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Students Corner - A Decade of Economic
Reforms in India - A Review

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The provision of credit is considered an essential input to industrial activities. The credit delivery mechanism plays an important role, especially in developing economies with credit market imperfections. A major finding of the literature in this regard is that small firms are largely dependent on bank credit to meet their financing requirements while the big firms have alternative sources of finance (Gertler and Gilchrist, 1993; Olinear and Rudebusch, 1995). Therefore, small firms usually get affected more on occasions of tightening of bank credit. Not only the credit availability, but also the cost of credit has a significant impact on the production decisions of firms. Contextually, credit delivery system continues to be a major focal point of the on-going financial reforms in India since the early 1990s. The objective is to meet the credit requirements of the productive sectors and, more so, of the weaker bidders in the credit market.

The credit off-take from scheduled commercial banks to the commercial sector indicated a declining trend during the 1990s, barring an uptrend in the mid-1990s. At the disaggregated level also, there was a slowdown in credit growth for the various segments such as exports, Small Scale Industries (SSIs), medium and large industries, particularly in the second phase of the reform period. Export credit growth declined substantially to about 6.5 per cent during the second half of the 1990s from 31.3 per cent in the first phase. The deceleration in export credit while reflecting the slowdown in exports, can also be attributed to other forms of financing by exporters, such as, Exchange Earners' Foreign Currency Account and availability of funds at sub-PLR.

The slowdown in the credit growth was more pronounced for the SSIs vis-à-vis the medium and large industries. The credit needs of SSIs were largely met in the 1980s and earlier as part of the promotional policies for the SSIs under the priority sector lending by banks. During the period 1990-91 to 2001-02, the growth in credit to SSIs decelerated to 11.6 per cent from 19.4 per cent in the 1980s. Moreover, credit to SSIs as a percentage of non-food gross bank credit indicated a decline from 14.4 per cent in 1995-96 to 11.8 per cent in 2001-02. It may be noted that while the concessional element in lending rates for the SSIs stands largely withdrawn during the 1990s, financial vulnerability of State level institutions in view of poor recovery and other inherent inefficiencies also raises concerns regarding the prospects of credit flows to the SSI sector. This decline in credit flow to the SSI sector has to be seen in the context of falling productivity in the SSI sector as a whole in the 1990s as against the 1980s with the index declining to 34 in 1994-95 from 50 in 1984-85 (SIDBI, 2001). However, within the SSI sector the productivity in the modern segment remained higher than the traditional/tiny segment. Thus, a key issue for the SSI reforms is to enhance the credit assessment capability of the financial institutions so that the small scale as a whole is not equated with high risk for credit disbursement.

An analysis of credit to major industrial subgroups within the manufacturing sector reveals that during the reform period a substantial shift has taken place in favour of industries such as iron and steel, electricity, food processing, cement, gems and jewellery and petroleum (Table 3.22). Infrastructure sector improved its share to 6.5 per cent in March 2002 from 2.0 per cent in March 1998. The industries that recorded a decline in their respective shares were metal and metal products, engineering, cotton, jute and other textiles, paper and paper products, chemicals, leather and leather products and construction. The highest decline was noticed for the engineering industry with its share in gross bank credit declining from 22.6 per cent in 1991 to 10.5 per cent in 2002. The cotton, jute and other textiles together also witnessed shrinkage in their share from 13.2 per cent in 1991 to 11.3 per cent in 2002, reflecting partly the rising incidence of sickness in such industries.

Another important source of finance for industry is the financial assistance disbursed by the All India Financial Institutions (AIFIs) mainly for investment operations in medium to long-term horizon. In keeping with the trend in bank credit, the growth in disbursements by AIFIs increased from 21.8 per cent in the pre-reform decade to 24.7 per cent in the first phase of the reform period. Subsequently, however, disbursements witnessed a distinct slow down to 7.9 per cent in the second phase of the reform period. This is indicative of a slow down in the investment demand, particularly for the green-field projects and expansion activities in the industrial sector.

The slowdown in the credit flows from banks and financial institutions may be evaluated in the context of the behaviour of the prime lending rates (PLRs) charged by them. In real terms, the PLR of AIFIs (IDBI) ruled, on an average, 9.11 per cent during 1995-96 to 2001-02, which was higher than 5.52 per cent prevailing during the period 1990-91 to 1994-95 (Chart III.31 and Table 3.23). The real PLR of banks (weighted average lending rates of Scheduled Commercial Banks) also increased to 12.5 per cent from 6.8 per cent over the same period. Such high real interest rates on medium to long-term borrowings for the industrial sector work as a constraint in undertaking investment decisions. Persistence of high interest cost adversely impacts on the capacity buildup and upgradation. Over a medium-term, the high interest rate effect is ultimately reflected in lower output growth. An assessment of the present trends in the real interest rates for the industrial sector and the real output growth seems to indicate weakening sustainability of the investments. While during the period 1996-97 to 2001-02 growth of real output from industrial sector averaged to 4.9 per cent, the real PLRs remained distinctly high at around 9 per cent. Given the downward rigidity of medium and long-term real interest rates, industrial investment is rendered unviable when such rates are higher than the rate at which the industry is growing.

The decelerated credit off-take by industry from banks and AIFIs needs to be interpreted keeping in mind the alternative sources of finance that are available to industry in the reform period. 13 A comparative analysis of financing patterns of select non-financial public limited companies indicates an increasing recourse to internal sources of financing as against the borrowed sources of funds, particularly since the late 1990s. Among the borrowed sources of funds, financing through debentures, and loans and advances declined from 11 per cent and 13.5 per cent, respectively, during the period 1985-86 and 1989-90 to 5.7 per cent and 11.5 per cent during the second phase of the reform period (Table 3.24). The declining share of credit from banks and financial institutions has been evident particularly in the second phase of the reform period when their share in total sources of funds raised by the corporate sector declined to 17.4 per cent in 2000-01 from 23.8 per cent in 1995-96.

The reduced role of conventional financing for the corporate sector such as bank credit and financial assistance from AIFIs should be seen in the context of increasing recourse to private placements of debt and equity on account of less stringent disclosure norms, low cost of issuance, ease of structuring instruments and reduced time lag in issuance.Resource mobilisation through this route increased sharply from Rs.13,361 crore in 1995-96 to Rs.64,950 crore in 2001-02. Nevertheless, the high cost of credit in real terms from banks and AIFIs seems to have gone against the conventional sources of financing, inhibiting the growth of investment demand and capacity build-up in industry. The reduced industrial credit can also be seen as an outcome of the risk-based prudential requirements, such as capital adequacy and provisioning norms implemented for banks and financial institutions as part of the financial sector reforms (Nag and Das, 2002). As a result, bank funds have been largely deployed in Government securities, relatively risk free assets, which account for around 39 per cent of their net demand and time liabilities, far exceeding the minimum statutory liquidity requirement of 25 per cent.

It may be difficult to clearly distinguish as to what extent the lower credit growth to the commercial sector from banks and the financial institutions is attributable to the sluggishness in demand or to the heightened risk aversion arising from tighter supervisory/regulatory norms. While the present slowdown in the industrial demand seems to have contributed to the slowdown in the credit growth, both for working capital requirements and long-term investments, the possibility of high lending rates impacting on the credit demand of certain segments, particularly small enterprises having limited access to alternative sources of funds has been a matter of concern. Since large corporates can access alternative cheaper sources of funds, the burden of adjustment in the financial sector seems to have fallen relatively more on small and medium enterprises due to segmentation of credit markets. The problem seems to have been accentuated on account of lack of adequate credit risk assessment regarding small and medium enterprises emanating from poor credit information base on such enterprises. In view of these concerns, the credit delivery system has been a major focus of reforms since the 1990s with the objective of augmenting the total volume of institutional credit while securing an equitable distribution of credit, particularly for weaker bidders in the credit markets, including small enterprises. Besides improving the volume and terms of credit, policy efforts have been directed towards simplifying the procedures.