Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 7 Monetary Transmission Mechanism

Financial Stability: The Indian Approach
Corporate Balance Sheets and Financial Stability & Capital Markets

The state of the balance sheet of non-financial firms is a critical factor for the stability of the financial system. If there is widespread deterioration of balance sheet among borrowers, it worsens both the adverse selection and moral hazard problems. Several possible channels can be discerned. First, if a firm has high net worth, then if it defaults on debt payments, the lender can take title of its net worth and use the proceeds to recoup some of the losses. A decline in net worth increases incentives for borrowers to engage in moral hazard, since the lenders are less protected against the consequences of adverse selection because the value of net assets is lower. This reduces lending and economic activity declines. Second, a rise in interest rates raises interest payments, decreases cash flows and engenders deterioration in their balance sheets. This exacerbates the adverse selection and moral hazard problems, resulting in a further decline in lending and economic activity. On account of all these reasons, it has, therefore, been argued that financial stability indicators need to incorporate corporate balance sheets.

In this context, it is important to make a distinction between public and private corporate firms. Using a balanced panel dataset of over 1,000 manufacturing and services firms over the period 1992-2002, Ghosh and Sensarma (2004) find that-

1. public firms are relatively more responsive to a monetary contraction vis-à-vis their private counterparts;

2. listed firms lower their long-term bank borrowings in favour of short-term borrowings, post monetary tightening, as compared with unlisted firms; and,

3. manufacturing firms are relatively more responsive to a monetary shock than services firms.

The financial stability indicators in manufacturing suggest that public limited companies have considerably higher debt equity ratios than their private counterparts. Private companies have improved their profitability levels in 2003. On the other hand, current ratio (current assets/current liabilities) declined for public firms, while it remained same for private limited companies. To sum up, this suggests that the risk to financial stability arising from non-financial corporations may have moderated.

Another important channel through which non-financial firms can be a source of possible financial instability is unanticipated exchange rate depreciation or devaluation. With debt contracts denominated in foreign currency, unanticipated exchange rate changes increase the debt burden of firms. Since assets are typically denominated in domestic currency, the resulting decline in net worth once again propagates instability and contraction in lending and output. In recognition of these concerns, the Reserve Bank has stressed upon the banks to monitor large unhedged foreign currency exposures of their corporate borrowers. Banks were advised to extend foreign currency loans above US $ 10 million (or such lower limits as may be deemed appropriate vis-a-vis the banks' portfolios of such exposures), only on the basis of a well laid out policy with regard to hedging of such foreign currency loans.

The growth and development of capital markets has strengthened the resilience of the financial system. Since the liberalisation of both domestic capital markets and portfolio flows from abroad, and the development of modern capital market infrastructure led by efforts to establish a national stock exchange system, the growth of capital market has been impressive (Table 8.28 and Chart VIII.3). While the infrastructure and operations of stock markets have improved substantially, liquidity is not evenly spread, with a large proportion of infrequently traded stocks.

There are signs of increased integration of the Indian capital markets with global markets. Using daily data for the years 1999-2000 and 2000-01, Hansda and Ray (2002) find evidence that domestic IT indices have generally been a follower vis-à-vis the general or IT-related indices of the foreign bourses. Notwithstanding the turbulence in stock markets in several instances, no major disruption or failures of intermediaries has occurred. This suggests that Indian capital markets and their intermediaries are reasonably resilient to equity price shocks.

An important facet of financial sector vulnerability, viz., pertaining to Unit Trust of India (UTI) has been addressed. The Unit Trust of India Act, 1963 was repealed through an Ordinance in October 2002 by splitting UTI into two parts: UTI-I (comprising US-64 and assured return schemes placed under a Government-appointed administrator) and UTI-II¹¹ (consisting of NAV-based schemes, professionally managed and brought under the regulatory purview of SEBI). The Government has committed to small investors that it would meet all obligations for US-64 (estimated at Rs.6,000 crore) and other assured income schemes (estimated at Rs.8,561 crore). The Union Budget 2004-05 has made a provision of Rs.1,200 crore to meet the shortfall in assured returns schemes maturing in 2004-05 and related obligations (Government of India, 2004). This is in addition to Rs.6,500 crore provided in Union Budget 2003-04 to enable UTI to meet the shortfall between assured repurchase prices and NAV and to provide smooth transition to the NAV-based scheme¹²2.

The growth in private placements raises some important informational and regulatory issues. According to available information, total private placements over the period 1999-2000 to 2002-03 accounted for, on average, around 90 per cent of total debt issues and over 85 per cent of the total resource mobilised (NSE, 2003). This raises the concern of the quality of such issues and the extent of transparency in such deals. Additionally, the lack of 'market discipline' inherent in such issues enhances risks and distorts the 'level playing field' vis-à-vis public issues, which might engender regulatory arbitrage.

¹¹Renamed as UTI Mutual Fund.

¹²Unit Scheme-64 (US-64) was converted to NAV basis as on January 1, 2002.