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

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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

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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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