The Hindu Business Line : Capital market as source of finance

Market capitalisation of a company is merely the product of the number of equity shares issued and their market price. It is not a source of equity finance. The right indicator is the issue price. Market cap is up because of reduced risks and forecasts of robust growth, which signal banks have read to lend more to India Inc. With bank credit up nearly 80 per cent, they still remain the main source of corporate finance, says G. Ramachandran.

IT WOULD be quite a desirable state of affairs if India Inc. could depend on the capital market to fund short-, medium- and long-term assets. There will be more wheels to provide traction to the economy. The economy will roll forward at very high speeds, and there will be more spare tyres for it to roll on safely.

Mr Alan Greenspan, chairman of the US Federal Reserve, has rightly observed that functioning capital markets take the pressure off banks. They make the tyres of economies `flat-proof'.

India's domestic banks too would welcome this shift. Developed capital markets are allies of banks. First, bank asset structures and the riskiness thereof would undergo a favourable transformation when capital markets become a significant source of corporate finance.

Second, deeper and faster disintermediation would improve the profitability of banks without necessitating the addition of enormous regulatory capital.

Third, capital markets enable smarter, faster and safer securitisation of otherwise lumpy, non-marketable loans.

But India has a long way to go before it celebrates the coming of age of its capital market. India Inc. will have to wait at least until 2011 before it can regard the domestic capital market as a significant ally that funnels savings into corporate assets. The economic scenario analysis shows that the domestic capital market will fund no more than 15 per cent of the acquisition of new corporate assets in 2011.

Internal accruals and loans from onshore and offshore banks will constitute at least 85 per cent of India Inc.'s sources of funds. Pure bonds will make up 8.5 per cent of the total sources, while pure equity and bonds convertible into equity will form merely 6.5 per cent.

Therefore, it is too early to depend on debt and equity — especially equity — from the financial markets for funding the creation and acquisition of capital assets. It is also too early to write off the significance of bank loans.

The facts

An important metric has been inappropriately used to support the proposition that India's equity market has begun to dwarf bank loans (Business Line, December 4). That metric is the ratio of bank loans to market capitalisation. Bank loans on the books of corporate borrowers constitute the numerator. The aggregate equity market capitalisation of these borrowers constitutes the denominator.

Capital markets possess desirable characteristics. And equity markets border on the fetish in India. Moreover, regulators are aware of the need for banks to fully comply with the Basel 2 specifications. Hence, it is likely that some capital market regulators and banking supervisors may give in to temptation. They may draw some quick and comforting inferences from the metric used to support the proposition that India's equity market has begun to dwarf bank loans.

The empirical fact is that India's equity market has not dwarfed bank loans as a source of finance to companies.

First, bank credit has grown the most in India in a sample of six major economies. It grew 79 per cent between 2003 and 2005. Banks have not had a better time supplying credit to a range of corporate borrowers and over a range of terms.

What is not capital

Second, market capitalisation is not a source of finance. Given that equity markets are almost a fetish in India, it is easy to get carried away by the handsome rise in equity prices over the last two years. It is tempting to accept the suggestion that the rise in stock prices is a significant source of corporate capital.

Market capitalisation of a company is the product of the number of equity shares issued and the market price at which they trade. The issue price is usually a small fraction of the market price. But what matters is the issue price. The product of the number of shares issued and the issue price is the only source of equity finance.

Third, equity market capitalisation has risen in India over the last two years by over 300 per cent. This significant rise has been driven by offers for sale by some inside shareholders of very large companies to new outside shareholders. Such offers for sale have improved corporate governance and the incentives for managerial efficiency. Therefore, stock prices rose first on anticipation and then on good experience by investors.

But the transaction values are not sources of corporate finance. They are merely payments made by new shareholders to exiting shareholders. The payments do not enter the books of accounts of India Inc. as sources of finance.

What capital market?

India has the world's best securities market system. This comprises two of the world's largest demutualised stock exchanges that trade stocks online. India has the world's best clearing and settlement system. It has two of the world's most reliable securities depositories.

Thus, from the perspective of investors, everything is in their favour. But not all the trading in stocks and not all the rise in prices have a material impact on the sources of corporate capital. If India really had a reliable capital market system, it would provide an efficient structure for managing the riskiness and complexity of large investments. Big shareholder-owned corporations would be able to raise large amounts of equity and debt capital from retail savers and institutional investors. There would be immense confidence that the economy can be nurtured by nurturing shareholder-owned corporations. Then it would be possible to accelerate economic growth by making debt and equity readily available for investment at low cost. But the fact is India has a very tiny capital market.

Why lending has risen

It is easy to explain why market capitalisation has risen by over 300 per cent in two years (Business Line, September 16). Investors in Indian equity shares perceive fewer and lower risks in the foreseeable future. Therefore, they are satisfied with a lower desired return. Thus, they are willing to pay more for equity shares in the present. Moreover, the prospects for growth remain very bright for India Inc. Financial analysts and experts in corporate finance would agree that high growth expectations further reduce the desired rates of return from equity investments. The contraction of risk and forecasts of robust growth have driven market capitalisation up.

Bankers have read the same signals. They too are aware of the contraction of risks. Their forecasts of growth are as robust. They have pushed up lending to India Inc. by a whopping 79 per cent. India Inc. is happy as bank loans are cheaper than equity. It is win-win all the way. Hence, banks continue to be the most dominant source of corporate finance.

(The author is a financial analyst. Feedback may be sent to indiagrow@yahoo.com and pari@thehindu.co.in)

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