Download - Industrial Finance
1. Introduction
Finance is a crucial ingredient for economic growth. The key objective of India's economic reforms
initiated in the early 1990s was to accelerate growth. The reform process of the 1990s did help to
accelerate overall economic growth over that of the 1980s, but only marginally (RBI, 2003).1 Real gross
domestic product (GDP) grew at 5.9 per cent during the reform period (1992-93 to 2002-03), higher than
that of 5.6 per cent in the pre-reform period (1981-82 to 1990-91). Growth in both industry and
agriculture has been slow after the initial burst in the 1990s, although growth in the tertiary sector has
accelerated somewhat.
1.1 Framework for Corporate Financing
To set the stage, let me start with the basic framework of corporate financing. Corporate entities raise
capital from either a) internal sources, essentially retained profits, or b) external sources. External funds
are accessed from sources outside the firm through the issue of equity capital and debt instruments.
Equity capital can be raised from the firm's promoters or the capital market that taps institutional
investors, mutual funds and retail investors. Debt can be raised through floatation of corporate bonds or
borrowing from banks and non-bank financial intermediaries. An important aspect of the growth process
that has been widely discussed in recent times is the type of the financial system that is most conductive
to growth. Seen from this standpoint, most of the systems of industrial finance in developed countries
can be grouped into two clear systems. At one end is the Anglo-American model of market-based
finance where financial markets play an important role and the role of the banking industry is much less
emphasised. At the other extreme is the Continental/Japanese model of bank-based finance, in which
savings flow to their
productive uses predominantly through financial intermediaries such as banks and other financial
institutions, and the capital market is less important for the raising of funds.
1.2 The Pre-Reform Model of Industrial Finance in India
The Indian economy, like most of the former colonial economies, adopted a path of planned
development after Independence. This was, in a sense, dictated by the compulsions of contemporary
political economy. While there was a wide consensus that economic growth could only spring from
1 Reserve Bank of India, (2003a), “Report on Currency and Finance 2002-03” Reserve Bank of India.
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large-scale industrialisation, in consonance with the contemporary big-push theories of economic
development, it was thought that firms lacked the resources to finance such
rapid growth.
The corporate financing strategy, as it evolved, was, however, inextricably linked to the fiscal position,
because of the assumption that public investment would eventually generate surpluses for the social
good. As fiscal deficits began to enlarge, the entire financial system began to be geared to funding the
Government's budgetary needs.
Banks' statutory liquidity ratio, originally a prudential requirement for solvency, was steadily raised to
provide a captive market for public debt.
1.3 Industrial Finance Corporation of India2
At the time of independence in 1947, India's capital market was relatively underdeveloped. Although
there was significant demand for new capital, there was a dearth of providers. Merchant
bankers andunderwriting firms were almost non-existent. And commercial banks were not equipped to
provide long-term industrial finance in any significant manner.
It is against this backdrop that the government established The Industrial Finance Corporation of India
(IFCI) on July 1, 1948, as the first Development Financial Institution in the country to cater to the long-
term finance needs of the industrial sector. The newly-established DFI was provided access to low-cost
funds through the central bank's Statutory Liquidity Ratio or SLR which in turn enabled it to provide
loans and advances to corporate borrowers at concessional rates.
This arrangement continued until the 1990's when it was recognized that there was need for greater
flexibility to respond to the changing financial system. It was also felt that IFCI should directly access
the capital markets for its funds needs. It is with this objective the constitution of IFCI was changed in
1993 from a statutory corporation to a company under the Indian Companies Act, 1956. Subsequently
the name of the company was also changed to 'IFCI Limited ' with effect from October 1999.
IFCI has fulfilled its original mandate as a DFI by providing long term financial support to all segments
of Indian Industry. It has also been chiefly instrumental in translating the government's development
priorities into reality. Until the establishment of ICICI in 1956, IFCI remained solely responsible for
2 Industrial Finance Corporation of India and Its Financial Resources
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implementation of the government's industrial policy initiatives. Its contribution to the modernization of
Indian Industry, export promotion, import substitution, entrepreneurship development, pollution control,
energy conservation and generation of both direct and indirect employment is noteworthy.
1.3.1 Formation of IFCI
The IFCI was the 1st specialized financial institution setup in India to provide term finance to large
industries in India. It was established on 1st July, 1948 under The Industrial Finance Corporation Act of
1948. In 1993 it was reconstituted as a company to impart higher degree of operational flexibility.
1.3.2 Objectives of IFCI
The main objective of IFCI is to provide medium and long term financial assistance to large scale
industrial undertakings, particularly when ordinary bank accommodation does not suit the undertaking
or finance cannot be profitably raised by the concerned by the issue of shares.
1.3.3 Functions of IFCI
1) For setting up a new industrial undertaking.
2) For expansion and diversification of existing industrial undertaking.
3) For renovation and modernization of existing concerns.
4) For meeting the working capital requirements of industrial concerns in some exceptional cases.
5) Direct financial support (by way of rupee term loans as well as foreign currency loans) to industrial
units for under taking new projects, expansion, modernization, diversification etc.
6) Subscription and underwriting of public issues of shares and debentures.
7) Guaranteeing of foreign currency loans and also deferred payment guarantees.
8) Merchant banking, leasing and equipment finance.
1.4 Sources of Finance for Indian Industries3
First, banks have kept up their credit to industry. Not only has there been an increase in the proportion of
conventional credit to GDP, in addition there has also been resource flow in the form of investments in
non-SLR instruments - such as commercial paper, corporate bonds and equity. Second, financing from
3 Main sources of Industrial finance in Indiahttp://www.iasplanner.com/civilservices/ias-main/gs-model-answer-sources-of-industrial-finance-in-india-benefits-from-developments#.UhQv-NLTy0s
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FIs to industry has clearly fallen1. The decline has been sharper in recent years because of the
conversion of ICICI into a bank as well as the problems besetting Industrial Finance Corporation of
India.
The main sources of industrial finance in India are following:
1.4.1 Industrial Development Bank of India (IDBI): It provides credit and other facilities for
industrial development in the country. It provides long term finance for green field projects, as also for
modernization, expansion and diversification. It has structured various product such as equipment
finance, asset credit and corporate loans in order to eater to the diverse needs of its corporate clients.
1.4.2 Industrial credit and investment corporation of India Limited (ICICI Ltd.): It played a
facilitating role in consolidation in various sectors of the Indian industry, by funding mergers and
acquisitions. The ICICI group’s financing and banking operations, both whole sale and retail have been
integrated into a single company effective from May 2002.
1.4.3 Small Industries Development Bank of India (SIDBI): It offers refinance, bills rediscounting
lines of credit and resource support mechanisms to route assistance to SSI sector through a network of
banks and state-level financial institutions. It also offers direct finance for meeting specific requirements
of SSI sector.
1.4.4 Industrial Finance corporation of India Limited (IFCI Ltd): Its main financing comprises of
projects finance, financial services and corporate advisory services. It provides custodial and investor
services rating and venture capital services through its subsidiaries and associate companies.
1.4.5 Industrial Investment Bank of India Limited (IIBI Ltd): It offers a variety of financial products
such as Project financ, short duration none-project asset-backed financ and working capital and other
short term loans to companies.
1.4.6 Infrastructure Development finance company Limited (IDFC Ltd): It was incorporated in
1997 and was conceived as specialized institution to facilitate the flow of private finance to
commercially viable infrastructure projects through innovative products and processes.
1.4.7 Industrial Reconstruction Bank of India (IRBI): It has main aim to revive sick industries and
make them able to exist and compete in market by assistance.
1.4.8 State financial corporation’s (SFCs): It provides loans to need industries. They also promote
shares and debentures, if required they would provide guarantee for loans of third parties. Apart from
these through foreign investments, IPOs, these industries also get financial assistance.
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2. Capital Markets
The market for corporate debt is still in the process of development in the Indian economy, as is the case
with most developing economies. The private placement market has emerged as an
important source of resource mobilisation in the Indian debt market. The first steps in development of
the debt market have been taken through development of the government securities market. The issue of
government bonds through auction, and their active trading by banks has led to the emergence of a
sovereign yield curve. Steps have also been taken, though still in their infancy, to enable active trading
of government securities in the stock exchanges. As this market grows and as steps are taken to regulate
the private placement market, the corporate bond market will also develop. Creditworthy corporate
borrowers will then be able to raise longer term funds for financing their growth.
2.1 Pattern of Industrial Finance among Indian Corporates
Having run through the supply side of the story, let me now turn to the demand side of industrial finance
in India. In terms of external funding, a number of interesting trends emerge. The share of equity
increased in the 1990s. Besides, there was a shift to equity from debentures, especially during the mid-
1990s when the equity issues commanded a large premium in the public issues markets. The share of
capital market-based intermediaries has increased somewhat pulling down the debtequity ratio. The
overall share of borrowings, at about one third, remains, by and large,
intact. There has been a greater reliance on internal resources during the downturn during the latter half
of the 1990s. It is not clear at this stage whether this trend would change with an upturn in the capital
market.
It is now appropriate to arrive at broad generalisations from the sources side of financing. First of all,
bank credit has increased, but only marginally; the important aspect is that it has not gone down contrary
to general belief. Second, banks continue to prefer investing in government securities despite the
reduction in SLR requirements. Third, flows from DFIs have reduced, but they may not be
uncompetitive intrinsically. While their interest costs are high, they have managed to curtail operating
costs. Finally, the contraction in the capital market during the last 5 years has been dramatic.
2.2 Supply of Funds
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Household financial savings are the main source of funds in the Indian financial system. Private savings
performance, at about 25 per cent of GDP, has been reasonably impressive by international standards,
perhaps with the exception of some of the East Asian countries.
The present indications are that we can expect this continuing shift to life insurance, pension funds etc,
although there could be a return to the capital market if it does well for some time. As regards the other
sources of saving, the fiscal deficit continues to act as a drag, leading to negative public sector
dissavings, which pull down the overall savings of the country.
2.3 Options for Longer Term Finance
Against the backdrop of the discussion on various aspects of financing patterns, sources of funds,
maturity structure of assets and liabilities of banks and DFIs, it is apposite to discuss the options
available for financing investment for growth. There are, of course, many sources of project finance
available: banks, insurance companies, DFIs, pension funds, leasing companies, investment
management companies and individuals. It is perhaps useful to begin by exploring the options available
within the existing institutional framework and then turn to other possible innovations.
2.3.1 Existing Institutional Framework
We have already observed that the maturity structure of the liabilities of banks is essentially short-term
in nature. On the asset side, they already hold large volumes of longterm government paper, which is in
tradable form. The composition of assets suggests that banks are less averse to taking on interest rate
risk than credit risk. Given the portfolio choice, it seems to make sense for banks to keep the maturity of
their loans short. It is therefore necessary to change the perception
of banks regarding credit risk. An added set of institutional sources of finance is emerging with the
increasing magnitude of funds flowing to mutual funds, insurance and pension.
2.3.2 Development of the Corporate Debt Market
A necessary condition for the process of asset securitisation is the evolution of a deep and liquid
corporate debt market. As already mentioned, the corporate debt market has not fully developed in the
Indian context, though there is some activity in recent years, especially in the private placement
segment.
Several pre-conditions for the evolution of a successful corporate debt market are now in place. These
include a well-functioning market for government securities, well developed infrastructure for retail
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debt, a liquid money market, an efficient clearing and settlement system, a credible credit rating system
and a formal regulatory framework.
2.3.3 Market Based Financing
A final set of possibilities hinge around a shift in emphasis towards a market-based approach.
At the same time, the continuing increase in the saving rate of households suggests that there is no
supply constraint in terms of financial resources available. The challenge is really to harness these
savings into risk capital. In a country like India, where a large number of retail investors enter the equity
markets directly, there is great potential to develop institutional intermediaries
to tap these funds. In contrast, the investor profile in most developed countries is relatively more
institutional, with mutual funds and pension funds often accounting for a large proportion of the trade.
This effectively means that investors in India bear far more risks than their counterparts in developed
economies, who are able to spread their risk profile by say, buying units of a large mutual fund, with the
necessary technical expertise of investment management. The expansion of the mutual fund industry
thus becomes a target candidate for higher resource mobilisation from the capital markets.
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Conclusions
It is now time to take stock of where we stand. While reviewing the trends in industrial finance during
the last three decades, certain stylised facts stand out: l Bank credit to industry and agriculture has
increased as a proportion of their respective sectoral GDP - but not as much as it might have compared
with the size of the reduction in SLR.
l Given the current maturity profile of their assets and liabilities and the existing fiscal deficit, banks'
ability to lend in the medium- and long-term seems to be limited.
l DFIs are not intrinsically uncompetitive but they need to clean up their legacy of bad debts, emphasise
their strengths and enhance their market orientation.
l Adequate savings are available in the economy. The issue is to channel them for investment for
growth.
The Indian financial system, thus, needs to look at new ways of doing business, in terms of knowledge-
based banking and better management of information. It is necessary to tailor the new institutional funds
to longterm investments. Besides, the next stage of industrial financing would depend on an accelerated
development of the bond market facilitating the securitisation of corporate lending.
In terms of the broad framework of industrial financing, it is clear that there is sufficient room for a
greater role for market financing. At the same time, this does not mean that the Indian economy is ready
for a shift to a market-based system of finance. The panacea to the present challenges in industrial
financing hinges on the ability to design an appropriate mix of the bank- and the marketbased systems of
financing.
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Industrial Finance Corporation of India and Its Financial Resources
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Main sources of Industrial finance in India
http://www.iasplanner.com/civilservices/ias-main/gs-model-answer-sources-of-industrial-finance-in-
india-benefits-from-developments#.UhQv-NLTy0s
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