research on Dow Jones Islamic Market Index firms shows significant capital structure differences between developed and developing countries
Summary
A comprehensive academic study has uncovered substantial differences in how Shariah-compliant firms in developed and developing countries structure their debt. Analyzing 28,543 firm-year observations from the Dow Jones Islamic Market World Index (DJIM) across 56 countries between 2004 and 2018, the research reveals that firms in developing countries maintain significantly lower debt ratios than their developed country counterparts.
The study, published in the Journal of Capital Markets Studies, identifies that this difference primarily stems from the exceptionally low leverage ratios of firms operating in Muslim-majority nations. These firms consistently demonstrate lower debt levels over time, with average total debt ratios of 0.383 in developing countries compared to 0.423 in developed countries.
Firm-specific characteristics—including profitability, size, liquidity, and previous year’s debt levels—emerge as the primary determinants of capital structure across all country groups. However, country-level factors show striking variation. For developed country firms, inflation rates and legal rights strength positively influence debt ratios. In developing nations, GDP growth drives higher leverage, while Muslim-majority countries display unique patterns where both GDP growth and inflation positively affect debt, but financial market development shows a negative relationship with borrowing.
Perhaps most significantly, the research documents that firms in developing countries began deleveraging as early as 2006—well before the 2008 Global Financial Crisis—and continued reducing debt throughout the market downturn. This contrasts sharply with developed country firms, which initially increased leverage during the crisis before gradually reducing it afterward.
These findings carry important implications for global investors and Islamic finance practitioners. The study suggests that firms can effectively control their leverage through managing internal characteristics regardless of their operating country. For investors seeking protection against global market uncertainty, diversifying into developing markets may offer advantages, as deleveraging can be achieved more quickly in these economies.
Introduction
Capital structure decisions represent one of the most fundamental aspects of corporate finance, determining how firms finance their operations and growth. The research on this topic spans decades, with scholars developing various theories to explain why companies choose different mixes of debt and equity financing. However, relatively little attention has focused on how these decisions differ for Shariah-compliant firms operating under Islamic finance principles.
A groundbreaking new study published in the Journal of Capital Markets Studies addresses this gap by examining the capital structure determinants of firms included in the Dow Jones Islamic Market World Index (DJIM). This research, conducted by Evrim Hilal Kahya and colleagues from Istanbul Technical University, Rollins College, and other institutions, represents the most comprehensive analysis of its kind to date.
The study’s significance lies in its scope and methodology. By analyzing 28,543 firm-year observations from 56 countries between 2004 and 2018, the researchers capture a diverse range of economic conditions and institutional environments. Furthermore, the use of Hausman-Taylor random effects regression allows for robust analysis of both time-variant and time-invariant variables, providing more reliable results than previous studies.
Understanding capital structure determinants for Islamic firms carries particular importance given the rapid growth of Islamic finance globally. The DJIM index, one of the oldest and most widely recognized Islamic equity benchmarks, applies strict screening criteria including a debt limit of 33% of trailing 24-month average market capitalization. This creates a more homogeneous set of firms than conventional indexes, making it an ideal laboratory for studying capital structure decisions.
The research questions addressed by this study are both timely and relevant: What factors determine the capital structure of Shariah-compliant firms? How do these determinants differ between developed and developing countries? Does operating in a Muslim-majority country influence borrowing decisions? How did the 2008 Global Financial Crisis affect leverage patterns across different country groups?
Understanding Capital Structure Theories
Trade-Off Theory
The Trade-Off Theory, pioneered by Kraus and Litzenberger (1973), proposes that firms determine their optimal debt ratio by balancing the tax advantages of borrowing against bankruptcy costs. Under this framework, companies weigh the benefits of interest tax shields against the potential costs of financial distress, eventually arriving at an optimal capital structure that maximizes firm value.
This theory predicts several relationships between firm characteristics and leverage. Larger firms, which tend to be more diversified and have lower bankruptcy risk, should carry higher debt levels. Similarly, firms with more tangible assets can offer better collateral, enabling greater borrowing capacity. The theory also suggests that more profitable firms might actually use more debt to benefit from tax shields, though empirical evidence on this relationship remains mixed.
Pecking Order Theory
The Pecking Order Theory, developed by Myers and Majluf (1984), offers a different perspective on capital structure decisions. This theory argues that firms follow a hierarchy of financing preferences: first using internal funds (retained earnings), then low-risk debt, and finally equity financing as a last resort. The rationale behind this ordering stems from asymmetric information—managers know more about their firm’s prospects than outside investors, leading to adverse selection costs for external financing.
Under the pecking order framework, more profitable firms should have lower debt ratios because they generate sufficient internal funds to finance their operations. Similarly, firms with higher liquidity should rely less on external borrowing. This theory predicts a negative relationship between profitability and leverage, as well as between liquidity and debt ratios.
Agency Theory
Jensen and Meckling (1976) introduced Agency Theory, which focuses on conflicts of interest among various stakeholders including managers, shareholders, and debt holders. These conflicts arise because different parties have different objectives and information access. For example, managers might pursue growth opportunities that benefit themselves at the expense of shareholders, or shareholders might take excessive risks that harm debt holders.
The theory suggests that debt can serve as a disciplining mechanism, reducing agency costs by limiting managers’ discretion over free cash flows. However, excessive debt can also create conflicts between shareholders and debt holders, particularly when firms face financial distress. The presence of tangible assets can mitigate these conflicts by providing collateral that protects debt holders’ interests.
The Islamic Finance Context
Shariah Screening Requirements
Firms included in Islamic equity indexes must satisfy specific screening criteria to ensure compliance with Islamic law. The DJIM index, which serves as the basis for this study, applies both qualitative and quantitative screens to determine Shariah compliance.
Qualitative screens restrict investment in firms whose revenue from prohibited sources exceeds 5% of total revenue. These prohibited activities include alcohol production and sales, gambling, pork-related products, conventional financial services, entertainment, and weapons and defense. This ensures that investors’ funds are not used to support activities considered harmful or unethical under Islamic principles.
Quantitative screens impose financial limits designed to ensure compliance with Islamic prohibitions on interest (riba) and excessive risk (gharar). The most significant of these screens is the debt limit: total debt must be less than 33% of the firm’s trailing 24-month average market capitalization. Similarly, accounts receivables and the sum of cash and interest-bearing securities must each fall below the same threshold. These screens create a more homogeneous set of firms with respect to capital structure, as all constituents operate under strict leverage constraints.
Islamic Finance Principles
The prohibition of interest (riba) represents a fundamental principle of Islamic finance. This prohibition extends beyond charging interest on loans to include any guaranteed return on capital, whether in the form of interest or other predetermined returns. Instead, Islamic finance promotes profit-and-loss sharing arrangements where returns depend on the actual performance of the underlying investment.
Another key principle is the prohibition of excessive uncertainty (gharar) and gambling (maysir). This restricts transactions involving excessive risk or speculation, promoting transparency and fairness in business dealings. The prohibition of gharar affects various financial instruments and practices, influencing how Islamic firms structure their financing arrangements.
These principles directly impact capital structure decisions. The debt limit screen essentially enforces a maximum leverage ratio, while the prohibition of interest influences the types of financing available to Islamic firms. Consequently, Shariah-compliant firms might exhibit different capital structure patterns compared to conventional firms, particularly regarding their use of debt versus equity financing.
Research Methodology and Data
Sample Composition
The study analyzes all firms included in the Dow Jones Islamic Market World Index (DJIM) as of December 31, 2017. This comprehensive approach captures a diverse range of firms across 56 countries, representing both developed and developing economies. After applying filters for missing data, the final sample comprises 2,759 companies with 28,543 firm-year observations.
The geographic distribution reveals interesting patterns. Developed countries contribute 1,409 firms on average per year, with the United States (382 firms), Japan (194), and the United Kingdom (74) representing the largest constituencies. Developing countries contribute 349 firms annually, with Malaysia (198), India (32), and China (29) among the most represented nations. Notably, eleven Muslim-majority countries appear in the developing country sample, including Malaysia, Indonesia, Pakistan, and Turkey.
Variables and Expected Relationships
The dependent variable in this analysis is Total Debt Ratio (Total Liabilities divided by Total Assets), measured based on book values to avoid the noise inherent in market-based leverage proxies. Seven firm-level independent variables capture various firm characteristics expected to influence capital structure decisions:
Profitability (Return on Assets): Following prior literature, the researchers expect a negative relationship with leverage. More profitable firms generate sufficient internal funds, reducing their need for external borrowing.
Moral Hazard (measured by Inventory-to-Assets and Property, Plant, and Equipment ratios): Higher ratios should increase debt capacity, as tangible assets provide collateral that reduces bankruptcy costs.
Liquidity (Current Ratio): The expected relationship is negative, as more liquid firms can use internal funds rather than debt to finance operations.
Size (Log of Sales): Larger firms should have higher leverage, as they benefit from greater diversification and easier access to financial markets.
Market Valuation (Price-to-Book Ratio): Higher market values should lead to lower capital costs and potentially higher debt ratios.
Distance from Bankruptcy (Altman Z-Score): The expected relationship is negative, as firms further from bankruptcy risk can access more favorable borrowing terms.
Lagged Leverage (Prior Year’s Total Debt Ratio): Included to capture the time trend in leverage decisions.
Four country-level variables capture institutional and macroeconomic factors:
Stock Market Capitalization as a proportion of GDP: Measures financial market development, with developed markets potentially offering alternative financing options.
Strength of Legal Rights Index: Measures creditor protection and institutional quality.
Inflation Rate: Expected to negatively affect leverage by increasing borrowing costs and economic uncertainty.
GDP Growth: Expected to positively influence leverage by improving borrowing capacity and investment opportunities.
Analytical Approach
The researchers employ Hausman-Taylor random effects regression, a sophisticated panel data technique that accommodates both time-variant and time-invariant variables. This approach offers advantages over fixed-effects models, which cannot estimate coefficients for time-invariant variables like country dummies, and traditional random-effects models, which make strong assumptions about variable exogeneity.
The regression includes country dummies to capture fixed country-specific effects, industry dummies to control for sectoral differences, and year dummies to account for time trends including the 2008 Global Financial Crisis. This comprehensive specification enables the researchers to isolate the unique effects of each determinant while controlling for other relevant factors.
Key Findings
Descriptive Statistics and Time Trends
The descriptive analysis reveals significant differences between developed and developing country firms. The average total debt ratio for developed country firms stands at 0.423, compared to 0.383 for developing country firms, a difference that proves statistically significant. This gap primarily reflects the extremely low leverage ratios of firms in Muslim-majority countries, which average around 0.350 throughout most of the sample period.
Figure 1 in the study illustrates the time trend in leverage across different country groups. Firms in Muslim-majority countries consistently maintain lower debt ratios throughout the sample period. Interestingly, non-Muslim developing countries show greater similarity to developed countries in their leverage patterns, although this convergence appears to have reversed recently as debt ratios in Muslim-majority nations have increased.
The time trend reveals particularly interesting dynamics during the 2008 Global Financial Crisis. Developing country firms began deleveraging as early as 2006, well before the crisis intensified, and continued reducing debt throughout the market downturn. This contrasts with developed country firms, which initially increased leverage during the crisis before gradually reducing it in subsequent years. This pattern suggests that Islamic firms in developing countries may have been more conservative in their borrowing practices even before the crisis.
Firm-Level Determinants
The regression analysis confirms that firm-specific characteristics represent the primary determinants of capital structure for DJIM firms. Profitability consistently exhibits a negative relationship with leverage across all country groups, supporting the pecking order theory. This finding indicates that more profitable firms rely less on debt financing, preferring to use internal funds for their operations.
Firm size demonstrates a positive relationship with leverage, consistent with the trade-off theory. Larger firms, being more diversified and having easier access to capital markets, can support higher debt levels. This effect proves particularly pronounced in Muslim-majority countries, where the size coefficient is significantly larger than in other groups.
Liquidity shows a consistently negative relationship with leverage, supporting the pecking order theory. More liquid firms can finance their operations internally, reducing their need for external borrowing. This finding aligns with Islamic finance principles, suggesting that firms operating in accordance with Shariah prefer to use available funds rather than relying on debt.
The Altman Z-score, measuring distance from bankruptcy, exhibits a negative relationship with leverage. Firms further from bankruptcy risk should theoretically be able to carry more debt, yet these findings suggest that financially stronger firms actually use less leverage. This counterintuitive result might reflect the conservative borrowing practices of Islamic firms.
Country-Level Determinants
The country-level determinants show striking variation across the four subsamples, highlighting the importance of institutional and macroeconomic factors in capital structure decisions.
For developed country firms, the inflation rate and strength of legal rights index both show positive relationships with leverage. Higher inflation might reduce the real cost of debt, encouraging borrowing. Stronger legal rights potentially improve creditor protection, making debt financing more attractive and accessible.
In developing countries, GDP growth emerges as the only significant country-level determinant, with a positive impact on leverage. Economic growth improves firms’ borrowing capacity and investment opportunities, encouraging greater use of debt financing.
Muslim-majority countries display the most distinctive pattern. Both GDP growth and inflation positively affect leverage, while financial market development (stock market capitalization) shows a negative relationship. This suggests that firms in these countries rely on debt financing during periods of economic expansion but reduce borrowing as financial markets develop, potentially substituting equity financing for debt.
Interestingly, the analysis finds no evidence that operating in a Muslim-majority country affects capital structure after controlling for other factors. This suggests that differences in average debt ratios reflect other country characteristics rather than religious factors per se.
Time Trends and Crisis Effects
The year dummy variables reveal significant temporal patterns in leverage decisions. Developed country firms experienced a notable increase in debt ratios during 2008, reflecting the crisis impact on their financing decisions. However, this was followed by significant decreases in subsequent years as firms began deleveraging.
Developing country firms show a different pattern, with consistently negative coefficients starting from 2007 onward. This indicates that these firms began reducing leverage even before the crisis fully manifested and continued this trend throughout the recession. The effect appears particularly pronounced in Muslim-majority countries, where the coefficients are generally larger and more significant.
These findings suggest that Islamic firms in developing countries adopted more conservative financing strategies during the crisis period, potentially because of their adherence to Islamic finance principles that discourage excessive debt. This pattern could have helped these firms weather the financial turmoil more effectively than their counterparts in developed countries.
Implications for Practice
For Corporate Managers
The findings carry important implications for managers of Shariah-compliant firms. Firm-specific characteristics emerge as the primary determinants of capital structure, suggesting that managers can exercise significant control over their leverage decisions through internal strategies. This means that firms can manage their debt levels effectively regardless of their operating environment.
Managers should focus on improving profitability, maintaining adequate liquidity, and optimizing firm size to achieve desired capital structure outcomes. These internal factors prove more influential than country-level conditions, providing managers with greater autonomy in financing decisions.
The positive effect of size on leverage suggests that growing firms might need to carefully manage their debt levels to avoid violating Shariah compliance requirements. As firms expand, their debt capacity increases, but they must remain within the 33% debt limit imposed by Islamic index screens.
For Investors
Global investors can draw several insights from these findings. The study reveals that firms in developing countries deleverage more quickly during economic downturns, potentially offering a hedge against global market uncertainty. This suggests that diversifying into developing markets might provide portfolio protection during periods of financial stress.
The relatively homogeneous capital structure of Islamic firms, resulting from strict debt screens, means that investors can expect more consistent leverage patterns across different geographies. This predictability might be valued by risk-averse investors seeking stable, Shariah-compliant investment opportunities.
However, investors should recognize that country-level factors still influence leverage decisions, particularly through inflation, GDP growth, and legal institutions. Understanding these country-specific dynamics can help investors make more informed allocation decisions across different markets.
For Policymakers
Policymakers in both developed and developing countries can use these findings to inform regulatory approaches. The significant impact of legal rights protection on leverage in developed countries suggests that strengthening creditor protection might influence corporate financing decisions. Similarly, the positive relationship between GDP growth and leverage in developing countries indicates that economic conditions substantially affect corporate borrowing patterns.
For countries seeking to develop Islamic finance sectors, these findings offer important guidance. The study shows that operating in a Muslim-majority country does not automatically determine capital structure after controlling for other factors. This suggests that developing robust Islamic finance infrastructure and institutional frameworks might be more important than relying solely on religious demographics.
Tables
Average Debt Levels of Islamic Firms by Country Group
| Country Group | Average Debt Ratio | What This Means |
|---|---|---|
| Developed Countries | 42.3% | Firms finance about 42% of their assets with debt |
| Developing Countries | 38.3% | Firms finance about 38% of their assets with debt |
| Muslim-Majority Countries | Approximately 35% | Firms in these countries use the least debt |
| Non-Muslim Developing Countries | Close to developed country levels | These firms behave more like developed country firms |
Both major capital structure theories find support in the data. Firms follow different patterns depending on whether we look at firm-level factors (like profitability) or country-level factors (like inflation).
What Drives Debt Levels in Islamic Firms?
| Factor | What It Measures | Does More of This Mean More Debt? | Which Theory Does This Support? |
|---|---|---|---|
| Profitability | How much profit the firm makes | ❌ More profit = LESS debt | Pecking Order Theory |
| Firm Size | How large the company is | ✅ Larger firms = MORE debt | Trade-Off Theory |
| Liquidity | How much cash the firm has available | ❌ More cash = LESS debt | Pecking Order Theory |
| Legal Rights Strength | How well creditor rights are protected | ✅ Stronger rights = MORE debt | Trade-Off Theory |
| GDP Growth | How fast the economy is growing | ✅ Faster growth = MORE debt | Trade-Off Theory |
| Inflation Rate | How fast prices are rising | ✅ Higher inflation = MORE debt | Trade-Off Theory |
| Financial Market Development | How developed the stock market is | ❌ Better markets = LESS debt | Trade-Off Theory |
Islamic firms in developing countries, especially in Muslim-majority nations, began reducing their debt before the global financial crisis even started. They were more conservative in their borrowing practices than developed country firms.
Key Firm Characteristics That Really Matter
| Characteristic | Effect on Debt | Size of Effect | Who Is Most Affected? |
|---|---|---|---|
| Prior Year’s Debt Level | Strong positive | Largest effect | All country groups equally |
| Profitability | Negative | Very strong | All country groups |
| Liquidity | Negative | Very strong | All country groups |
| Firm Size | Positive | Strong | Especially strong in Muslim-majority countries |
| Market Valuation | Positive | Moderate | All country groups |
| Distance from Bankruptcy | Negative | Moderate | All country groups |
The most important factor determining current debt levels is past debt levels—firms tend to maintain stable financing patterns. Profitability and liquidity are the next most important factors, with more profitable and more liquid firms using less debt.
Country-Level Factors That Matter Most
| Country-Level Factor | Developed Countries | Developing Countries | Muslim-Majority Countries | Developing Non-Muslim Countries |
|---|---|---|---|---|
| Inflation Rate | ✅ Important (+) | ❌ Not important | ✅ Important (+) | ❌ Not important |
| GDP Growth | ❌ Not important | ✅ Important (+) | ✅ Important (+) | ❌ Not important |
| Legal Rights Strength | ✅ Important (+) | ✅ Important (-) | ❌ Not important | ❌ Not important |
| Stock Market Development | ❌ Not important | ✅ Important (-) | ✅ Important (-) | ❌ Not important |
The factors that influence debt levels vary dramatically depending on where the firm operates. What matters for developed countries doesn’t necessarily matter for developing countries, and Muslim-majority countries show their own unique patterns.
Conclusion
This comprehensive study of capital structure determinants for Shariah-compliant firms yields several important conclusions. First, firm-specific characteristics represent the primary drivers of capital structure across all country groups, with profitability, size, liquidity, and previous leverage consistently influencing debt ratios. These findings remain robust regardless of whether firms operate in developed or developing countries.
Second, country-level factors exhibit significant variation across different country groups. Developed country firms respond to inflation and legal rights protection, developing country firms respond to GDP growth, and Muslim-majority countries display unique patterns involving inflation, growth, and financial market development. This variation highlights the importance of institutional and macroeconomic contexts in shaping corporate financing decisions.
Third, the 2008 Global Financial Crisis affected firms differently across country groups. Developing country firms, particularly those in Muslim-majority nations, began deleveraging well before the crisis and continued reducing debt throughout the downturn. This contrasts with developed country firms, which initially increased leverage during the crisis.
Finally, the study demonstrates that capital structure theories continue to provide useful frameworks for understanding corporate financing decisions. Both trade-off theory and pecking order theory find support in different aspects of the results, suggesting that firms consider multiple factors when making financing decisions.
These findings have important implications for managers, investors, and policymakers. For managers, the results emphasize the importance of internal factors over external conditions. For investors, the study suggests diversification benefits from developing markets. For policymakers, the findings highlight the significance of institutional quality and macroeconomic conditions in shaping corporate borrowing patterns.
Future research could extend this analysis by examining industry-level factors, incorporating corruption measures, or including additional debt market indicators. Comparisons with conventional firms would also help identify whether Islamic screening requirements produce genuinely different capital structure patterns.
