The Institutionalisation Of Markets

It seems to be a law of development. As the financial markets deepen and widen, up goes the share of institutional participation. Retail involvement will increasingly veer towards indirect participation through the mutual and pension funds. Of course, the track-record of the Rs 85,000-crore Indian mutual funds industry can, at best, be described as patchy, but once accounting and disclosure norms are enforced, it should be able to shrug off its murky reputation. And, as is the case in the developed markets, the bulk of the offerings in the primary market will be mopped up by such funds.

Deregulation will further bolster this trend. Already, many of the regulations that trammelled institutional participation and segmented markets have been dismantled. For instance, the cap limiting a bank's investments in preference shares and corporate debentures to 5 per cent of its incremental deposits has been lifted, adding a funds-flush investor category for such securities. Similarly, expect the pools of money locked into the Rs 150,000-crore provident fund industry to flow into blue-chip corporates as the restrictions damming up such flows are loosened.

Look also for increased participation in both the debt and equity markets by Foreign Institutional Investors (FIIs) as full convertibility unfurls. Companies such as the Rs 139.22-crore Infosys Technologies and the Rs 32.53-crore Mastek have already passed resolutions enabling a hike in FII holdings to 30 per cent of their equity capital. Equity participation will surge even more once the FIIs are allowed into the rupee-dollar forward market. Already, $2 billion of FII-dedicated debt funds have been cleared by the Securities & Exchange Board of India (SEBI), and more are in the pipeline.

Moreover, private placements have emerged as the dominant mechanism for fund raising. Although the move away from public issues has been driven by the sluggish primary markets, the institutionalisation of the markets has benefited the CFO. Marketing to a select group of institutional investors is, often, quicker and less expensive than servicing a scattered mass of retail investors. And playing to a sophisticated institutional audience is also more conducive to the innovative structuring of instruments.

The De-Institutionalisation Of Corporate Finance

While the share, and POWER, of the institutional investor is expanding in the capital market, traditional financial intermediation is shrinking. Increasingly, the banks and development financial institutions (DFIs) will be cut out of the loop that links the investor with the saver. With deregulation, corporates will find it cheaper to access the markets directly. This phenomenon of disintermediation is intertwined with securitisation, or the tendency of corporates to raise capital by issuing securities rather than relying on direct loans. While short-term working capital needs can be met by the issue of commercial paper, long-term project finance requirements can be partially serviced through debenture offerings. In fact, in the more developed capital markets, funds are raised by even securitising the regular cash-flows generated by receivables.

Of course, since brand names are being leveraged in the market to obtain low-cost capital, securitisation is an option that can only be exercised by top-flight corporates. Mid-sized and small firms will still have to rely heavily on loans. But the competition among the lenders is hotting up. Convertibility will multiply the potential lenders abroad while liberalisation is blurring the once-sharp distinction between the banks and the DFIs. Fierce competition among the lenders will transform once-standard working capital or term-loans for the CFO. The lender will be forced to assume higher credit risk. Project financing will, increasingly, be of the non-recourse variety while a rising proportion of working capital finance may be extended on an unsecured basis. Remember, however, that since credit risk will be transferred in full to the financial intermediary, that intermediary will be much more involved in monitoring the loan. Banks and FIs will pay close attention to the quality of management. So, while securitisation moves towards more impersonal forms of financing, lending will become more intimate.

Given this backdrop, what are the instruments and processes that have been, and will be, created by the deregulation and globalisation of a once tightly-regimented financial sector? To analyse how the CFO can creatively use these instruments, BT first identified the basic corporate finance needs: seed capital (the financing of start-ups), working capital (the financing of operations), and project finance (the financing of long-term capital expenditure). Trade finance (the financing of exports and imports) was not considered because the successful liberalisation of trade finance hinges on its demise. A policy superstructure built on the notion of foreign exchange scarcity is an anachronism for an economy on the brink of capital account convertibility. Nor does it make much sense in the freer global trading regime that the World Trade Organisation is seeking to build. Policy props to exports will have to be, and are, indeed, being dismantled. Remove the crutch of subsidies--and export finance will cease to be different. Sure, operating cycles stretch out longer and receivables are denoted in a different currency, but financing exports will not be much different from financing working capital for products sold in the domestic market.

Although deregulation may have done away with the need to treat trade finance as a separate category, it has created a new need: the need to manage interest rate and exchange rate volatility. Therefore, this has been analysed separately. And since, seven years into the liberalisation process, risk management remains uncharted territory for the Indian CFO, a lexicon of hedging instruments has also been included. Weaving together the complex changes initiated by the process of financial sector liberalisation, bt presents the new paradigms for project financing, working capital finance, risk management, and venture capital. In short, the CFO's guide to Financing 2000.