Raising Funds from the Capital Market: Challenges for the Private Sector

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1 Raising Funds from the Capital Market: Challenges for the Private Sector R H Patil In this Perspectives piece, R H Patil, a specialist on capital markets and stock exchanges, analyses the challenging task before the private corporate sector in raising funds from the capital market to meet the investment targets envisaged in the Seventh Plan. Author of several articles on capital markets and finance, R H Patil is General Manager (Research & Planning], Industrial Development Bank of India, Bombay. Private corporate sector companies are expected to invest Rs 54,236 crore (at prices) during the Seventh Plan period, from April 1985 to March There was an investment of Rs 25,521 crore (at prices) in the Sixth Plan period. Can the level of investment be more than doubled as envisaged? To achieve the investment target of Rs 54,236 crore, the private corporate sector is expected to raise Rs 15,191 crore or (28 per cent of resources) from the household sector via the capital market. Would the private corporate sector be able to raise the expected amount from the capital market? What competition for funds would the private corporate sector face in the capital market? How should it meet the challenge? To answer these questions, it is necessary to analyse the projected pattern of financing investments and the competition for funds in the capital market. Projected Pattern of Financing The pattern of financing the aggregate investment of Rs 54,236 crore by the private corporate sector has been visualized as follows: 53 per cent of the funds, i.e., Rs 28,779 crore, through internally generated funds; 28 per cent of the funds, i.e., Rs 15,191 crore, through recourse to household sector savings via the capital market; 15.3 per cent of the funds, i.e., Rs 8,266 crore, from public financial institutions [the Indust rial Development Bank of India (IDBI), Indust rial Finance Corporation of India (IFCI), Indust rial Credit and Investment Corporation of India (ICICI), state financial corporations, and state industrial development corporations]; and

2 Table 1 Internal Generation of Funds by the Private Corporate Sector during the Sixth Plan Period [in Rs crore) Component Retained Profit depreciation Total Internal Generation Year Total 940 1,000 1,100 1,050 1,150 5,240 1,410 1,610 1,850 2,130 2,450 9,450 2,350 2,610 2,950 3,180 3,600 14,.690 Source : Centre for Monitoring Indian Economy, Bombay 3.7 percent of the funds, i.e., Rs 2,000 through external borrowings. It is estimated thai during the Sixth Plan period the corporate sector internally generated Rs 14,690 crore of funds. (See Table 1.) They account for about 43 per cent of the gross capital formation of Rs 34,000 crore by the corporate sector during the Sixth Plan. The Seventh Plan projections require that the private corporate sector double the amount generated internally and increase the contribution from internally generated funds to nearly 53 per cent, i.e., Rs 28,779 crore. The reliance on equity as a source of finance is higher than it was in the Sixth Plan. Will the corporate sector be able to achieve the high levels of profits and generate its own funds as expected? The recent liberalizations in industrial policy have considerably strengthened competition within the industrial sector. Government also intends to expose the industrial sector to external competition in a selective- way. With the gradual disappearance of the protective atmosphere to which the industrial sector has got accustomed so far, the capacity of industry to generate surpluses would remain considerably limited until it is able to step up the productive efficiency of its capital. In the meanwhile, it would have to depend on either financial institutions or the capital market. Thus the capital market has not only to raise large funds (Rs 15,191 crore), but may also have to fill the gap between planned, internally generated funds and actuals. Will the capital market be able to do so? Capital Market During the Sixth Plan period, the capital market emerged as one of the major sources of.funds for the private corporate sector. The market has since become highly buoyant, and hardly any capital issues go unsupported by the investors. The capital market which used to raise, on an average, less than Rs 100 crore per annum during the 1970s entered a rapid expansionary phase in the 1980s. The capital issued by the private corporate sector increased from Rs 414 crore in 1981 to Rs 1,889 crore in In 1985, capital raised by the private corporate sector represented 5.3 per cent of domestic savings compared to 1.7 per cent in (See Table 2.) The expansion has been helped by the attractive package of incentives to investors in non-convertible debentures (NCDs) introduced in by investment institutions. Of the total amount of capital raised from the market of Rs crore in 1981, NCDs accounted for Rs 76.9 crore, or 18.6 per cent of the total capital issued to public. (See Table 2.) As a result of the incentives offered, the amount of funds raised through NCDs rose to a record Rs 1,218 crore in 1985, equivalent to nearly two-thirds of the total funds mobilized by the corporate sector from the market in NCDs have pushed convertible debentures into the background. Convertible debentures accounted for two-thirds of the total debentures issued in 1981 and 1982, while they accounted for just over 2 per cent in Equity issues fall somewhere in between: they have not lost out in absolute terms as con- 6 Vikalpa

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4 * These data include both the household sector savings entering the capital market directly as well as the investments of financial institutions such as UTI and LIC in shares and debentures of private corporate sector. ** Provisional Data Source: Centre for Monitoring Indian Economy, Bombay. vertible debentures have, but at the same time, the funds raised through equity have not increased as rapidly as those raised through NCDs. During 1981, equity issues of Rs 202 crore accounted for nearly 49 per cent of the total capital raised in the market. Although the share of equity declined to about 34 per cent in 1985, the absolute amount of equity issued has gone up to Rs 642 crore in Projected Growth of Capital Market Although the capital market has become very active, it might not prove to be a source of funds for the private corporate sector to the extent envisaged. The capital market may not continue to grow at a compound growth rate of 50 per cent per annum as it did in the Sixth Plan period. Investors' confidence is a tender plant and can grow rapidly only in a favourable climate. If the past is any guide, the capital will beat a hasty retreat if the turn of events proves to be adverse. During the capital market exhibited a buoyant state and funds raised on the market accounted for about 10 per cent of the net domestic savings as against 5.3 per cent envisaged in The decade of the 1960s and the first half of the 1970s witnessed a dormant phase of capital market arising out of a sequence of unfavourable develop- ments such as the Chinese War (1962), devaluation (1966), the split in the Congress Party (1969), and subsequent policies of the government, especially the restrictions on payment of dividends. The market started becoming active again only after a large number of Foreign Exchange Regulation Act (FERA) companies started diluting equity in favour of Indian investors. Assuming that the current favourable investment climate would continue to prevail during the Seventh Plan period, we may expect the capital market to develop as follows: (In Rs crore) , , , , ,000 15,000 The activity level in the capital market may be expected to be of the order of Rs 15,000 crore during the Seventh Plan period. However, in assessing its activity level vis-a-vis the projected pattern of financing of the private corporate sector, it is important to note that individual as well as institutional investors provide funds to the Vol. 11, No. 1, January-March

5 capital market. Although separate data for individual and institutional investors are not available, it is known that investment institutions, viz., the Life Insurance Corporation of India (LIC), the General Insurance Corporation (GIC), and the Unit Trust of India (UTI), have been providing substantial amount of funds to the corporate sector by subscribing to the bonds and shares floated by it on the capital market and by participating in consortium lending with the IDBI, ICICI, and IFCI. Another important structural change that has taken place in the capital market recently relates to the rapidly expanding resource base of the UTI. Current trends indicate that the UTI would be able to provide funds to the private corporate sector by way of subscribing to its shares and debentures (including privately placed debentures) to the extent of Rs crore per annum during the Seventh Plan period. The target for the private corporate sector is to raise Rs 15,191 crore from the household sector via the capital market. Of the total funds of Rs 15,000 crore, likely to be provided by the capital market during the Seventh Plan, only Rs 10,000 crore may flow directly from the household sector to the capital market (as distinguished from the flows from the household sector via the investment institutions). Can the private corporate sector induce more household savings to flow into the capital market? In financing its investment plans, the private corporate sector has to take note of two other developments on the capital market: (i) the recent increase in the activity of public sector units in the capital market and (ii) the strong likelihood of direct borrowing by Government from the market.the availability of capital market resources to private sector will be influenced by these developments which are discussed below. couple of years. Except for the "jumbo" issues by some companies like Reliance Industries and Larsen & Toubro, a majority of the large private sector issues are in the range of Rs 20 crorerto Rs 30 crore. On the other hand, the bond issues of the National Thermal Power Corporation, the Indian Telephone Industries, and the Rural Electrification Corporation have been of Rs 100 crore each. The resource needs of these public sector units are so large that the market could be swamped by their activities. It should also be noted that the terms offered by the public sector corporations are considerably more attractive than those offered by the private sector units. The NCDs issued by the private sector companies fetch 15 per cent interest with a 5 per cent premium at redemption time. In contrast, although the bonds floated by the public sector units yield nominally a slightly lower return of 14 per cent, their effective rate of return is significantly higher on account of a number of tax benefits. Not only interest incomes from these bonds are eligible for concession under 80 L, the entire holdings of these bonds are exempted from Wealth Tax. Further, there is no deduction of tax at source, and there is no limit on this facility. These bonds are freely transferrable with mere endorsement, and even the stamp duty need not be paid at the time of transfer. All the interest coupons due over the life of the bonds are issued along with bond certificates. Hence, these bonds could be freely circulated without re-registration in the books of the issuing company until the period of redemption. The terms offered by the private sector units are much less attractive than those of the public sector corporations which also enjoy a special status since they are owned and backed by the Government. The private corporate sector would thus find it increasingly difficult to compete with public sector bonds to raise large amount of resources from potential investors. Public Sector Units in Capital Market Public sector units have started entering the capital market in a big way. The requirements of some of the public sector undertakings are substantially higher than the average size of issues that have been coming to the market during the last Government's Direct Borrowings from Capital Market In addition to the public sector units, the government is also likely to borrow directly from the capital market. In April 1985, a Reserve Bank of India Committee, under the chairmanship of 8 Vikalpa

6 Sukhamoy Chakravarty, submitted a report recommending the lines along which the monetary system of the country could be reformed. There are several important suggestions contained in the report which, if implemented, would have a direct bearing on the capital market. The committee has recommended that to avoid the inflationary impact of government borrowings from the Reserve Bank of India (RBI), the Government should increasingly tap the savings of the public through an appropriate interest rate structure and by offering a wider spectrum of savings instruments with attractive features. Lending by the RBI to the Government leads to the creation of reserve money, or what is sometimes called "the high-powered money," which in turn leads to multiple credit creation in the economy. Thus, government borrowings from the RBI has a far greater inflationary impact than its borrowings either from the commercial banks or the general public. Given the Government's concern about inflation, the RBI and the Government are likely to accept the committee's recommendations. The Government is, therefore, likely to borrow directly from investors by floating special types of bonds or new types of securities and deposit instruments. The implications of such a measure need to be noted carefully. During , the Government borrowed Rs 3,987 crore from the RBI. The borrowings increased substantially to Rs 7,426 crore in If the Government wants to bring down substantially borrowings from the RBI, it will have to borrow much more from the rr«i^te*t and the investors. These borrowings would be over and above its current borrowings from the public through the National Savings Certificates and National Deposit Scheme. The bulk of the financial savings of the household sector are attracted to the banking system, provident funds, insurance agencies, corporate sector, and government savings schemes. Given the present pattern of deployment of savings of the household sector (presented in Table 3), it is obvious that government borrowings from the household sector would impinge directly on the savings now deposited in the banking system. Since the Government's requirement of funds is quite large, its borrowing from the household sector would make a noticeable impact on the flow of household sector's savings to both the corporate sector via the capital market and the banking system. Since banks Table 3 Composition of Financial Savings of the Household Sector: (In Rs crore) Savings of the Household Sector It would, therefore, be important to assess the likely source from which the Government would tap these funds. Among the different sectors that contribute to the overall national savings, the household sector is the biggest, accounting for nearly 85 per cent of the savings of the community. The Government would have to tap this sector for meeting that part of the resources which it has been getting all along from the RBI. Vol. 11, No. 1, January-March 1986

7 would be mobilizing less funds by way of deposits, this, in turn, would imply a lower level of subscriptions to government bonds by the banking institutions. Thus, in the second round, this would have a further impact on the banking system when government has to meet its fund requirements through additional borrowings. The term-lending institutions also depend on the banks for a sizeable part of their resource requirements as the bulk of the bonds floated by them are absorbed by banks. With a slower rate of growth of bank deposits, the term-lending institutions would either have to accept a lower growth rate in their lending or tap the capital market by floating new types of securities at market related interest rates. In either case, the corporate private sector would find that the total resources available to it through the capital market have diminished. Type of Funds to be Raised Recent developments have thus made the horizon of the private corporate sector resource mobilization from capital market somewhat foggy. The likely future developments would not render it any more clear. Although it is too early to say whether the private sector would be in a position to raise the funds it needs to realize its Seventh Plan investment target of Rs 54,236 crore or not, it would be well-advised to prepare its own contingency 1 plans. It would have to raise at least some resources from the market fpr financing its growth. The most crucial type of finance for the corporate private sector is equity which determines its ability to raise loan capital from financial institutions and banks. Until recently the financial institutions had adopted relatively liberal debt-equity norms. As a rule, a debt-equity ratio of up to 2 : 1 was permitted in respect of projects costing up to Rs 10 crore. For larger projects, the ratio of 3.5 : 1 was permitted. Recently, this norm has been revised, and projects costing up to Rs 10 crore are now permitted to have a debt-equity of 1.5 : 1. A similar modification in the debt-equity ratio has been envisaged for projects costing above Rs 10 crore; The change in the policy of the.financial institutions in regard to debt-equity norm is justified on several counts. Excessive reliance on loan funds makes corporate entities highly vulnerable to risks arising put of fluctuating fortunes in business. With growing liberalization in industrial policy,' corporate units would have to prepare themselves for a highly competitive atmosphere in which profit margins and market shares depend primarily on production efficiency, quality of the product, and effective marketing arrangements. Since servicing of debt is a contractual obligation, a high debt service burden reduces the ability of corporate units to absorb unforeseen business shocks. It is only a healthy equity base that lends strength to the private corporate sector units to face the risks of fluctuating fortunes in business. Irrespective of the policy pursued by the institutions in regard to debt-equity norms, prudent corporate units should adopt a conservative approach by adopting a low debt-equity ratio and raise the desired amount of equity capital from the market. The corporate units which already have a very strong equity base would find it advantageous to raise loan capital in the form of NCDs from the market. Some units would also' find it convenient to raise resources through debentures if they prefer not to rely on institutional funds in order to avoid either the convertibility stipulation or the usual appraisal and follow-up discipline of the financial institutions. Moreover, for providing additional margin money for working capital, funds may have to be raised through NGDs since financial institutions do not provide margin money for working capital, except when it forms part of the cost of the project they are financing. Recommendations The resource mobilization task is going to be a challenging one for the private corporate sector in view of the ambitious Seventh Plan investment targets. The new public sector corporations entering the capital market with more attractive instruments makes the task even more difficult. The new developments thus offer new challenges as well as opportunities to the private corporate sector: it has to devise new and ingenious methods 10 Vikalpa

8 for mobilizing the needed resources. This is also perhaps the right time for the private corporate sector to have a thorough self-examination with a view to improving its own house-keeping. The private sector should consider the following recommendations : Improve work efficiency by cutting down wasteful expenditure, maximize profits, and generate higher level of accruals. Pass on a part of the additional profits based on improved efficiency to the shareholders so that new public issues become more at tractive for the existing as well as potential investors. Tap new markets, especially those in the prosperous, virgin rural areas and rich urban areas for resources by way of fresh equity or convertible and non-convertible debentures. Devise new and innovative instruments to suit the varied preferences of investors. Look for export oriented schemes so that foreign funds could be tapped for invest ment. (The Government might consider favourably permitting export oriented units to borrow from abroad directly.) Explore possibilities of establishing mutual Funds for mobilizing resources. Acceptance and implementation of these recommendations would render the private corpo-late sector bs'tar equipped to take the challenges during the Seventh Plan period. Vol. 11, No. 1, January-March