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  Issue 13 | Archive November 2012

Financing Firms in India

A paper by Franklin Allen (University of Pennsylvania), Rajesh Chakrabarti (Indian School of Business), Sankar De (Indian School of Business), Jun ”QJ” Qian (Boston College) and Meijun Qian (National University of Singapore)

In a forthcoming paper to be published in the Journal of Financial Intermediation titled “Financing Firms in India”, RMI affiliated researcher Dr. Meijun Qian, in collaboration with her co-authors, examined the relationships between the legal and business environments in India, coupled with its impact on the growth of Indian businesses and their financing channels.

Many studies on economic growth mechanisms have found the correlations between finance and law as the key causes for growth in various countries. But their academic approaches were, arguably, less than comprehensive. Amongst many other factors, the studies failed to account for the country size as well as explore other alternate financing options. By taking a different approach from past literature, the authors chose to study the linkages between legal, finance and growth but within a single country context of India.

Section I of the paper introduces the overall picture of study. It describes the business and legal environments Indian companies have faced between 1996 and 2006. Unlike companies in developed countries, strong legal protection was not available for businesses in India while effective and non-legal substitutes were available. Equally, Indian companies did not access capital markets for the majority of their funding needs and alternative channels were obtainable. Thirdly, Indian companies had grown at impressive rates despite poor investor protection practices. Lastly, a large number of Indian businesses were able to function beyond the country’s legal system, minimizing the political cost and supporting the country’s growth.

Section II explores the growth, financial and legal aspects of India relative to other regions. The nation had experienced strong economic growth through the years, with growth rates averaging 3.5% in the first 30 years after independence and 5.6% after 1980. Investor protection varied greatly under law and in practice, largely due to an ineffectual legal system and corrupted government. In the 2005 World Development Report, the police and the judiciary were identified as the two most corrupt institutions and the country ranked among the worst in corruption according to the Transparency International Corruption Perception Index. Additionally, India scored poorly in the administration of legal documents and did not have a reliable accounting system as managers had a strong tendency to manipulate earnings. Furthermore, the stock exchange and banking system had not been effective mechanisms in allocating capital to firms. The nation’s ratios of stock market capitalization to Gross Domestic Product (GDP) and bank credit to GDP were extremely low compared to other countries.

Section III discusses legal and business issues at the firm level but also explores alternative financing options for Indian companies. A study conducted using the Centre for Monitoring the Indian Economy (CMIE) Prowess database found that 26% of large Indian firms approached banks and capital markets for funding. On the other hand, only 8% of small and medium enterprises (SME) sought funding from banks and capital markets, as most of their resources came from alternative financing routes. Besides, Indian companies shared similar characteristics with companies elsewhere of a low investor protection regime, such as paying low dividends to shareholders and having a large controlling stake from an individual or a single family. Nonetheless, Indian companies did register impressive annual growth rates through the years. In fact, Indian SMEs grew faster than larger firms both in terms of sales and total assets.

Section IV of the paper analyzes the legal, operational and financial aspects of the Indian SME sector by presenting the details of the survey conducted in 2006 around New Delhi in North India and Hyderabad in South India. Results of this survey provide a greater understanding of SMEs in these metropolitan areas, specifically ownership, business structure and corporate governance trends. According to the survey, most firms did not seek legal recourse with regard to defaults, disputes and breach of agreements. Companies were instead more concerned about their loss of reputation and property. Illegal measures in resolving contract disagreements were found to be more effective. The survey also confirmed their earlier finding that SMEs received as much as 85% of their funding needs from alternative sources. Smaller companies were reported to be coerced into informal funding methods because of the unapproachability of public financing channels. Firms that had alternative sources of funding in the startup phases were inclined to stick with them through the growth stages. Another interesting detail from the surveys was that companies in the New Delhi region appeared to have a higher propensity to pursue alternative sources of funding compared to companies located in Hyderabad. Firms located in the latter region found bank financings and retained earnings more appealing as compared to non-formal sources.

In conclusion, the paper shows that India had a weak legal framework and low level of investor protection despite having a democratic government, British style judicial system and English common law system for many years. Correspondingly, the authors found that small Indian firms with low levels of corporate governance and limited access to public funding were able to grow faster than larger companies who enjoyed easy access to public financing and had stronger legal protections.

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Editor: Ivy Wang (rmiwy@nus.edu.sg)