International Journal of Management

Capital structure—the mix of debt and equity used by companies to finance growth and operations—is a central strategic decision for firms worldwide. In emerging markets, however, these choices are shaped by unique challenges: limited access to capital, volatile economic conditions, institutional weaknesses, and rapidly evolving financial systems. This article analyzes the enduring and emerging influences on capital structure in emerging economies, reviewing empirical evidence, contextual determinants, and strategic best practices for 2025 and beyond.

Key Theories

• Trade-Off Theory: Firms balance the tax benefits of debt against costs of potential financial distress.
• Pecking Order Theory: Firms use internal financing first, then debt, and issue equity as a last resort.
• Agency Theory: Ownership concentration and regulation affect the costs and benefits of external financing.

In emerging markets, these theories interact with unique country-specific factors, creating distinct corporate finance patterns compared to developed economies^[1][2].

Characteristics

• Higher Cost of Capital: Firms face capital costs 540 basis points higher than in the US, with average cost of equity around 15-16%^[3].
• Greater Reliance on Debt: Institutional constraints, underdeveloped markets, and tax incentives often push firms toward debt as equity markets remain less accessible^[1][3].
• Short-Term Debt Dominance: Limited long-term bond markets and lender preferences for shorter tenors increase refinancing risks^[4][3].
• Reliance on Internal Funds: Where external capital is scarce or costly, firms lean heavily on retained earnings^[1][3].

Quantitative Overview

Firm-Specific Factors

• Profitability: Profitable firms prefer low leverage, funding growth with retained earnings, in line with the pecking order theory^[1][2].
• Firm Size: Larger firms have better access to external funding and negotiate lower costs. Smaller firms face higher capital constraints and risk premiums^[1][5][4].
• Asset Tangibility: Firms with fixed assets are more likely to use debt, leveraging collateral to secure loans^[1][2][5].
• Growth Prospects: High-growth firms often have limited collateral and rely more on equity, but may face restricted access to equity markets^[5].

Macroeconomic and Institutional Variables

• Banking System & Credit GDP Ratio: An underdeveloped banking sector limits long-term lending and raises overall costs^[5][6].
• Inflation and Interest Rates: Higher inflation encourages short-term borrowing and, paradoxically, can favor more debt over equity^[3][6].
• Legal and Regulatory Environment: Weak investor protection, poor contract enforcement, low transparency, and lack of strong bankruptcy laws constrain companies’ ability to access and manage diverse forms of capital^[1][3].
• Stock Market Development: More robust exchanges support higher equity ratios, but many emerging markets lack this maturity^[2][4].
• Economic Volatility: Periodic crises (e.g., Asian Financial Crisis) and currency risks make firms cautious about leverage and currency mismatches^[2][4].

Empirical Studies (2025)

Longitudinal research across seven emerging markets (2010–2018) finds that:

• Firm size, profitability, and asset tangibility remain primary drivers of capital structure.
• Macroeconomic variables—including inflation, FDI inflows, and GDP growth—also shape leverage, but effects vary by country and region.
• Shareholder rights, creditor protection, and regulatory frameworks are particularly influential during and after financial crises^[1][2][5].

In an 18-country study, higher asset tangibility and firm size correlate with increased leverage, whereas profitability and growth opportunities yield lower leverage^[2]. The effect of these variables is amplified during macroeconomic shocks, revealing substantial volatility in capital structure decisions.

Illustration: Capital Structure Mix

Challenges Unique to Emerging Markets

• Structural Market Limitations: Absence of robust local bond markets pushes firms toward expensive, short-term bank loans^[4][3].
• Volatile Capital Flows: Sudden stops or reversals, especially during global financial shocks, force rapid deleveraging or asset sales^[3].
• Regulatory Uncertainty: Inconsistent policy signals and uneven enforcement raise risk premiums for both debt and equity^[7][4].
• Currency Mismatches: Heavy reliance on foreign-currency debt without matching revenues exposes firms to exchange rate risk during currency devaluation episodes^[3].
• Ownership and Corporate Governance Issues: High ownership concentration and related-party transactions complicate monitoring and increase agency costs^[3][8].

Graph: Key Challenges for Capital Structure Decisions in Emerging Markets (2025)

Strengthening Capital Markets

• Policy Initiatives: Enforcing consistent, transparent regulations and investor protections boosts market confidence and access to multiple funding sources^[7][4].
• Developing Local Bond Markets: Broadening investor bases and lengthening debt maturities create more favorable funding options^[7][4].
• Fostering Corporate Governance: Reforms to protect minority investor rights and improve transparency reduce reliance on costly debt^[3].

Firm-Level Actions

• Diversification of Funding: Combining local and foreign currency, and short- and long-term funding, helps mitigate risks.
• Hedging and Currency Management: Utilizing derivatives or natural hedges (export revenues in borrowed currency) counters exchange rate risk.
• Building Internal Resilience: Maintaining healthy liquidity and robust internal controls improves access to both debt and equity^[1].

Future Directions (2025 and Beyond)

• Integration of ESG: Environmental, Social, and Governance factors are becoming central to capital raising, with international investors prioritizing sustainable operations.
• Digital Financial Platforms: Fintech solutions are expanding access to financing for SMEs, reducing costs, and increasing transparency.
• South-South Integration: As trade and financial flows increase between emerging markets, cross-border listings are expected to account for an increasing share of future IPOs and capital raises^[9][10].

Capital structure decisions in emerging markets reflect a complex interplay between firm-specific, macroeconomic, and institutional variables. While many challenges remain—limited access to domestic capital markets, regulatory uncertainty, and macroeconomic volatility—reforms in governance, capital market development, and regulatory frameworks are improving conditions for firms to diversify and optimize their funding structures. The next decade will test the resilience and adaptability of emerging-market corporates as new financial instruments, digital platforms, and evolving investor preferences reshape the capital-raising landscape.