodology. Section 4 presents our findings, and Section 5 puts forward a conclusion and policy recommendations.

2. A Review of the Literature

The empirical research on the determinants of corporate profitability can be classified into two categories: (i) structure-conduct performance models, and (ii) firm effect models (Mauri & Michaels, 1998; Schmalensee, 1989; Stierwald, 2010). The first explain profitability based on industry effects (concentration) while the second explain profitability based on variations in firms' characteristics (Stierwald, 2010). As noted by Bain (1951), a high industry concentration allows firms to exercise higher monopoly power in the market and makes collusion possible between firms, and thus gives them an opportunity to earn more profits. Barriers to entry of new firms allow existing firms to earn higher profits (Bain, 1956).

Lambson (1991), Jovanovic (1982), and Bartelsman and Doms (2000) highlight the persistent variation in firms' productivity. Demsetz (1973) points out that there is substantial variation in firms' characteristics, and that firms with higher productivity or efficiency earn higher profits. Ammar, Hanna, Nordheim, and Russell (2003) note that small, medium, and large firms differ significantly from one other in terms of their profit rate-profitability drops as firms grow beyond USD 50 million in sales. …

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