Source: E-mail dt. 8.7.2011
Indian Financial Sector Reforms: A Corporate Perspective
Dr. N.A. Anbarasan
Associate Professor and Head
PG & Research Dept of Commerce
Government Arts College
Dharmapuri-636 705, Tamilnadu.
Dr. K. Pongiannan
PG & Research Dept of Commerce
Government Arts College
Dharmapuri-636 705, Tamilnadu.
Until the early nineties, corporate financial management in India was a relatively drab and placid activity. There were not many important financial decisions to be made for the simple reason that firms were given very little freedom in the choice of key financial policies. The government regulated the price at which firms could issue equity, the rate of interest which they could offer on their bonds, and the debt equity ratio that was permissible in different industries. Moreover, most of the debt and a significant part of the equity was provided by public sector institutions.
Working capital management was even more constrained with detailed regulations on how much inventory the firms could carry or how much credit they could give to their customers. Working capital was financed almost entirely by banks at interest rates laid down by the central bank. The idea that the interest rate should be related to the creditworthiness of the borrower was still heretical. Even the quantum of working capital finance was related more to the credit need of the borrower than to creditworthiness on the principle that bank credit should be used only for productive purposes. What is more, the mandatory consortium
arrangements regulating bank credit ensured that it was not easy for large firms to change their banks or vice versa.
Firms did not even have to worry about the deployment of surplus cash. Bank credit was provided in the form of an overdraft (or cash credit as it was called) on which interest was calculated on daily balances. This meant that even an overnight cash surplus could be parked in the overdraft account where it could earn (or rather save) interest at the firm’s borrowing rate. Effectively, firms could push their cash management problems to their banks.
Volatility was not something that most finance managers worried about or needed to. The exchange rate of the rupee changed predictably and almost imperceptibly. Administered interest rates were changed infrequently and the changes too were usually quite small. More worrisome were the regulatory changes that could alter the quantum of credit or the purposes for which credit could be given.
In that era, financial genius consisted largely of finding one’s way through the regulatory maze, exploiting loopholes wherever they existed and above all cultivating relationships with those officials in the banks and institutions who had some discretionary powers.
The last six years of financial reforms have changed all this beyond recognition. Corporate finance managers today have to choose from an array of complex financial instruments; they can now price them more or less freely; and they have access (albeit limited) to global capital markets. On the other hand, they now have to deal with a whole new breed of aggressive financial intermediaries and institutional investors; they are exposed to the volatility of interest rates and exchange rates; they have to agonize over capital structure decisions and worry about their credit ratings. If they make mistakes, they face retribution from an increasingly competitive financial marketplace, and the retribution is often swift and brutal.
This paper begins with a quick summary of the financial sector reforms that have taken place since 1991. It then discusses the impact of these reforms on the corporate sector under five main heads: corporate governance, risk management, capital structure, group structure and working capital management. The paper concludes with a few pointers to the tasks that lie ahead particularly in the light of the East Asian financial crisis.
Financial Sector Reforms: A Summary
Financial sector reforms are at the centre stage of the economic liberalization that was initiated in India in mid 1991. This is partly because the economic reform process itself took place amidst two serious crises involving the financial sector:
Exchange Control and Convertibility
One of the early successes of the reforms was the speed with which exceptional financing was mobilized from multilateral and bilateral sources to avert what at one stage looked like a imminent default on the country's external obligations. Subsequently, devaluation, trade reforms and the opening up of the economy to capital inflows helped to strengthen the balance of payments position. The significant reforms in this area were:
Banking and credit policy
At the beginning of the reform process, the banking system probably had a negative net worth when all financial assets and liabilities were restated at fair market values (Varma 1992). This unhappy state of affairs had been brought about partly by imprudent lending and partly by adverse interest rate movements. At the peak of this crisis, the balance sheets of the banks, however, painted a very different rosy picture. Accounting policies not only allowed the banks to avoid making provisions for bad loans, but also permitted them to recognize as income the overdue interest on these loans. The severity of the problem was thus hidden from the general public.
The threat of insolvency that loomed large in the early 1990s was, by and large, corrected by the government extending financial support of over Rs 100 billion to the public sector banks. The banks have also used a large part of their operating profits in recent years to make provisions for non performing assets (NPAs). Capital adequacy has been further shored up by revaluation of real estate and by raising money from the capital markets in the form of equity and subordinated debt. With the possible exception of two or three weak banks, the public sector banks have now put the threat of insolvency behind them.
The major reforms relating to the banking system were:
Interest rate deregulation and financial repression
Perhaps the single most important element of the financial sector reforms has been the deregulation of interest rates.
For all practical purposes, financial repression is a thing of the past. Even on short term retail bank deposits which are still regulated, the ceiling rate is well above the historic average rate of inflation. Moreover, quite often the ceiling has not been a binding constraint in the sense that actual interest rates have often been below the regulatory ceiling. Similarly, the prices of most other financial assets are also now determined by the more or less free play of market forces. Consequently, financial markets are increasingly able to perform the important function of allocating resources efficiently to the most productive sectors of the economy. This must count as one of the most enduring and decisive successes of the financial reforms.
The major reform in the capital market was the abolition of capital issues control and the introduction of free pricing of equity issues in 1992. Simultaneously the Securities and Exchange Board of India (SEBI) was set up as the apex regulator of the Indian capital markets. In the last five years, SEBI has framed regulations on a number of matters relating to capital markets. Some of the measures taken in the primary market include:
SEBI has been going through a protracted learning phase since its inception. The apparent urgency of immediate short term problems in the capital market has often seemed to distract SEBI from the more critical task of formulating and implementing a strategic vision for the development and regulation of the capital markets.
In quantitative terms, the growth of the Indian capital markets since the advent of reforms has been very impressive. The market capitalization of the Bombay Stock Exchange (which represents about 90% of the total market capitalization of the country) has quadrupled from Rs 1.1 trillion at the end of 1990-91 to Rs 4.3 trillion at the end of 1996-97. As a percentage of GDP, market capitalization has been more erratic, but on the whole this ratio has also been rising. Total trading volume at the Bombay Stock Exchange and the National Stock Exchange (which together account for well over half of the total stock market trading in the country) has risen more than ten-fold from Rs 0.4 trillion in 1990-91 to Rs 4.1 trillion in 1996-97. The stock market index has shown a significant increase during the period despite several ups and downs, but the increase is much less impressive in dollar terms because of the substantial depreciation of the Indian rupee (see Chart 3). It may also be seen from the chart that after reached its peak in 1994-95, the stock market index has been languishing at lower levels apart from a brief burst of euphoria that followed an investor friendly budget in 1997. For the primary equity market too, 1994-95 was the best year with total equity issues (public, rights and private placement) of Rs 355 billion. Thereafter, the primary market collapsed rapidly. Equity issues in 1996-97 fell to one-third of 1994-95 levels and the decline appears to be continuing in 1997-98 as well. More importantly, most of the equity issues in recent months have been by the public sector and by banks. Equity issues by private manufacturing companies are very few.
In its mid-term review of the reform process (Ministry of Finance, 1993a), the government stated: “Our overall strategy for broader financial sector reform is to make a wide choice of instruments accessible to the public and to producers. ... This requires a regulatory framework which gives reasonable protection to investors without smothering the market with regulations. It requires the breaking up of monopolies and promotion of competition in the provision of services to the public. ... It requires the development of new markets such as security markets for public debt instruments and options, futures and forward markets for financial instruments and commodities.”
Unfortunately, this is one area where actual progress has lagged far behind stated intent. It is true that some steps have been taken to increase competition between financial intermediaries both within and across categories. Banks and financial institutions have been allowed to enter each other's territories. Fields like mutual funds, leasing, merchant banking have been thrown open to the banks and their subsidiaries. The private sector has been allowed into fields like banking and mutual funds. Nevertheless, major structural barriers remain:
Monetary policy and debt markets
In the early nineties, the Indian debt market was best described as a dead market. Financial repression and over-regulation were responsible for this situation (Barua et al., 1994). Reforms have eliminated financial repression and created the pre-conditions for the development of an active debt market:
Meanwhile a spate of well subscribed retail debt issues in 1996 and 1997 shattered the myth that the Indian retail investor has no appetite for debt. While only Rs 6 billion was raised through public debt issues in 1994 and Rs 11 billion in 1995, the amounts raised in 1996 was Rs 56 billion. Debt accounted for more than half of the total amount raised through public issues in 1996 compared to less than 10% two years earlier. In 1997, public issues of debt fell to Rs 29 billion, but with the collapse of the primary market for equity, the share of debt in all public issues increased to 57%. Meanwhile, private placement of debt (which is a much bigger market than public issues) has grown very rapidly. Private placement of debt jumped from Rs 100 billion in 1995-96 to Rs 181 billion in 1996-97; in the first half of 1997-98, it grew again by over 50% with Rs 136 billion mobilized in these six months alone.
India is perhaps closer to the development of a vibrant debt market than ever before, but several problems remain:
Impact on Corporate Sector
Corporate governance: In the mid nineties, corporate governance became an important area of concern for regulators, industrialists and investors alike. Indian industry considered the matter important enough for them to propose model corporate governance code (Bajaj, 1997). However, the major pressure for better corporate governance came from the capital markets (Varma, 1997). Capital markets have always had the potential to exercise discipline over promoters and management alike, but it was the structural changes created by economic reform that effectively unleashed this power. Minority investors can bring the discipline of capital markets to bear on companies by voting with their wallets. They can vote with their wallets in the primary market by refusing to subscribe to any fresh issues by the company. They can also sell their shares in the secondary market thereby depressing the share price. Financial sector reforms set in motion several key forces that made these forces far more potent than in the past:
Deregulation: Economic reforms have not only increased growth prospects, but they have also made markets more competitive. This means that in order to survive companies will need to invest continuously on a large scale. The most powerful impact of voting with the wallet is on companies with large growth opportunities that have a constant need to approach the capital market for additional funds.
Disintermediation: Meanwhile, financial sector reforms have made it imperative for firms to rely on capital markets to a greater degree for their needs of additional capital. As long as firms relied on directed credit, what mattered was the ability to manipulate bureaucratic and political processes; the capital markets, however, demand performance.
Globalization: Globalization of our financial markets has exposed issuers, investors and
intermediaries to the higher standards of disclosure and corporate governance that prevail in more developed capital markets.
Institutionalization: Simultaneously, the increasing institutionalization of the capital markets has tremendously enhanced the disciplining power of the market. Large institutions (both domestic and foreign), in a sense, act as the gatekeepers to the capital market. When they vote with their wallets and their pens, they have an even more profound effect on the ability of the companies to tap the capital markets. Indian companies that opened their doors to foreign investors have seen this power of the minority shareholder in very stark terms. International investors can perhaps be fooled for the first time about as easily as any other intelligent investor, but the next time around, the company finds that its ability to tap the international markets with an offering of Global Depository Receipts (GDRs) or other instrument has practically vanished. In the mid-90s, company after company in India has woken up in this manner to the power that minority shareholders enjoy when they also double up as gatekeepers to the capital market.
Tax reforms: Tax reforms coupled with deregulation and competition have tilted the balance away from black money transactions. It is not often realized that when a company makes profits in black money, it is cheating not only the government, but also the minority shareholders. Black money profits do not enter the books of account of the company at all, but usually go into the pockets of the promoters.
The past few years have witnessed a silent revolution in Indian corporate governance where managements have woken up to the disciplining power of capital markets. In response to this power, the more progressive companies are voluntarily accepting tougher accounting standards and more stringent disclosure norms than are mandated by law. They are also adopting more healthy governance practices. Nevertheless, it is still true that the state of corporate governance in India remains pathetic. It is this more than anything else that lies behind the prolonged slump in the primary market today.
Working capital management
Working capital management has been impacted by a number of the developments discussed above - operational reforms in the area of credit assessment and delivery, interest rate deregulation, changes in the competitive structure of the banking and credit systems, and the emergence of money and debt markets. Some of the important implications of these changes for short term financial management in the Indian corporate sector are:
Creditworthiness: The abolition of the notion of maximum permissible bank finance has given banks greater freedom and responsibility for assessing credit needs and creditworthiness. Similarly commercial paper and other disintermediated forms of short term finance are very sensitive to the company’s credit rating and perceived creditworthiness. Companies are suddenly finding that their creditworthiness is under greater scrutiny than ever before. Over a period of time, companies will have to strengthen their balance sheets significantly to ensure a smooth flow of credit. In the meantime, many borrowers especially small and medium businesses have seen their source of credit dry up.
Choice: Top notch corporate borrowers are seeing a plethora of choices. The is integration
of the consortium system, the entry of term lending institutions into working capital finance, and the emergence of money market borrowing options gives them the opportunity to shop around for the best possible deal. Some borrowers indeed appear to have moved to a highly transaction oriented approach to their bankers. Over time, however, we would probably see the re-emergence of relationship banking in a very different form.
Maturity Profile: The greater concern for interest rate risk makes choice of debt maturity more important than before. Short term borrowings expose borrowers to roll-over risk and interest rate risk.
Cash Management: Cash management has become an important task with the phasing out of the cash credit system. Companies now have to decide on the optimal amount of cash or near-cash that they need to hold, and also on how to deploy the cash. Deployment in turn involves decisions about maturity, credit risk and liquidity. In the mid-nineties, many corporates found that they had got these decisions wrong. During the tight money policy of this period, some companies were left with too little liquid cash, while others found that their “cash was locked up in unrealizable or illiquid assets of uncertain value.
As one looks back at the last six years of reforms, it is evident that India has undertaken financial sector reforms at a leisurely pace and that there is a large unfinished agenda of reforms in this sector (Varma, 1996b). At the same time, it is true that India has avoided the financial sector problems that plagued Latin America in the eighties and are confronting East Asia today. It is tempting (and perhaps fashionable) to adopt a posture of smug satisfaction and point to East Asia as a vindication of the slow pace of liberalization in India.
It would however be a mistake if Indian corporates allowed themselves to be lulled into complacency. East Asia has awakened us to the dangers that arise from a combination of high leverage in the corporate sector, poor corporate governance, an implicit currency peg and the resulting overvaluation of the currency, high dependence on external borrowings, a weak banking system and widespread implicit guarantees by the government. Though many of these factors are present in India too, they have been far more muted than in East Asia, and India has therefore come to be seen as less vulnerable. More importantly, extensive capital controls have meant that India is less exposed to global financial markets. Some analysts now appear to think that this a good thing. However, we must not forget that financial markets are only the messengers of bad news and that by cutting ourselves off from these messengers, we do not get rid of the bad news itself. East Asia should be seen as a warning for the Indian corporate sector to pursue more prudent and sustainable financial policies.
Slow liberalization has so far given Indian corporates the luxury of learning slowly and adapting gradually. It would be a mistake to believe that this luxury will last long. Rather
Indian companies should use this breathing space to prepare themselves for the further changes that lie ahead. If in the end, Indian corporates find themselves ill equipped to operate
in a highly competitive and demanding financial marketplace they will have only themselves to blame.
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