chapt 34

Chapter 34

Sources of International Long-term Finance

34.1 Risks Associated with Project Financing34.2 Political Risk34.3 Factors to be Considered for Investment in Other Countries34.4 Country Risk34.5 Factors to be considered in Country Risk Rating34.6 Economic Risk34.7 Social Risk34.8 External Risk34.9 Exchange Risks34.10 Other Risks Associated with Project Finance34.11 Issuance of ADRs/GDRs34.12 Similarities in ADRs and GDRs34.13 Salient Features of ADRs/GDRs34.14 Benefits of ADR/GDR Issue to Indian Company34.15 Benefits of ADR/GDR issue to Overseas Investors34.16 Comparison of ADRs and GDRs34.17 Guidelines for ADR/GDR Issue34.18 Fungibility Contd. on next page ……

34.19 Foreign Currency Convertible Bonds34.20 Advantages of Issue of FCCBs to Issuing Company34.21 Advantages of Issue of FCCBs to Issuing Company34.22 Disadvantages of Issue of FCCBs34.23 Taxation Aspects of FCCBs34.24 End Use Restrictions of FCCB Proceeds34.25 Conditions of Issue of FCCBs34.26 Foreign Currency Exchangeable Bonds34.27 Conditions of Issue of FCCBs34.28 End Use Restrictions of FCEB Proceeds34.29 External Commercial Borrowings34.30 RBI Guidelines on ECBs34.31 Foreign Direct Investment34.32 Euro Currency Market34.33 Functions of Euro Currency Markets34.34 Types of Euro Currency Loans34.35 Foreign Domestic Capital Markets34.36 Syndicated Credits Contd. on next page ……

34.37 Eurobond34.38 Multiple Currency Bonds34.39 Foreign Bonds34.40 Alpine Convertibles34.41 Europe Medium Term Notes34.42 Qualified Institutional Placement34.43 Foreign Institutional Investors34.44 Participatory Notes34.45 Multilateral Agencies34.46 International Monetary Fund34.47 World Bank34.48 International Development Association34.49 International Finance Corporation34.50 Asian Development Bank34.51 All India Financial Institutions (AIFIs)34.52 Multinational Corporations 34.53 Commercial Banks having Internal Operations

34.1 Risks Associated with Project Financing

From the lender’s point of view, project finance can be a risky proposition, since the projects are usually of long-term nature, the debt maturities can stretch out to number of years, increasing the riskiness of the credit. Therefore, it is the central task of financial institutions involved in project finance is to identify and quantify the risks and then to allocate them acceptably among the various participants in the project.

34.2 Political Risk

Political risk is defined as "the possibility of a multinational company being significantly affected by political events in a host country or a change in the political relationships between a host country and one or more other countries". Political risk is the unwanted consequences of political activities that will have effect on the value of the firm. The multinational companies which are making foreign direct investment must assess the political risk, before any such investments are made.

Contd. on next page ……

The political component in country risk can be subdivided into two categories, internal political risk and external political risk. Internal political risk arises due to internal conflicts such as racial/religious riots, rebellions, rural/separatist insurgency or political turmoil. Such activities tend to destabilize the state, which will in turn result in delays or defaults in the repayment of loans. External political risk is exposure to loss as a result of acts such as war or occupation by foreign powers, while a war may cause a delay in the repayment of debts.


Occupation of foreign power may result in default, as the new power may not reorganize the debt obligations of the former Government. The possibility of such political upheaval needs to be carefully evaluated by the lender before releasing funds to a foreign state. High political risk does not necessarily mean that a company should not invest in a particular country, if the level of returns available may be large enough to justify the taking of the risk.

34.3 Factors to be Considered for Investment in Other Countries

Restriction on access to local funding agencies. Increase in tax rates unfavourable to foreign companies. Regulatory constraints in price setting and transfer pricing. Foreign exchange controls exercised to protect the home currency rates against other currencies. Rules restricting the use of local labour and materials.


Quotas, tariffs and other trade barriers imposed on foreign companies. Grants and subsidies available to indigenous industries. Delicencing and encouragement to competition. Expropriation or nationalization of foreign owned business. Discrimination against foreign businesses. Environmental, health and safety measures may make unit unviable due exorbitant costs of complying due to subsequently introduced legislation.

34.4 Country Risk

The country risk is defined as exposure to a loss in offshore lending, caused by events in a particular country, events which are, at least to some extent, under control of the Government but definitely not under the control of a private enterprise or individual. Country risk is a broad concept encompassing sovereign, political as well as other forms of risks like economic, social and external risks. Since country risk is the sum total of a number of different types or risk, assessing country risk would mean the evaluation of each of these risks that contribute towards it.


The country risk is an all embracing term incorporating all types of risks a lender encounters in offshore lending. Country risk means with reference foreign funding the possibility that a borrower will be unwilling or unable to service its debt in a timely fashion - the risk from cross-border lending that arises from events to some degree under the control of the government of the borrowing country. Country risk is inherent with dealing of state (sovereign risk) or any overseas business. The assessment of country risk, involves both qualitative and quantitative analysis of political, social, economic and natural conditions in the country in which the borrower operates.

34.5 Factors to be considered in Country Risk Rating

Political Analysis- Depth and experience of government bureaucrats- Political intervention on economic management- Political links with foreign partners- Past behaviour under stress- Political stability- Ethnic tensions- Corruption- Political turmoil


Economic Analysis- Monetary and fiscal policy- Global economic environment- Natural resources- Export diversification- Stability of banking industry- GDP growth and inflation rates


Financial Analysis- Foreign indebtedness, both in absolute terms and relative to GDP- Debt service payments relative to exports- Current account- Capital inflows and outflows- Exchange rate stability- Foreign exchange reserves

The above analysis is equally applicable to cross-border investment decisions.

34.6 Economic Risk

Economic risk is concerned with the general economic climate within the country. Some of the factors which reflect the economic climate of a country are:

- level of affluence enjoyed by the country.- the growth rate of income.- the nations's propensity to save/invest.- the stability of prices (inflation).- characteristics of the labour force.


- level of sophistication of the financial system.- level of foreign debt outstanding.- major income earners (exports) and their sensitivity to overall

global economic changes.- extent of dependence on major export items.- trends in balance of payments.- level of imports - level of reserve and credit standing, and- fluctuations of exchange rate and controls on foreign exchange.

34.7 Social Risk

Social risk refers to the possibilities of loss due to factors such as religious fanaticism, ethnic polarization, dissatisfaction among the people as a result of wide disparity in income distribution, or regionalism. These sociological problems eventually lead to riot and revaluations resulting in loss of lives and property. An economy plagued by riots and revolutions will undoubtedly face problems in repaying its debts. Thus, social factors too need to be carefully evaluated by lenders.

34.8 External Risk

The external risk component of country risk arises due to situations outside the country. For instance, if the borrower nation is situated beside a country which is at war, the country risk ratios of the prospective borrower will be higher than what will be the case if its neighbour is at peace. This difference in the risk rating is attributable to external risk. Although the borrower nation may not be directly involved in the conflict, the chance of spillover may exist.


Additionally, the borrower of refugees fleeing the war may upset the economic conditions in the borrower nation. Hence, the lender has also to consider the external environment of the prospective borrower before sanctioning the loan.

34.9 Exchange Risks

Since the liability of the borrower of the foreign currency financing remains in the currency in which the borrower obtains loan, so at the time of repayment the rupee liability is determined on the basis of the exchange rate prevailing on the date of repayment. The exchange rate fluctuates widely with the passage of time, so the borrower is subject to exposure to exchange rate fluctuations on the outstanding principal of the foreign currency financing.


Further if the borrowing is made at a floating rate of interest, there can be substantial variations in the rate of interest with the passage of time, depends on the variations in the LIBOR. Therefore, the borrower should keep in mind the following exposure to exchange risks:

- Exchange risk due to fluctuations in the currency of borrowing vis-a-vis the currency in which the payments are to be effected to the overseas suppliers.

- Exchange risk due to fluctuations in the currency borrowing vis-a-vis the rupee over the entire tenure of the foreign currency financing.

34.10 Other Risks Associated with Project Finance

Resource Risk - The possibility that raw materials, power, labour, water, gas, oil, minerals etc. required for the project may not be in sufficient quantities to service the debt. Input Risk - The chance that the basic viability of project will be threatened by the unavailability or high prices of key inputs such as energy or raw materials. Completion Risk - The risk may arise due to delay in completion of project, resulting in substantial overruns.


Market Risk - Due to changes in technology and tastes and habits, the future demand for the product may decline. Operating Risk - This risk may arise at the stage when the project becomes operational, due to disruption of labour, transport etc. Force majeure - The possibility of acts of God like earthquake, war, climatic changes, unfavourable weather conditions will make the projects to fail. Technological Risk - The risk may arise due to invention of new ways of doing things will reduce or destroy the existing products, even the project under implementation. Environmental Risk - The need to comply with environmental or safety legislation, the costs which can be considerable, it may not even be economically viable to continue the operations.

34.11 Issue of ADRs/GDRs

Depository Receipts (DRs) are a type of negotiable (transferrable) financial security that can be traded on a local stock exchange, representing ownership of shares in companies of other countries. As a part of globalizing the economy, the government undertook two major steps - that of allowing Foreign Institutional Investors (FIIs) to invest in the Indian capital market and permitting Indian companies to float their stock in foreign markets.


An Indian company can raise finances from other countries investors by issue of any of the instruments like American Depository Receipts (ADRs) and Global Depository Receipts (GDRs). An ADR is a stock which can be traded in the United States, representing a specified number of shares of a foreign company. ADRs are bought and sold on the American stock exchanges. A foreign company might make an issue in U.S. by issuing securities through appointment of U.S. bank as depository. By keeping the securities issued by a foreign company, the U.S. bank will issue receipts called American Depository Receipts (ADRs) to the investors.


It is a negotiable instrument recognizing a claim on foreign security. Depository receipts that are traded on the stock exchanges in other parts of the globe are called 'Global Depository Receipts' (GDRs). These are commonly listed on European stock exchanges, such as the Luxembourg and London stock exchanges or on the Asian stock exchanges such as the Dubai and Singapore stock exchanges. The issue of ADRs/GDRs are governed by the provisions of the Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993.

34.12 Similarities in ADRs and GDRs

Both ADRs and GDRs are usually denominated in US dollars. Though the ADR/GDR is quoted and traded in dollar terms, the underlying equity shares are denominated in rupees only. Instead of issuing in the names of individual shareholders, the shares are issued by the company to an intermediary called the 'depository', usually in overseas depository bank, in whose name the shares are registered. It is the depository, which subsequently issues ADRs/GDRs to the subscribing public.


The physical possession of the equity shares will be with another intermediary called the 'custodian'. The custodian will act as an agent of the depository. Though ADRs/GDRs represents the company's shares, it has a distinct identity and does not figure in the books of the company. The shares usually correspond to the ADR/GDR in a fixed ratio. The ADRs/GDRs could be issued in a negotiable form.


The ADRs/GDRs can be redeemed at the price of the corresponding shares of the issuing company ruling on the date of redemption. The holder of ADR/GDR can transfer the instrument as in case of domestic instrument and also entitled for dividends as and when declared. The ADR/GDR holder can ask the bank for the original foreign security by exchanging the ADR/GDR.

34.13 Salient Features of ADRs/GDRs

Track Record - The issuer company seeking permission for raising foreign funds by issue of ADRs/GDRs would be required to have a consistent track record of good performance (financial or otherwise) for a period of at least three years. However, issuer companies making ADR/GDR issues to fund export projects or infrastructure projects (in sectors such as power, oil exploration, telecommunication, railways etc.) need not have a past track record of financial performance.


Prior Approval - Indian companies raising funds by issue of ADRs/GDRs through recognized stock exchanges is allowed under 'automatic route' and prior approval of Ministry of Finance, Department of Company Affairs is not required. Private Placement - The private placement of ADRs/GDRs would also be eligible for an automatic approval provided the issue is lead managed by an investment banker. Automatic Route - The automatic route for ADRs/GDRs issue would also cover issue of Employee Stock Options by Indian software/IT companies. Issue of ADRs/GDRs arising out of business reorganization/ merger/demerger would also be governed by automatic route.


Approvals under FDI Policy - In all cases of automatic approval, the companies are required to obtain approvals under FDI policy, Companies Act, and approvals for overseas investment/business acquisition etc. before ADR/GDR issue. RBI Approval - The issuer company would need to obtain RBI approval under the provisions of FEMA prior to the overseas issue. Retirement of Proceeds Abroad - The companies may retain the proceeds abroad or may remit funds into India in anticipation of the use of funds for approved end-users. The retention and deployment of funds abroad would be as prescribed by RBI.


Ceiling on Issue Expenses - The issue expenses, covering both fixed expenses like underwriting commissions, lead managers charges, legal expenses and other reimbursable expenses shall be subject to a ceiling of 4% in case of GDRs and 7% in case of listing in US stock exchanges. Issue expenses beyond the ceiling would need the approval of RBI. Conversion Ratio - The ADRs/GDRs can be issued on the basis of the ratio worked out by the Indian company in consultation with the lead manager of the issue. Foreign Direct Investment - Foreign investment through ADRs/GDRs is treated as FDI. Indian companies are allowed to raise equity capital in the international market through issue of ADRs/GDRs. These are not subject to any ceiling on investment.


No. of Issues - There is no restriction on the number of ADRs/GDRs to be floated by a company or group of companies in a financial year. End Use Restrictions - There is no end use restrictions on ADRs/GDRs issue proceeds, except for an express ban on investment in real estate and capital markets. No Repayment Liability - ADRs/GDRs are equity instruments and there is no repayment liability on the issuing company and these receipts are full risk equity. Therefore, end use restrictions on ADRs/GDRs issue proceeds are removed. Right or Entitlement - If an ordinary shareholder of the issuing company acquires a right or entitlement by virtue of ownership of ordinary shares, ADR/GDR holder also acquires the same rights or entitlements like bonus shares, rights shares etc.


Two-way Fungibility - A limited two-way fungibility scheme has been put in place by the Government of India for ADRs/GDRs. Under this scheme, a stock broker in India, registered with SEBI, can purchase the shares from the market for conversion into ADRs/GDRs. Re-issuance of ADRs/GDRs would be permitted to the extent of ADRs/GDRs which have been redeemed into underlying shares and sold in the domestic market. Voting - ADR/GDR holders are not entitled to any voting rights. Therefore, the issuer company need not fear about losing management control. Till redemption, ADRs/GDRs don't carry any voting rights. Since the underlying shares are held by the depository, the depository is entitled to vote at the general meetings of the issuer company.


Transfer - ADRs/GDRs may be purchased, possessed and freely transferable by the non-resident subject to the provisions of FEMA. ADRs/GDRs are freely tradable in the overseas market like any other dollar denominated security. The record of ownership in India doesn't change with every transfer of ADRs/GDRs and as such, the issuer company is in no position to control the registration of transfers. Dividend - The dividend will be paid by the issuer company in rupees only, but the depository converts these rupees and pays the dividend (after withholding tax) to the ultimate investor, in US dollars. Thus, there will be no exchange rate rate risk for the issuer company.


Entitlement to Shares - When ADR/GDR holders acquire an entitlement to shares in a company, the company would need to issue and place ordinary shares with the domestic custodian against which the overseas Depository would issue corresponding ADRs/GDRs. Settlement - ADRs/GDRs are usually settled on a book entry basis through the system of Euroclear or Cedel in Europe and the Depository Trust Company in US. Lock-in - There is no lock-in period for the ADRs/GDRs issued. Listing of Underlying Shares - Once redemption takes place, the underlying shares are listed and traded on a domestic stock exchange. The underlying shares are denominated in Indian currency only.


Sponsor Mechanism - An Indian company can also sponsor an issue of ADR/GDR. Under this mechanism, the company offers its resident shareholders a choice to submit their shares back to the company so that on the basis of such shares, ADRs/GDRs can be issued abroad. The proceeds of the ADR/GDR issue is remitted back to India and distributed among the resident investors who had offered their rupee denominated shares for conversion. These proceeds can be kept in foreign currency accounts in India by the shareholders who have tendered such shares for conversion into ADR/GDR. Overseas Investment - Proceeds of ADR/GDR can be used for overseas investment. Indian company can acquire shares of foreign company engaged in same core activity upto US $100 million by way of swap of fresh issues of ADRs/GDRs.

34.14 Benefits of ADR/GDR Issue to Indian Company

Better corporate image both in India and abroad which is useful for strengthening the business operations in the overseas market. Exposure to international markets and hence stock prices in line with international trends. Means of raising capital abroad in foreign exchange. Use of the foreign exchange proceeds for activities like overseas acquisitions, setting up offices abroad and other capital expenditure.


Increased recognition internationally by bankers, customers, suppliers etc. No risk of foreign exchange fluctuations as the company will be paying the interest and dividends in Indian rupees to the domestic depository bank. The issuer company collects the issue proceeds in foreign currency and thus able to utilize the same for meeting the foreign exchange component of project cost, repayment of foreign currency loans etc. Large amount can be raised in the global market without much of a problem. The issue proceeds may be retained outside India and used for approved end uses like import of capital goods, repayment of ECBs, purchase of plant and equipment etc.

34.15 Benefits of ADR/GDR Issue to Overseas Investors

Assured liquidity due to presence of market makers. Convenience to investors as ADRs are quoted and pay dividends in U.S. dollars, and they trade exactly like other U.S. securities. Cost-effectiveness due to elimination of the need to custodize underlying securities in India. Overseas investors will not be taxed in India in respect of capital gains on transfer of ADRs to another nonresident outside India.


The identity of ADR/GDR holders is kept confidential since they are freely transferable. Quick settlement of ADRs/GDRs due to the existence of international systems like Euroclear and Cedel in Europe and the Depository Trust Company in the U.S. ADRs/GDRs are designated in foreign currency, which is acceptable to global investors. Global investors/holders of ADRs/GDRs don't need to be registered with SEBI.

34.16 Comparison of ADRs and GDRs

Both are negotiable instruments, their holders are entitled to corporate benefits such as dividend, bonus shares and rights issues. The holders of both the instruments may exercise their vote through the Overseas Depository Bank (ODB). Both can be sold outside India in their existing form. The underlying shares arising after redemption can be sold in India. Sale of both outside India to nonresidents is not taxable in India. Redemption of both into underlying shares is tax-exempt in India.


Dividend income received by ADR holder or the holder of underlying shares is not taxed in their hands. After the transfer of shares, where consideration is in terms of rupee payment, the normal tax rates would apply to the income arising or accruing on these shares. ADRs are listed on an American Stock Exchange, where as all GDRs are listed in a stock exchange other than American Stock Exchange, say London or Luxemburg. The disclosure requirements for GDR issues are less stringent.


GDR market is mainly an institutional market, with lower liquidity, where as an ADR listing allows US retail investors to participate in the offering, which in turn leads to wider interest and better valuations of a company’s stock. The period of holding of the equity shares is to be computed from the date on which the Overseas Depository Bank advised the Domestic Custodian Bank to redeem the GDRs/ADRs into ordinary equity shares in issuing company and not the date of purchase of the GDRs/ADRs. For Indian tax purposes, the cost of acquisition of the ordinary equity shares earlier held as GDRs/ADRs, it is the market price of the equity shares on the date of conversion of the GDRs/ADRs to ordinary shares will be taken into consideration and not the price at which the GDRs/ADRs were originally purchased.

34.17 Guidelines for ADR/GDR Issues

With a view to liberalizing the operational guidelines of ADR/GDR issues, given the fact that investments through GDR/ADR being risk capital, tract-record scrutiny process for ADR/GDR dispensed with. Indian companies raising funds by issue of ADRs/GDRs through registered stock exchanges is allowed under Automatic Route, and the prior approval of Ministry of Finance, Department of Company Affairs is not required. Private placement of ADRs/GDRs would also be eligible for automatic approval provided the issue is lead managed by an Investment Banker.


Automatic Route for ADR/GDR issue would also cover issue of Employee stock options by Indian Software/IT companies. Issue of ADRs/GDRs arising out of business reorganization/merger/demerger would also be governed by Automatic Route. In all cases of Automatic Approval, the companies are required to obtain other approvals under FDI policy, Companies Act, and approvals for overseas investment/business acquisition etc. before ADR/GDR issue. The issuer company would need to obtain RBI approval under the provisions of FEMA prior to the overseas issue. RBI will be issuing necessary guidelines.


The companies may retain the proceeds abroad or may remit funds into India in anticipation of the use of funds for approved end-uses. The retention and deployment of funds abroad would be as prescribed by RBI. The issue expenses, covering both fixed expenses like underwriting commissions, lead managers charges, legal expenses and other reimbursable expenses shall be subject to a ceiling of 4% in case of GDRs and 7% in case of listing on US Stock Exchanges. Issue expenses beyond the ceiling would need the approval of RBI. The FCCBs means bonds subscribed by nonresident in foreign currency and convertible into equity shares of the issuing company, either in part or whole, on the basis of equity related warrants attached to debt instrument. Prepayment of FCCB is permitted as per RBI guidelines.


The ADR/GDR can be issued on the basis of the ratio worked out by the Indian company in consultation with the Lead Manager of the issue. The Indian company will issue its rupee denominated shares in the name of the Overseas Depository and will keep in the custody of the Domestic Custodian in India. On the basis of the ratio worked out and the rupee shares kept with the Domestic Custodian, the overseas Depository will issue ADRs/GDRs abroad. Foreign investment through ADRs/GDRs is treated as Foreign Direct Investment. Indian companies are allowed to raise equity capital in the international market through issue of ADRs/GDRs. These are not subject to any ceiling on investment.


There is no restriction on the number of ADRs/GDRs/FCCBs to be floated by a company or a group of companies in a financial year. There is no such restriction because a company engaged in the manufacture of items covered under Automatic Route is likely to exceed the percentage limits under Automatic Route, whose foreign direct investment after a proposed ADRs/GDRs/FCCBs is likely to exceed 50 per cent/51 per cent/74 per cent as the case may be. There is no end use restrictions on ADRs/GDRs issue proceeds, except for an express ban on investment in real estate and stock markets. The FCCB issue proceeds need to conform to external commercial borrowing and use requirements. In addition, 25 per cent of the FCCB proceeds can be used for general corporate restructuring.


ADRs/GDRs are equity instruments and there is no repayment liability on the issuing company. Unlike a commercial borrowing or a Foreign currency convertible bond which carries a repayment liability on the company. ADRs/GDRs are full risk equity. Therefore, end-use restrictions on ADR/GDR issue proceeds are removed. If an ordinary shareholder of the issuing company acquires a right or entitlement by virtue of ownership of ordinary shares, the ADR/GDR holder also acquires the same rights or entitlements owing to his rights over underlying ordinary shares. ADR/GDR holders, therefore, are entitled to same bonus or rights issue of shares, as any ordinary shareholders of the company.


When ADR/GDR holders acquire an entitlement to shares in a company, the company would need to issue and place ordinary shares with the Domestic Custodian against which the Overseas Depository would issue corresponding ADRs/GDRs to the ADR/GDR holders. A listed company may transfer an issue of ADRs/GDRs with an Overseas Depository against shares held by its shareholders. Such a facility would be available pari passu to all categories of shareholders of the company whose shares are being sold in the ADR/GDR market overseas. A limited Two-way Fungibility scheme has been put in place by the Government of India for ADRs/GDRs. Under this scheme, a stock broker in India, registered with SEBI, can purchase the shares from the market for conversion into ADR/GDR. Re-issuance of ADRs/GDR would be permitted to the extent of ADRs/GDRs which have been redeemed into underlying shares and sold in the domestic market.


An Indian company can also sponsor an issue of ADR/GDR. Under this mechanism, the company offers its resident shareholders a choice to submit their shares back to the company so that on the basis of such shares, ADRs/GDRs can be issued abroad. The proceeds of the ADR/GDR issue is remitted back to India and distributed among the resident investors who had offered their rupee denominated shares for conversion. These proceeds can be kept in foreign currency accounts in India by the shareholders who have tendered such shares for conversion into ADR/GDR.

34.18 Fungibility

Fungibility means division or conversion into smaller parts. Two-way fungibility means conversion into smaller parts and vice versa. The term is used by RBI in announcing its guidelines on issue of ADRs/GDRs with facility of two-way fungibility. In the sense of ADRs/GDRs, fungibility means division of depository receipts into local shares and two-way fungibility includes conversion of depository receipts into local shares and vice versa. Two-way fungibility of depository receipts is crucial for providing a boost to foreign investment in Indian capital market. The idea of fungibility removed the controls maintained with distinctive numbers by the companies.

34.19 Foreign Currency Convertible Bonds

A foreign currency convertible bond (FCCB), issued as a bond by an Indian company is expressed in foreign currency and the principal and interest too are payable in foreign currency. The maximum tenure of the bond is 5 years. FCCB is a quasi-debt investment, which can be converted into equity shares at the choice of investors either immediately after issue, or upon maturity or during a set period, at a predetermined strike rate or a conversion price.


It acts like a bond by making regular interest and principal payments, but these bonds also give the bond holder an option to convert the bond into shares. The investor benefits if the conversion price is higher than the traded price and vice versa. The conversion price is set at a premium over the current stock price, or is set by a formula based on the price at the time of redemption. The issuer may some times have a call option, generally with a call hurdle. i.e., subject to a minimum stock price at the time of call, which means that invariably at the exercise of a call, the investor would opt for conversion into equity.


The convertibility of the bond is akin to a put option to the bond holder, as he can redeem the bond while opting for conversion. As an investor in the equity, the bond holder has a call option, in the sense that he has the right to buy equity at the set price. This hybrid product offers many of the advantages of both equity and debt. It gives the investor much of the upside of investment in equity and the debt element protects the downside. The denomination of FCCB in foreign currency makes it more acceptable in the international market and allows buyers of the bond to take advantage of the difference in international rates.


The FCCB is a quasi equity instrument which accords the benefit of debt market. The FCCB may carry a coupon rate or can be zero coupon. In case the bond is not a zero coupon, the issuer would be under obligation to pay the coupon rate at agreed intervals. If the holder of the bond does not exercise conversion option, the issuer would redeem the bonds at on agreed redemption price. In a rising stock market, FCCB is preferred means of raising medium to long-term sources. The investors who generally in FCCBs like arbitrage funds, overseas banks, global fixed income funds & super nationals, private banking accounts/high networth individuals.

34.20 Advantages of Issue of FCCBs to Issuing Company

The company gains high leverage as debt is reduced and equity capital is enhanced upon conversion. The impact on cash flow is positive as most companies issue FCCB with a redemption premium, which is payable on maturity, only if the stock price is less than the conversion price. FCCB do not dilute ownership immediately, as the holder of ADR/GDR do not have voting rights.


The conversion premium adds to the capital reserve of the company. The coupon rate is lower than the traditional bank finance, there by reducing the debt financing costs. The issue of FCCBs do not receive credit rating.

34.21 Advantages of Issue of FCCBs to Issuing to Investors

FCCB offers dural advantage of debt and equity to the investors. Thus, guaranteed returns in the form of coupon or YTM, and at the same time, an option to take advantage of upside in the price of the stock.

34.22 Disadvantages of Issue of FCCBs

FCCB when converted into equity brings down the earnings per share, and will also dilute the ownership. In a falling stock market, there will be no demand for FCCB. FCCB may remain as debt and not get converted at all. FCCB is shown as debt on balance sheet until conversion. In case of redemption, cash outflow is heavy in one financial year, unlike traditional debt which has regular repayment.


Any depreciation in rupee against the designated foreign currency may make the interest and principal repayment costly. The end use of proceeds is restricted. The issuer does not control conversion. the book value of converted shares depends on prevailing exchange rates. The cost ultimately dependent on share price development.

34.23 Taxation Aspects of FCCBs

The conversion of FCCBs into shares is not subject to Income-tax. Capital gains arising on the transfer of FCCBs made outside India between nonresidents shall not be subject to Income-tax in India. Any other transfers are liable to tax withholding. Payment of interest on FCCBs to nonresident holders of the FCCBs will be subject to withholding tax. Company is liable to pay a ‘divided distribution tax’ at the rate of 12.5% (plus applicable surcharge and education cess) on the total amount distributed as divided.


Dividends are not taxable in India in the hands of the recipient or after the conversion of bonds to shares. Long-term capital gain arising out of transfer of shares acquired from the conversion of the FCCBs shall not be liable to long-term capital gains tax provided the securities transaction tax has been paid. Short-term capital gain arising out of transfer of shares acquired from the conversion of FCCBs where the shares are subject to the securities transaction tax are taxable and also subject to withholding tax.

34.24 End Use Restriction of FCCB Proceeds

FCCB proceeds should not be used for lending or investment in capital market or acquiring a company (or a part thereof) in India by a corporate. FCCBs can be raised for investment (such as import of capital goods, new projects modernization/expansion of existing production units) in real sector - industrial sector including small and medium enterprises (SME) and infrastructure sector - in India; Subject to the existing guidelines, FCCB proceeds can be utilized for overseas direct investment in Joint Ventures (JV)/Wholly Owned subsidiaries abroad;


FCCB proceeds can be utilized for the first stage acquisition of shares in the disinvestment process and also in the mandatory second stage offer to the public under the Government’s disinvestment program of PSU shares. FCCB proceeds can be utilized by NGOs engaged in micro finance activities for lending to self-help groups or for micro credit or for bona fide micro finance activity including capacity building. Utilization of FCCB proceeds is not permitted in real estate; and End-uses of FCCBs for working capital, general corporate purpose and repayment of existing rupee loans are not permitted.

34.25 Conditions of Issue of FCCBs

The Indian company which is not eligible to raise funds from the domestic security market shall not be eligible to issue FCCBs. The overseas issue of FCCBs have to be priced at the average six monthly prices or the average price of the last fortnight before the ‘due date’, which is a month before the AGM approving the overseas issue. The overseas corporate bodies (OCBs) who are not eligible to invest in India are not eligible to subscribe FCCBs. The issue of FCCBs shall be subject to the foreign direct investment (FDI) sectorial caps prescribed by the Government of India regulations and directions of RBI from time to time.


The maximum amount of FCCBs that may be raised by an eligible borrower under the automatic route is US $500 million or its equivalent during a financial year and any issue in excess of US $500 million requires RBI approval. FCCBs upto US $20 million must have a minimum average maturity period of 3 years. FCCBs above US $20 million and upto US $500 million must have a minimum average maturity of five year. The public issue of FCCBs are to be made through reputable lead managers in international capital market.


The private issue of FCCBs shall be with Banks, or with multilateral and bilateral financial institutions or foreign collaborators or with foreign equity holders having a minimum paid-up capital of the issuing company. The ‘all in cost’ ceiling for the issue of FCCBs having a minimum average maturity period of three years upto five years must not exceed six month LIBOR plus 2%. In case of FCCBs having a minimum average maturity period of more than five years, the ‘all in cost’ ceiling should not exceed six month LIBOR plus 3.5%. Issue of FCCBs with attached warrants is not permitted.


The issue related expenses may not exceed 4% of the total issue size and in case of a private placement, cannot exceed 2% of the issue size. Net proceeds from one FCCBs issue must remain overseas until they are actually required in India. Proceeds parked overseas can be invested in the prescribed liquid assets. Issuance of guarantee, stand by letter of credit, letter of undertaking or letter of comfort by banks, financial institutions and NBFCs is not permitted. The borrower shall be at liberty to provide security to the lender in the form of immovable property in India or shares of a company in India. Loan agreement entered into shall confirm to existing guidelines. Drawal of loan shall be made in accordance with the terms of loan agreement after obtaining loan registration number from RBI.

34.26 Foreign Currency Exchangeable Bonds

The Foreign Currency Exchangeable Bonds (FCEBs) are financial instruments similar to FCCBs in nature. FCEBs will allow corporate to raise money from overseas markets by issuing bonds. In case of FCCBs, bonds can be converted into equity shares of the issuing company. But in case FCEBs, the bonds can be converted into shares of a group company of the issuer.


The issue of FCEBs in India is procedurally governed by the companies Act, 1956; FEMA, 1999; SEBI (Disclosure and Investor protection) Guidelines, 2000; Issue of Foreign Currency Exchangeable Bonds Scheme, 2008. The issuing company shall be part of the promotor group of the offered company. The offered company mean an Indian company whose equity shares shall be offered in exchange of FCCB. The issuing company mean an Indian company whose equity shares shall be offered in exchange of FCCB.


The offered company shall be a listed company which is engaged in a sector

eligible to receive Foreign Direct Investment (FDI) and eligible to issue or avail of FCCB or External Commercial Borrowing (ECBs). Wherever needed prior approval of Foreign Investment Promotion Board (FIPB) shall be obtained under Foreign Direct Investment Policy.

34.27 Conditions of Issue of FCEBs

The minimum maturity of FCEB shall be five years for the purpose of redemption. The exchange option can be exercised at any time before redemption. The rate of interest payable on FCCB and the issue expenses shall be within the cost ceiling as specified by RBI under ECB policy. Prior approval of RBI shall be required for issuance of FCEB. FCEB may be denominated in any freely convertible foreign currency.


The Indian company which is not eligible to raise funds from the domestic security market shall not be eligible to issue FCEBs. The overseas issue of FCEBs have to be priced at the average six monthly prices or the average price of the last fortnight before the ‘due date’, which is a month before the AGM approving the overseas issue. The proceeds of FCEBs shall be retained and/or deployed overseas in accordance with the policy for proceeds FCEBs. The encourage of FCEBs into shall not give rise to any capital gains liable to income-tax in India.


The interest on the bond or dividend on exchanged portion shall be subject to deduction of tax at source. The issuing company shall not transfer, mortgage or offer as collateral and to keep the offered shares under FCEBs free from all encumbrances from the date of issue of FCEBs till the date of exchange or reduction While exercising exchange option, the holder of FCEBs shall take delivery of offered wages. Cash settlement is not permitted. An Indian company which is not eligible to raise funds from the Indian securities market, shall not be eligible to issue FCEBs. The proceeds of FCEBs may be invested by the issuing company in the promoter group companies.

34.28 End use Restrictions of FCEB Proceeds

The amount raised from the issue of FCEBs may be invested by the issuing company in the promotor group companies. The promotor group company receiving such investments shall be required to use the proceeds in accordance with the uses prescribed under FCB Policy.


The promotor group company receiving such investments will not be permitted to utilize the proceeds for investments in the capital market or in real estate in India. The proceeds of FCEBs may be invested by the issuing company overseas by way of direct investment including in joint ventures or wholly owned subsidiaries subject to the existing guidelines on Indian Direct Investment in joint ventures or wholly owned subsidiaries abroad.

34.29 External Commercial Borrowings

External Commercial Borrowings (ECBs) is a borrowing of over 180 days. ECB is the borrowing by corporate and financial institutions from international markets. ECBs include commercial bank loans, buyers credit, suppliers credit, security instruments such as floating rate notes and fixed rate bonds, credit from export-credit agencies, borrowings from international financial institutions such as IFC etc.


The incentive available for such loans is the relative lower financing cost. ECB’s can be taken in any major currency and for various maturities. ECBs are being permitted by the government for providing an additional source of funds to Indian corporate and PSU’s for financing expansion of existing capacity as well as for fresh investment to augment the resources available domestically. ECBs are approved with an overall annual ceiling. Consistent with prudent debt-management keeping in view the balance of payments position and level of foreign exchange reserves.

34.30 RBI Guidelines on ECBs

ECBs refer to commercial loans availed from nonresident lenders with minimum average maturity of 3 years. ECBs may be raised in the form of bank loans, buyers’ credit, suppliers’ credit, securitized instruments like floating rate notes, fixed rate bonds. ECBs can be accessed under two routes viz., (i) Automatic route, and (ii) Approval route. The latest guidelines prevailing, on ECBs are under automatic route are summarized as follows:


No Approvals - ECBs for Investment in Real Sector - industrial sector, especially infrastructure sector will come under Automatic Route and it will not require RBI/Government Approval. In case of doubt as regards eligibility to access Automatic Route, applicants may take recourse to the Approval Route. Eligible Borrowers - All companies incorporated under the Companies Act, except financial intermediaries, are eligible for access to ECBs. Recognized Lenders - The ECBs can be raised from internationally recognized sources such as:


- International Banks- International Capital Markets- Multilateral financial institutions such as IFC, ADB, CDC etc.- Export Credit Agencies- Suppliers of Equipment- Foreign Collaborators- Foreign Equity holders

Eligible Amount and Period of Maturity - The ECBs can be raised to the extent of specified amounts and maturity periods as given below:


- ECB upto US $20 million or equivalent with minimum average maturity of 3 years.

- ECB above US $20 million and upto US $500 million or equivalent with minimum average maturity of 5 years.

- ECB upto US $20 million can have call/put option provided the minimum average maturity of 3 years is completed before exercising call/put option. All-in-Cost Ceiling - The all-in-cost includes rate of interest, other fees and expenses in foreign currency except commitment fee, prepayment and fees payable in Indian Rupees shall not exceed ceilings based on minimum average maturity period as given below:


3 years and upto 5 year 6 month LIBOR + 200 basis points More than 5 years 6 month LIBOR + 350 basis points

End use of ECB Amount - ECBs can be raised only for investment in real sector such as:

- Import of capital goods- New projects- Modernization/expansion of existing production units.

Real sector means industrial sector (including small and medium enterprises) and infrastructure sector, ECB proceeds are not permitted for on-lending or investment in capital market by corporate. ECB proceeds should not be used in real estate.


Guarantees - Guarantees and standby letter of credit or letter of comfort by banks, financial institutions and NBFCs relating to ECB is not permitted. Security - The choice of security to be provided to the lender/supplier is left to the borrower. But, creation of charge over immovable assets and financial securities is subject to approval from RBI. Parking of Funds - ECB proceeds should be parked overseas until actual requirement in India. Prepayment - Prepayment of ECB upto US $100 million is permitted without prior approval of RBI, subject to the condition of minimum average maturity period.


Debt Servicing - The remittance of interest, installments and other charges is permitted through Authorized Dealer. Other Obligations

- The banks, financial institutions and other financial intermediaries are allowed to access ECB funds through automatic route.

- Under Approval Route, the applicants are required to submit an application in Form ECB to RBI, ECB Division, Mumbai. The liberalizations made for ECB is also extended to FCCB in all respects.


- The Indian corporate are permitted use ECB funds to make overseas direct investment in joint ventures/wholly owned subsidiaries. This facilitate corporate to undertake fresh investment or expansion of existing joint ventures/wholly owned subsidiaries including mergers and acquisitions abroad by harnessing resources at globally competitive rates.

- Under latest ECB guidelines, end-user of ECB for working capital, general corporate purpose and repayment of existing rupee loans are not permitted.

- The maximum amount of ECB which can be raised by an eligible borrower under the Automatic Route is US $500 million or equivalent during a financial year.

34.31 Foreign Direct Investment

In a globalized and liberalized economy, Foreign Direct Investment (FDI) is an important driving force for the development of a nation. Now the countries are competing each other to attract FDIs by way of liberalizing the policy and simplifying the procedures relating to FDI. FDI involves the engagement of considerable assets and resources and satisfies the requirements of investment in the host country. It provides the much needed foreign exchange to help bridge the balance of trade deficits.


It raises the technology standards, level of efficiency and competitiveness of the host country. It helps to improve its export performance by providing the host country better access to foreign markets. The International Monetary Fund (IMF) in its Balance of Payments Manual defines FDI as “the category of international investment that reflects the objective of obtaining a lasting interest by a resident entity in one economy in an enterprise resident in another economy.” The lasting interest implies the existence of a long-term relationship between the direct investor and the enterprise and a significant degree of influence by the investor on the management of the enterprise.


As per IMF definition, FDI inflows also include the following:- Reinvested earnings by foreign companies (which are part of

foreign investor profits that are not distributed to shareholders as dividends and are reinvested in the affiliates in the country).

- Process of foreign equity lasting and foreign subordinated loans to domestic subsidiaries as part of intercompany (short and long-term) debt transactions.

- Overseas commercial borrowings (financial leasing, trade credits, grants, bonds) by foreign direct investors in foreign invested firms.

- Noncash acquisitions of equity investment made by foreign venture capital investors.


The administration policy governing Foreign Direct Investment (FDI) by the Government of India opened up in India can be divided into two major areas - the first between 1991 and 1999, when activities in which FDI was permitted were specifically spelt out. Unless specifically permitted, FDI was prohibited. Where permitted, one needed government’s approval in most cases. Gradually more and more activities moved into the ‘automatic approval’ list. However, in early 1999, a fundamental shift occurred. FDI in specific areas became prohibited or regulated. Except for such areas, FDI in any activity become freely permitted.


Foreign investors are investing through Foreign Direct Investment (FDI) and Portfolio Investment (PI). FDI are involved in capital investment per project and longer locking period compared to the Portfolio Investment (PI) route. The recent trend in foreign funds inflow shows, the capital inflow through PI was much higher than FDI. FDI is more crucial for the country’s economic development. It contributes to employment generation and industry modernization. Due to long lock-in period, FDIs influence in foreign exchange rate is less due to less volatility. Both FDIs and PIs will improve the country’s foreign exchange reserves position.

34.32 Euro Currency Market

The Euro currency market refers to funds channelled via financial intermediaries from international lenders to international borrowers. The Euro currency markets provide the short to medium term debt required by banks, corporate and government borrowers. The source of these funds is domestic bank deposits whose ownership is transferred to bank outside the controlled domestic monetary systems. The deposits are in large denominations, frequently $ 100,000 or more, and the banks use them to make Euro currency loans to quality borrowers. The Euro currency deposit rate is usually slightly higher than the rate paid by the domestic banks.


The Euro currency loans in a particular currency are priced according to a ‘LIBOR plus basis’, with the margin over LIBOR depending on market conditions and the credit quality standing or riskiness of the borrower. The banks generally arrange syndicated loans in this market. Thus the risk of a particular borrower are distributed across several banks. The Euro currency market is not regulated by any government and, therefore, is an international currency. The ‘Euro’ prefix refers to the high volume of these funds circulating in Europe, mainly through London. However, this market is world wide, and sectors of the market exist in the Middle East and Far East (Asia dollar market).

34.33 Functions of Euro Currency Markets

They are extensively used for foreign exchange hedging purposes as the banks seek to balance out their foreign assets and liabilities. The banks, therefore, take positions in the Euro currency markets to cover the forward commitments they have made with their customers. Euro currency markets can at times bypass domestic channels of 'financial intermediation’, especially when governments impose tight credit policies. For example, US Corporation can acquire Eurodollars in London. These deposits may be US domestic dollar deposits that have been transferred abroad during a US domestic credit squeeze.


Function of the markets is the full international intermediation role of channelling surplus liquid resources from, say, OPEC countries or corporations who need to borrow.

34.34 Types of Euro Currency Loans

Fixed interest loans are usually over a medium term of up to five years, and the borrower knows in advance what the interest payments will be. Standby credits are overdraft facilities offered by banks to customers in Euro currency. Most Euro currency loans are roll-over loans, where the bank agrees to make funds available over a given period of time, say five years, but the interest rate is open to renegotiation every three or six months. A number of banks may form themselves into a syndicate in order to provide a large loan to a single customer over a period that is longer than usual. Such loans are called ‘syndicated loans’.

34.35 Foreign Domestic Capital Markets

The third major sector of the international capital market consists of the set of domestic equity, bond and credit markets within which the international investor can operate. These markets differ from the Euro currency and Eurobond markets in that they are subject to the laws of the sovereign state which they reside. The domestic markets of US, UK, France, Germany, Switzerland and the Netherlands have considerable international importance because they are relatively open to international investors and borrowers.


The regulatory climate in these markets is liberal and this makes them attractive to international capital. As a result, the same investors and borrowers are likely to be active in both domestic and offshore markets.

34.36 Syndicated Credits

Syndicated credits have emerged as one of the important sources of finance in the international market. In this type of credits, lenders usually form as a syndicate and will pool their funds. They provide medium-term financing ranging from 3 to 7 years out of the pooled funds. The rates of interest would be generally fixed on LIBOR plus basis. The big companies might avail these credit at cheaper rates than the rates prevailing in the domestic rates for financing project proposals and working capital finance. Some companies borrow these funds for takeover activities.

34.37 Eurobond

Euro bond refers to the bonds issued and sold outside the home country of the currency of issue. For example, dollar bond issued in Europe is called 'Euro bond'. Euro bonds are simultaneously sold in many countries other than the country of currency in which the issue is denominated. These bonds are issued in international market and denominated in hard currency i.e. dollar., yen, pound, euro.


Euro bonds in particular are bearer securities, the names of the bearer are not registered anywhere. Euro bonds generally unsecured debt securities maturing at least a year after launch. Euro bonds are long-term loans usually having a maturity period between 5 years to 30 years. Nowadays euro bonds have a maximum maturity period of 10 years. The euro bonds may be fixed or floating rate bonds. Eurobonds are suitable sources of finance for operations, which require:

- Large capital sums of money for long period.- Borrowing not subject to domestic regulations especially exchange

controls, which may limit their ability to export capital gains.

34.38 Multiple Currency Bonds

Certain bonds give the option to the holder of the bond to claim payment of coupon or principal in currencies of his option, the bond holder may insist for payment of coupon in DM and principal portion in US$. The exchange rate is fixed at the time of issue. Another feature of this bond is conversion option might be given which permits as instrument denominated in one currency to be converted into an instrument denominated in another. For example, UK based company might issue a US dollar bond which is convertible into shares of stock quoted in pound sterling. These bonds are also called 'currency option bonds'.

34.39 Foreign Bonds

A bond issued in a particular country by a foreign borrower (or) a bond sold by a foreign borrower, denominated in the currency of country in which it is sold and is underwritten and syndicated by national underwriting syndicate in the lending country. Foreign bonds are floated in the domestic capital markets (and are in the domestic currency of those markets) by non-resident entities. These bonds are different from Euro bonds in the sense that they are governed by the regulations of the country in which they are issued whereas Euro bonds are not.


The bonds are generally named on the basis of the capital markets in which they are floated. Some of the well-known foreign bonds are as follows: Yankee Bonds - These bonds are dollar denominated and issued in U.S. by a non-U.S. borrower in the U.S. market. The advantages of Yankee bonds are that the longer maturities of bonds place them outside the ECB ceiling. Yankee bond markets are extremely deep and liquid market and funds are available at low interest rates for long maturity periods. The U.S. markets are not bound by rigid syndicates and fee structures. Samurai Bonds - These bonds are issued Yen denominated bonds issued in Japan by a non-Japanese borrower. Bulldog Bonds - These bonds are pound denominated bonds issued in U.K. domestic market by a non-U.K. borrower.

34.40 Alpine Convertibles

Alpine convertibles is a new alternative for the companies who are scouting for overseas funds. Alpines are making an entry into the country through the three major Swiss banks, Union Bank of Switzerland (UBS), Credit Suisse and Swiss Banking Corporation. Alpines are convertible bonds sold to the Swiss investors through Swiss banking syndicates. They are issued in dollars and sold only through the Swiss retail investors network.


The offer for an issue comes from the Swiss market and if the company qualifies for the issue, it is subsequently placed by the investment banker. A clean and strong balance sheet is the only qualification which the arranger ask for. An Alpine could be unlisted and thus free from post market pressures. The issue costs are lower (only 1.75%) since the concerned Swiss bank pays a single cheque to the corporate and places out the convertible to its retail clients.


The companies going in for Alpines will be forced to operate in a closed market and to that extent the size of the issue will be limited. When the amount is small and is needed at a short notice Alpines are a good option. In addition, companies are not protected against the currency fluctuation as far as interest payments in Swiss Franc is concerned. Alpines have been a major source of funds for companies in Asia.

34.41 Europe Medium Term Notes

The Europe Medium Term Notes (EMTNs) first appeared in the international capital markets in mid eighties in USA. The increase in the issue of EMTNs resulted because of the following reasons: EMTNs provide an extremely important vehicle to help further each one major objectives for issuers. The EMTNs are omnibus financial deal to facilitate access to a broad international investor base.


For investors it is an investment deal that can be designed to meet their special needs for currency, structure or maturity. For the dealers this provides a greater flow of business. EMTNs are flexible as they can be structured to facilitate issuance in multiple currency viz., in Yen, Sterling, Francs, Dollars and other European currencies. Maturity could also be in a definitive bearers global bearers or registered for and can be listed or unlisted, and EMTNs could also be programmed keeping in view the needs of the investors.


The medium term notes are continuously issued notes, which are usually unsecured, with maturities ranging from nine months to ten years. They allow the borrower flexibility with respect to maturity profiles and timing of issues. These MTNs are useful tool for treasury management. The borrowers i.e. the issuers of MTNs include sovereign governments as well as large companies and financial institutions.

34.42 Qualified Institutional Placement

The SEBI has now permitted listed companies to raise funds from the domestic market by making private placement of securities with Qualified Institutional Buyers (QIBs). The process will be called Qualified Institutional Placement (QIP) and the securities so issued would constitute the fully paid-up capital of the company.


SEBI has introduced QIPs with an object that Indian companies to use the QIP route to raise capital rather than raising funds through ADRs/GDRs/ FCCBs route. The Indian listed companies can now place 'specified securities' with QIBs. The specified securities include equity shares, fully convertible debentures or any securities other than warrants, which are convertible into or exchangeable with equity shares at a later date. QIP can be made by a listed company, which fulfils the following conditions:

- Its equity shares of the same class are listed on a stock exchange having nationwide trading terminals, and

- It is in compliance with the prescribed minimum public shareholding requirements of the listing agreement.

34.43 Foreign Institutional Investors

Globalization and liberalization policies implemented by the Government of India have led to large inflows of foreign capital in different channels, which has led to increased capital formation and improving domestic investment in the economy in general and capital market in particular. After the opening-up of the Indian economy, the foreign investors have been encouraged to invest in India. The foreign investors - individuals as well as institutions have invested in India through different routes.


Foreign Institutional Investors (FIIs) including institutions such as Pension funds, Mutual funds, Investment Trusts, Asset Management Companies, Nominee Companies and incorporated/institutional portfolio managers or their power of attorney holders are permitted to make investments under the guidelines issued by Government of India, Ministry of Finance on September 14, 1992. FIIs can invest in all the securities traded on the primary and secondary markets including the equity and other securities/instruments of companies which are listed or to be listed on the stock exchanges in India. These include shares, debentures, warrants and the schemes floated by domestic mutual funds.


Government may even like to add further categories of securities later from time to time. The Government has allowed FIIs to invest in all types of securities in primary and secondary capital markets since September, 1992. As a precondition the FIIs, have been required to obtain registration from the SEBI and approval from RBI. SEBI shall take into account the track record of the FII, its professional competence, financial soundness, experience and such other criteria that may be considered by SEBI to be relevant. There is no restriction on the value of investment for the purpose of entry of FIIs in the capital market.


Investment in debt instrument has been permitted including gilt-edged instruments. The new scheme has made the Indian rupee fully convertible in current account for FIIs, since their entry and exit has been permitted at market determined foreign exchange rates, without any limits and lock-in period conditions. By the above policy liberalizations for FIIs, the Government is encouraging foreign investments in India to boost the capital market activities. The rationale behind this policy is to make the Indian economy strong with injection of more foreign funds.

34.44 Participatory Notes

Participatory Notes (PNs) are an indirect way through which unregistered overseas investors - who cannot directly play in the stock market in India - invest in Indian stocks. PNs are derivative products with securities as under lying. FIIs and their agents issue PNs to overseas clients investing in India. PNs are offshore financial instruments which are mostly used by foreign found investors who are not registered with the SEBI or those who do not want to register themselves with SEBI.


PN is a derivative instrument issued against an underlying security, which permits the holder to share in the capital appreciation/income from the underlying security. The foreign fund investors who are interested in investing indirectly in the Indian capital market use the PN route. PNs are generally issued overseas by the FII sub-accounts or India based foreign brokers to get an exposure in the Indian capital market. Brokers issue PNs based on Indian underlying securities in favor of foreign investors and then brokers buy and sell securities on behalf of their clients.


Investors place their orders through brokerage houses and these houses repatriate the dividend and capital gain to their clients. However, the houses do not disclose the name of their clients. PN flow into the economy is a healthy trend only for short-term. But in long-term the Indian economy needs the foreign investment which can lock-in for a reasonable period. The foreign investors cannot be allowed to destabilize Indian economy by doing speculative activities in the Indian secondary stock market. Sudden withdrawal of investments by the foreign investors may some times lead to crashing of the secondary market.


To curb the unscrupulous practices by the foreign investors, SEBI has widened the definition of FIIs, fixes the limit of FIIs investment in Government securities. The SEBI has also made amendments on FIIs restricting the sub-accounts for issuance of Offshore Derivative Investments (ODIs) only to persons regulated by an appropriate foreign authority and only after compliance with ‘know your client’ norms. The amendments lay emphasis on establishing the identity of foreign entities investing in India.


The market regulator intends to encourage FIIs to register in India and invest directly here, rather than coming via the PNs route. This is expected to increase transparency in their operations. SEBI forbid FIIs and their sub-agents, from issuing any fresh PNs in the derivative market and asked them to windup their positions in 18 months.

34.45 Multilateral Agencies

The multilateral agencies are development financial institutions dedicated to and engaged in promoting the economic and social progress of its developing member countries. Contrary to popular belief, all direct loans from these agencies are not at concessional terms. The agencies raise resources in the world capital markets and charge a certain percentage over their cost of borrowing over a period of six months or one year.


The rates are generally revised twice a year. Loans sourced from multilateral agencies are generally for longer duration as compared to other commercial loans. The loans are required to be guaranteed by the government of the member country. The agencies generally fix fund quotas for the countries and the different sectors of their economies.


In case the credit has to be given, the projects have to be approved by the concerned multilateral agency. Only after the project is approved by the agency, the financial institutions can lend the funds. The time taken for the loans to come through, on an average ranges from 6-12 months.

34.46 International Monetary Fund

The International Monetary Fund (IMF) was first mooted in 1944 and the articles of agreement on the IMF were formulated at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire in July, 1945 and came into force in December, 1945. IMF has started its financial operations in 1947.


The Fund was set up with a reserve of currencies supplied by members. Its objectives are:

- To assist in the development of international prosperity by helping members with balance of payments deficits.

- To implement guidelines for international monetary stability.

- To promote cooperation on international monetary matters.


The IMF is an organization of countries that seeks to promote international monetary cooperation and to facilitate the expansion of trade, thus contributing to increased employment and improved economic conditions in all member countries. To achieve its purpose, the fund has a code of economic behaviour of its members, makes financing available to members in balance of payments difficulties and provide them with technical assistance to improve their economic management. As of 1992, the fund had 173 member countries, accounting for four-fifths of total world production and 90 per cent of world trade.


The IMF acts internationally in a manner similar to that of a local commercial bank. The Fund provides temporary or emergency currency reserves to countries in balance of payments difficulties just as a bank provides overdraft facilities to a company. A member’s maximum access to the fund’s reserves is determined by its quota, which is effectively, its subscription to the Fund and which is subject to revision every five years or so.


A country running deficits can borrow from the IMF. As the level of borrowings increases so to do the restrictions imposed on the borrower. The objective is for the borrower to implement economic policies which will redress the adverse balance.


In the late 1960s the Fund membership agreed to the creation of Special Drawing Rights (SDRs). This was a major step towards the creation of a supernational central bank. SDRs are a form of international credit instrument. Countries can use them to cover deficits and/or they can be kept as reserves.

34.47 World Bank

The World Bank was created at Bretton Woods as a new type of international investment institution to make or to guarantee loans for reconstruction and development projects. It was conceived originally to assist in the reconstruction of postwar Europe but soon evolved into an organization to assist in developing third world countries, by fostering economic development through financial, technical and advisory aid.


The World Bank comprises a group of three affiliated institutions : the International Bank for Reconstruction and Development (also known as the World Bank), the International Development Association (IDA) and the International Finance Corporation (IFC). The World Bank (IBRD) and IDA make loans for high priority projects and programs in member countries to further their development plans.


These loans are made to sovereign governments or to entities enjoying the full faith and credit of sovereign governments. In the case of the Bank these loans are made on commercial terms. The lending terms of the IDA, on the other hand, are very generous or ‘soft’ as IDA was established to assist the poorest countries, which could not afford to borrow money from the bank on its normal terms. The purpose of the IFC is to assist developing countries in promoting private enterprise.


The corporation’s investments take the form of both loan and equity financing of private sector projects in developing countries. In the earlier years of its operations, the bank concentrated its lending on capital infrastructure projects - primarily transportation, electric power, telecommunications, and irrigation and flood control.


In the 1970s the development of such sectors as agriculture, education and industry was recognized by the bank and IDA to be crucial to social and economic progress and lending was extended to those sectors. In recent years the bank has increased the amount of loan finance which is not tied to specific projects but is conditional on national policies being adjusted to cope with balance of payments difficulties and to promote growth. This lending is known as structural adjustment lending. It is employed widely in Africa and South America.


The bank’s finances are based on increases in capital subscriptions made from time to time by its members. At the end of 1994 over 180 billion dollars had been subscribed but of this only about 6.36% is paid in. The bank’s lending program is financed in part through the paid-in capital, but mainly through commercial borrowing on the international capital markets.


The IDA’s resources come predominantly from grant contributions, known as replenishments, from the richer countries among its membership. From its establishment to end 1994 IDA had issued over 62 billion dollars in credits to member countries.


As in the case of the World Bank, member countries subscribe for capital in the IFC. Paid-in capital amounted to over 2 billion dollars at the end of 1994. These subscriptions, in conjunction with borrowings, are used to fund the corporations’ investments.

34.48 International Development Association

The International Development Association (IDA) supplements activities of World Bank by financing those projects which are crucial in the development of the country’s economy. It provides finance to the projects which have faced foreign exchange difficulties or where the foreign debt service burden is very high that they cannot prudently borrow on conventional terms all the external capital which they require for their priority programs.


The Government of India has obtained for a total value of $20.682 billion for the year ending 31st December, 1993 from IDA.

34.49 International Finance Corporation

The International Finance Corporation, Washington (IFCW) is affiliated to the World Bank and is the world’s largest multinational organization which extends financial assistance to the private sector business of the developing member countries. It has the main objective of promoting economic development of the member countries through private sector.


It aims to finance private sector projects helping companies in developing world to mobilize financing in the international financial markets and providing advice and technical assistance to business and governments. IFCW extends foreign currency financial assistance without Government guarantees in a form and combination most suitable to the project, if sufficient funds cannot be obtained on reasonable terms from other sources.


IFCW provides foreign currency financial assistance on the basis of its own assessment of the project cost, irrespective of the project cost estimated by Indian Financial Institutions. IFCW extends financial assistance to the private sector in developing countries as also joint sector. It invests in large as well as small projects.


Recently, great emphasis has been given on agriculture and agro based products, food and food processing. IFCW participates in projects which have the prospect of earning profit and benefit the economy of the country in which it is implemented.


The IFCW offers an array of financial products and services to companies in its developing member countries like:

- Long-term loans in major currencies at fixed or variable rates.

- Equity investments.- Quasi-equity instruments (subordinate loans,

preferred stock, income notes).- Guarantees and standby financing.- Risk management (intermediation of currency

and interest rate swaps, provision of hedging facilities).


In order to receive IFC funding, a project must meet a number of IFCW guidelines like:

- The project must be in the private sector.- It must be technically sound.- It must have a good prospect of being profitable.- It must benefit the local economy.

34.50 Asian Development Bank

The Asian Development Bank (ADB) has started its operations in 1966 to provide financial assistance to the member countries in the Asia-pacific region with a view to improve the quality of life of the people. It aims at not only the development of the region but also for attaining harmonious growth of subregions.


The main functions of ADB are as follows:- To advance loans and equity investment for the

economic and social advancement of the developing member countries.

- To provide financial assistance.- To promote investment of public and private

capital for development purposes.- To help in coordinating development policies and

plans of member countries.


Presently about 49 countries have joined as members in IDA in the region. ADB provides financial assistance to the developed member countries from ordinary capital resources which constitutes roughly 67% of the total financial assistance from ADB. The interest rate on ADB loans are of variable nature. It provides financial assistance to its member countries on concessional terms. India is one of the major subscribers to the capital of ADB.

34.51 All India Financial Institutions (AIFIs)

The AIFIs like IDBI, IFCI and ICICI are providing foreign currency financial assistance to Indian projects through various lines of credit already procured by them from international financial market. IDBI and IFCI have been linked with lines of credit in DM from West Germany, Pound Sterling from U.K. and Swedish Kroner under Indo-Swedish Development Cooperation Agreement.


Sub-loans are also available from AIFIs in other currencies like Japanese Yen and U.S. Dollars. AIFIs are raising funds in the international financial market through issue of bonds to cater the needs of the domestic projects.


As foreign currency financial assistance has been excluded from single window system, each of the term financing financial institution issue separately the letters of intent sanctioning foreign currency financing. It is important to mention that in case of foreign currency loan, the liability of the borrower remains in the currency in which the loan has been obtained. For instance, suppose, a borrower obtains a loan in US Dollars, he will have to payoff the loan in US Dollars only.


The financial institutions allocate the currency to the borrowers on the basis of the lines of credit available and the time duration during the entire available line of credit has to be utilized fully. These foreign currencies are convertible, that is, one currency can be used in making payments in other currencies. For instance, borrowing in Deutsche Marks can be used in making payments in US Dollars or Swiss Francs etc.

34.52 Multinational Corporations

The multinational corporations (MNCs) finance the indigenous project in the form of foreign direct investment i.e., direct participation in the equity of domestic company. Before making any investment by MNCs in other countries they will consider the factors like political stability of the country, economic stability and growth of the country, earnings from the proposed investment, infrastructure facilities available in the country, availability of raw material and cheap labour, favourable economic and tax laws of the country, potential to widen the market for their technology, conducive business environment, provisions allowing repatriation of investments and earnings there on etc. Contd. on next page ……

The projects which are setting up with technical and/or financial collaboration with the foreign firms are to be approved by the Government of India. In order to attract the foreign investments into India, the Government has released all its previous guidelines providing a conducive environment for foreign investments in India.

34.53 Commercial Banks having International Operations

Foreign currency financial assistance can also be procured from commercial banks having international operations. But Indian financial institutions, generally do not permit industrial undertakings to raise foreign currency financial assistance from international banks. This is due to the fact that financial institutions themselves raise foreign currency resources from international market for on-lending to industrial undertakings.


The foreign commercial banks having their operations in India are active in loan syndication in foreign currencies and also arrange foreign currency loans from the banks who make finances in business sector.

Chapter 35

International Trade Finance

35.1 Export Finance35.2 Packing Credit35.3 Types of Packing Credit35.4 Advance Against Cash Incentives35.5 Advance Against Duty Drawback Entitlement35.6 Documentary Credit35.7 Discounting of Export Bills35.8 Advances Against Bills Sent on Collection Basis35.9 Advances Against Goods Sent on Consignment Basis35.10 Advances Against Undrawn Balances35.11 Advances Against Retention Money35.12 Finance for Project Exports35.13 Post-shipment Credit in Foreign Currency (PSCFC) Scheme35.14 Forfaiting35.15 Mechanism of International Forfaiting35.16 Problem Areas in Forfaiting35.17 Benefits of International Forfaiting to Exporters35.18 Benefits of International Forfaiting to Importers


35.19 International Factoring35.20 Counter Trade35.21 Documentary Credit35.22 Letter of Credit and Bank Guarantee : Distinction35.23 Export Credit and Insurance35.24 Export Credit Guarantee Corporation of India Limited35.25 Services provided by ECGC35.26 Export Import Bank of India35.27 Functions of EXIM Bank35.28 Export Credit Facilities from EXIM Bank35.29 Finance for Export Oriented Units from EXIM Bank35.30 Finance for Non-exporting Companies from EXIM Bank35.31 Bilateral Credit35.32 Suppliers Line of Credit35.33 Special Economic Zones35.34 Objectives of Setting up of SEZ35.35 Preconditions for Setting up of SEZ35.36 Acquisition of Land for SEZ35.37 Exemptions, Drawbacks and Concessions under SEZ Act

35.1 Export Finance

Export finance plays a significant role in the export promotion. An exporter may use financial assistance for export of his goods and services to foreign importer which is available from the bankers in two stages viz., pre-shipment stage and post-shipment stage. Pre-shipment finance covers the credits extended by banks to exporters prior to the shipment of goods. Such credits are meant for the purchase of raw materials, processing of the raw materials, packaging, transporting the goods meant for export, warehousing etc. Generally, this form of credit is in the form of working capital advances, loans, cash credit and overdraft.


Any loan or advance granted or any other credit provided by an institution to an exporter of the goods from India from the date of extending the credit after the shipment of goods to the date of realization of the export proceeds and includes any loan or advance granted to an exporter in consideration of or on the security of any duty drawback or any cash payment by way of incentive from, the marketing development fund or any other relevant source. The need for post-shipment finance arises because exporters who sell goods abroad have to wait for a long time before payment is received from overseas buyers. The actual period of waiting depends on the payment terms. In the mean time, the exporter has to make payment to the loan manufacturer of goods or if he is a manufacturer exporter, he has to pay the suppliers.


Under such circumstances, very few manufacturer-exporters and merchant exporters have the means to finance the credit terms they extend to overseas buyer. There are number of agencies engaged in providing export finance. Among the various institutions which promote foreign trade, commercial banks used to provide export finance in the country. Commercial banks provide both pre-shipment and post-shipment credit for the exporters. Generally banks provide export credit against the security of irrevocable letter of credit (LCs), confirmed order or the contract placed by the overseas buyers. The post-shipment credit provided by the banks mainly helps the exporters to face delay in receiving payments from overseas buyers. While extending financial assistance to the exporters, banks are governed by the RBI guidelines issued from time to time, the Trade and Exchange Control Regulations and the International Conventions and Codes of the International Chamber of Commerce.

35.2 Packing Credit

Packing credit is available to all types of exporters i.e., manufacturer exporters, merchant exporters, export houses and even to manufacturers of goods supplying to merchant exporters and export houses who do not receive export order in their own name. Packing credit advance is generally available to the eligible exporters for the purpose of purchasing, manufacturing, processing, transporting, warehousing, packing and shipping etc. of the goods meant for export against lodgement of documentary letter of credit established/transferred in his favour by the overseas buyer or against confirmed order/contract placed by the buyer for export of goods from India. The period of packing credit depends upon the requirements of the exporter. The maximum period for which the credit can be granted is 180 days from the date of disbursement.


The period can be extended by another 90 days at the discretion of the commercial bank, subject to the additional interest for extended period. The packing credit finance amount is decided by the bank on the basis of export order and the credit rating of the exporter which does not normally exceed the FOB value of the goods meant for export.

35.3 Types of Packing Credit

Clean packing credit - This is an advance made available to an exporter only on production of a firm export order or a letter of credit without exercising any charge or control over raw material or finished goods. It is a clean type of export advance. Each proposal is weighed according to particular requirements of the trade and credit worthiness of the exporter. A suitable margin has to be maintained. Also, Export Credit Guarantee Corporation (ECGC) cover should be obtained by the bank.


Packing credit against hypothecation of goods - Export finance is made available on certain terms and conditions where the exporter has pledgeble interest and the goods are hypothecated to the bank as security with stipulated margin. At the time of utilizing the advance, the exporter is required to submit, along with the firm export order or letter of credit, relative stock statements and thereafter continue submitting them every fortnight and whenever there is any movement in stock. Packing credit against pledge of goods - Export finance is made available on certain terms and conditions where the exportable finished goods are pledged to the banks with approved clearing agents who will ship the same from time to time as required by the exporter. The possession of the goods so pledged lies with the bank and are kept under its lock and key.

35.4 Advance Against Cash Incentives

Where the domestic cost of production of certain goods is high in relation to international price, Government may grant some incentives to the exporter so that he may compete effectively in the overseas market. Such advances are clean in nature and banks may stipulate a margin between 20% to 40% of such claims as the percentage of incentive varies from time to time as published in Government notifications. The bank may have any difficulty in assessing the quantum of cash subsidy payable at any point of time. These advances being in the nature of unsecured advances cannot be granted in isolation and could be granted only if all other types of the export finance are extended to the exporter by the same bank.

35.5 Advance Against Duty Drawback Entitlement

The Government of India have formulated a Duty Drawback Credit Scheme under which banks are able to grant advances to exporters against their entitlements of duty drawback on export of goods, free of interest charges. The period of advances will be upto a maximum 90 days beyond which the bank may not allow the advances or may charge normal interest applicable to export credit.

35.6 Documentary Credit

When a stipulation is incorporated in the sale contract that the goods shall be paid by a banker’s credit, the exporter need not worry whether the goods will be cleared by the importer on arrival at the destination and the exporter need not lock up his funds by making payment in advance. The importer applies to his banker in his country to open and issue in favour of the exporter a letter of credit and to pay the beneficiary the amount on his fulfilling the terms and conditions specified in the letter of credit.

35.7 Discounting of Export Bills

Where bills are not covered under letters of credit, the exporter would have to comply with the terms of the relevant sales contract/firm export order etc. At the request of the exporter, the bank will purchase or discount the export bill and pay the equivalent rupees to the exporter under post-shipment finance.

35.8 Advances Against Bills Sent on Collection Basis

Banks sometimes grant advances, against bills sent on collection basis. This may be restored to when the accommodation available under the foreign bills purchased is exhausted or when some export bills drawn under letter of credit have discrepancies. Such facility may also be granted where it is customary practice in the particular line of trade and in the case of exports to countries where there are problems of externalization.

35.9 Advances Against Goods Sent on Consignment Basis

When the goods are exported by the exporter on consignment basis at the risk of the exporter for sale and eventual remittance of sale proceeds by the agent/consignee, a suitable limit for this purpose will be sanctioned by the bankers to their customer exporters.

35.10 Advances Against Undrawn Balances

In certain lines of exports, it is the practice of exporters not to draw bills for the full invoice value of the goods but to leave a small part undrawn, for payment after adjustments due to differences in weight, quality etc. ascertained after arrival and inspection, weighment or analysis of goods. In such cases, banks are permitted to grant advances against undrawn balances till the receipt of remittance from abroad, subject to a maximum of 90 days.

35.11 Advances Against Retention Money

Banks are permitted to grant advances against retention money, which is payable within one year from the date of shipment at concessional rate of interest upto 90 days. If such advances extend beyond one year, they are treated as deferred payment advances which are also eligible for concessional rate of interest.

35.12 Finance for Project Exports

Export of engineering goods on deferred payment terms and execution of turnkey projects and civil construction contracts abroad are collectively referred to as ‘project exports’. Project export contracts are generally of high value - such contracts normally provide payment of a certain portion of the relative invoice value as advance or down payment, the balance being payable in installments over a period of time. The financing of project exports is a crucial element due to the time lag between the actual movement of goods or execution of a project and the receipt of funds. Revenues are earned after a considerable gestation period. Such contracts may be concluded by way of suppliers credit. The exporter extends credit directly to the foreign buyer and has to arrange for finance from a commercial bank/Exim bank.

35.13 Post-shipment Credit in Foreign Currency (PSCFC) Scheme

RBI has introduced a scheme called post-shipment export credit denominated in foreign currency (PSCFC) for the benefit of Indian exporters. Under the scheme the exporters are eligible to avail post-shipment finance denominated in foreign currency with the concessional rate of interest. Although the exporter will be paid the Indian rupee equivalent of the export bill, the indebtedness of the exporter to the banker by way of post-shipment advance would be designated in foreign currency.

35.14 Forfaiting

International trade has grown rapidly in the last few decades, and so in the cases with the techniques of financing. The waiting for payment against export bills for a long time, more particularly because of the financial and political risks, often creates worrying situation in export business. Forfaiting is a technique to help the exporter to sell his goods on credit and yet receive the cash well before the due date. The word ‘forfaiting’ evolved from the French word 'forfait’ which means, the exporter forfaits/surrenders his rights or claims to payments which he could have received in future in lieu of immediate cash payments.


In other words, forfaiting involves encashing future trade receivables now, at a charge. Forfaiting has emerged as an important tool of financing to an exporter while retaining the benefits of a cash sale. The exporters get the money soon on receipt of the notes from the importer which are presented to the forfaiter. Forfaiting is done without recourse i.e., the forfaiter cannot go back to the exporter for the recovery of the money which the importer may not have paid him. Thus forfaiting is defined as the nonrecourse purchase by a bank or other financial institution (forfaiter) of receivables arising from an export of goods and services.

35.15 Mechanism of International Forfaiting

Exporter explaining the forfaiter, giving the following details: -The type of goods and services to be shipped. - The price and the currency in which goods and services are to be shipped is invoiced. - The name of the importer and the country in which he stays. Receiving commitment from the forfaiter for the provision of cash finance upto a certain limit. Contract between exporter and importer specifying that payment will be made by the importer to the forfaiter. Signing of notes/trade obligations by the importer and sending them to his local bank for necessary guarantees.


Guaranteeing of notes by the importer’s bank and forwarding them to exporter’s bank with necessary instructions to release them to the exporter against the shipping documents. The exporter shipping the goods and presenting the shipping documents to his bank. The exporter’s bank releasing the notes to the exporter and forwarding the shipping documents to the importer through the importer’s bank. The exporter presenting the notes to his forfaiter and receiving the cash discounted proceeds.

35.16 Problem Areas in Forfaiting Absence of legal framework Lack of data base regarding importers as well as importing countries High risk (political, sovereign, transfer and commercial) involved in such transaction Possible amendment in Foreign Exchange Regulation Act, 1973 in terms of documentation, procedural mechanism, the liability of the export proceeds etc. Resource mobilization High cost of finance Absence of secondary market etc.

35.17 Benefits of International Forfaiting to Exporters

Flexibility in Operation - The most outstanding benefit of forfaiting is its flexibility. The institutions engaged in forfaiting provide the service in a manner which best meets the needs of the exporter and the importer. The bank guarantee provided by importer obviates the need to make a thorough check on creditworthiness of the importer. Only the guarantor bank’s standing needs to be verified besides the general economic scenario of the importing country.


Assured Payment - The exporter needs only to fulfil his commercial obligations under the contract and submit the correct documents. The finance is provided by the forfaiter without recourse. This means that the fluctuations in interest rates and the exchange rates do not matter during the commitment period. The exporter, therefore, has an assurance of receiving payment notwithstanding the risks regarding the buyer, the buyer’s bank and the buyer’s country. Relief from Maintaining Records etc - The exporter’s botherations about administering the sales ledger and collection of payment are taken over by the forfaiter. This gives considerable relief to exporters.

35.18 Benefits of International Forfaiting to Importers

100 Per cent Finance - An exporter can offer 100 per cent finance to the importer through the forfaiting agreement, if that could result in making the exporter’s bid more attracting. Goods purchased from different countries can be clubbed together in one package. The repayment program can be adopted his needs. Finance can be made available in a wide range of currencies though most often forfaiters use US Dollars, Deutsche Marks and Swiss Francs. Flexible Finance - Factoring allowed the importer to avail not only 100 per cent finance but also finance in a simple, fast and flexible manner.

35.19 International Factoring

It is a method whereby the factor undertakes to collect the debts assigned by exporters. Money comes to exporters only after collection of bills by the factor. Factor acts as an agent of exporters to whom the accounts receivables are assigned by exporters. The factor does not undertake the risk which lies with the exporter. Relationship between the exporter and the factor continues even after the assignment of debts by exporters. Factoring covers export of consumer goods for relatively short period.

35.20 Counter Trade

Counter trade is an important source of finance in international trade, in which the barter deals takes instead of payments in foreign exchange. If suppose Country ‘A’ imports food grains from Country ‘B’ in consideration petroleum products, it is a counter trade deal. These deals avoid the countries maintaining huge foreign currencies reserves. Generally third world countries resort to this type of trade due to shortage of foreign exchange reserves with them. Counter trade deals occupies substantial portion in international trade.

35.21 Documentary Credit

Trade between countries is financed mainly through letter of credits known as ‘documentary credit’. Goods can be bought and sold with payment of price in various forms like ready cash, cash against delivery of goods, cash against documents, cash against acceptance of bills of exchange and so on. In case of an international sale transaction, the seller does not desire to purchase (for resale) or manufacture the goods or after having done so, to give up control over them, unless he is certain to be paid on his fulfilling the terms of the contract. Similarly, the buyer wants to pay the price only when he has the contracted goods or at least they are out of the possession and control of the seller.


Thus, a conflict of interest arises. Difference in currency and local laws, uncertainty of political situation in the countries of the buyer and seller and ignorance about the other party whereby aggregate the conflict. It is here that ‘documentary credit’ comes to the rescue of the parties and promotes International trade. Letter of credit is a method of making trade payment, especially while dealing with unknown traders. Through this instrument, it is ensured of specific performance by both the parties i.e., importer as well as seller. The importer makes an application to his banker (issuing bank) to establish letter of credit in favour of the beneficiary, though another bank (known as correspondent bank). The correspondent bank shall in turn advise the beneficiary or beneficiary’s bank (advising bank).

35.22 Letter of Credit and Bank Guarantee : Distinction

A letter of credit differs from a bank guarantee. A letter of credit is independent of and unqualified by a contract of sale. A vendor of goods selling against a confirmed letter of credit is selling under the assurance that nothing will prevent him from receiving the price. Payment under a letter of credit does not depend on the performance of obligation on the part of the vendor except those which the ‘letter of credit’ expressly imposes. On the other hand, a bank guarantee has a dual aspect. It is not merely a contract between the bank and the beneficiary of the guarantee, it is also a security given to the beneficiary by a third party. Unless there is some act of omission or commission on the part of the third party, payment under a bank guarantee does not become due.

35.23 Export Credit and Insurance

Payments for exports are open to risk even at the best of times. The risks have assumed large proportions today due to the far reaching political and economic changes that are sweeping the world. An outbreak of war or civil war may block or delay the payment for goods exported. A coup or an insurrection may also bring about the same result. Economic difficulties or balance of payments problems may lead a country to impose restrictions on either import of certain goods or on transfer of payments for goods imported. In addition, one has to contend with the usual commercial risks of insolvency or protracted default of buyers.


The commercial risks of the foreign buyer going bankrupt or losing his capacity to-pay are heightened due to the political and economic uncertainties. Conducting export business in such conditions of uncertainty is fraught with dangers. Credit Insurance policy covers the payment risk arising out of nonpayment by overseas buyers and countries for the goods and services exported from India. Credit insurance usually pays around 80-90 per cent of invoice or receivable that remains unpaid as a result of protracted default, insolvency or bankruptcy of the overseas buyers or risks specific to the importing countries such as war, civil war, restriction on remittances, ban on the import of goods etc. The policy is bought by exporting entities to insure their accounts receivable from losses following the insolvency of debtors.


The FEMA and banking laws make it mandatory for exporters to bring in foreign currency during the stipulated period. Once an exporter receives payment from the overseas buyer, he needs to get his GR form released by the bank. In case the overseas buyer defaults, the exporter approaches the insurance company for settlement of claims. The loss of a large payment may spell disaster for any exporter whatever is his prudence and competence. On the other hand, too cautious an attitude in evaluating risks and selecting buyers may result in loss of hard-to-get business opportunities. Export credit insurance is designed to protect exporters from the consequences of the payment risks, both political and commercial, and to enable them to expand their overseas business without fear of loss.


Export credit insurance also seeks to create a favourable climate in which exporters can hope to get timely and liberal credit facilities from banks at home. For this purpose, export credit insurer provides guarantees to banks to protect them from the risk of loss inherent in granting various types of finance facilities to exporters.

35.24 Export Credit and Guarantee Corporation of India Limited

In order to provide export credit insurance support to Indian exporters, the Government of India set up the Export Risks Insurance Corporation (ERIC) in July, 1957. It was transformed into Export Credit and Guarantee Corporation Limited (ECGC) in 1964. To bring the Indian identity into sharper focus, the Corporation’s name was once again changed to the present Export Credit Guarantee Corporation of India Limited in 1983. ECGC is a company wholly owned by the Government of India. It functions under the administrative control of the Ministry of Commerce and is managed by a Board of Directors representing Government, Banking, Insurance, Trade, Industry, etc. The present paid-up capital of the company is Rs. 900 crore and authorized capital is Rs. 1,000 crore.


ECGC has launched a number of new export credit risk insurance products so as to suit the requirements of Indian exporters and commercial banks.

35.25 Services provided by ECGC ECGC provides policies to exporters which are designed to cover short-term export credit risks. The policy covers both commercial and political risks from the date of shipment. ECGC has introduced many policies such as 'export turnover policy' and 'Buyer exposure policy'. Other covers provided by ECGC include 'software project policy', introduced as a credit insurance cover to meet the needs of software exporters. The 'IT-enabled services policy ' is issued to cover the commercial and political risks involved in rendering IT-enabled services to overseas customers. Covers are issued to banks in India to protect them from the risks of loss involved in their extending financial support to exporters, both at pre and post-shipment stages.


Specific policies are designed to cover exports of goods and services on deferred terms of payment under medium and long-term exports. Covers are also available for supplies, civil constructions, turnkey projects and also provided for 'buyer's credit' and 'lines of credit'. ECGC offers special schemes such as 'transfer guarantees' meant to protect banks which add confirmation to letters of credit issued by foreign banks. The Corporation also issues 'customer specific cover' to the exporters and banks, also termed as 'tailor-made covers' which will address the specific risk cover requirements of exporters and banks.


ECGC has started export factoring services under which an exporter can avail finance and credit insurance under one roof. ECGC also provides marine insurance covers free of cost to all its exporters holding specific covers. The Corporation plans to introduce 'domestic credit insurance covers'

35.26 Export Import Bank of India

Export Import Bank of India (EXIM Bank) was set up in September 1981 under an Act of parliament The Export-Import Bank of India Act, 1981 with an objective for providing financial assistance to exporters and importers, and for functioning as the principal financial institution for coordinating the working of institutions engaged in financing of export and import of goods and services with a view to promoting the country's international trade and shall act on business principles with due regard to public interest. Exim Bank is managed by a Board of Directors, which has representatives from the Government, Reserve Bank of India, Export Credit Guarantee Corporation (ECGC) of India, a financial institution, public sector banks, and the business community.


Exim Bank plays four-pronged role with regard to India's foreign trade: those of a coordinator, a source of finance, consultant and promoter. Exim offers a diverse range of information, advisory and support services, which enable exporters to evaluate international risks, exploit export opportunities and improve competitiveness.

35.27 Functions of EXIM Bank

Corporate Banking Group - It handles a variety of financing programs for Export Oriented Units (EOUs), Importers, and overseas investment by Indian companies. Project Finance/Trade Finance Group - It handles the entire range of export credit services such as supplier's credit, pre-shipment credit, buyer's credit, finance for export of project services, guarantees, forfaiting etc. Lines of Credit Group - Lines of Credit (LOC) is a financing mechanism that provides a safe mode of nonrecourse financing option to Indian exporters, especially to small and medium enterprises, and serves as an effective market entry tool. Agri Business Group - It is aimed to spearhead the initiative to promote and support Agri-exports. The group handles projects and export transactions in the agricultural sector for financing.


Small and Medium Enterprises Group - It handles the specific financing requirements of export oriented SMEs. The group handles credit proposals from SMEs under various lending programs of the Bank. Export Services Group - It offers variety of advisory and value-added information services aimed at investment promotion. Fee based Export Marketing Services - Bank offers assistance to Indian companies, to enable them establish their products in overseas markets.

35.28 Export Credit Facilities from EXIM Bank

Pre-shipment Credit - Exim Bank's pre-shipment credit facility, in Indian Rupees and foreign currency, provides access to finance at the manufacturing stage-enabling exporters to purchase raw materials and other inputs. Supplier's Credit - This facility enables Indian exporters to extend term credit to importers (overseas) of eligible goods at the post-shipment stage. For Project Exporters - Indian project exporters incur Rupee expenditure while executing overseas project export contracts i.e. costs of mobilization/acquisition of materials, personnel and equipment etc. Exim Bank's facility helps them meet these expenses.


For Exporters of Consultancy and Technological Services - Exim Bank offers a special credit facility to Indian exporters of consultancy and technology services, so that they can, in turn, extend term credit to overseas importers. Guarantee Facilities - Indian companies can avail of these to furnish requisite guarantees to facilitate execution of export contracts and import transactions.

35.29 Finance for Export Oriented Units from EXIM Bank

Term Finance (for exporting companies) - Project finance - Equipment finance - Import of technology and related services - Domestic acquisitions of businesses/companies/brands - Export product development/Research and development - General corporate financeWorking Capital Finance (for exporting companies) - Working capital term loans (less than 2 years) - Long-term working capital (upto 5 years) - Export bills discounting - Export packing credit - Cash flow financingNon-funded - Letter of credit limits - Guarantee limits

35.30 Finance for Non-exporting Companies From EXIM Bank

Working Capital Finance - Bulk import of raw materialTerm Finance - Import equipmentExport Finance - Pre-shipment credit - Post shipment credit - Buyers' credit - Suppliers' credit (including deferred payment credit) - Bills discounting - Export receivables financing - Warehousing finance - Export lines of credit (nonrecourse finance)


Equity Participation (in Indian companies) - To part finance project expenditure (project, inter alia includes new project/expansion/acquisition of business/company/brands/research and development).

35.31 Bilateral Credit

The bilateral credits are government protocol credits or the credits, which are given by friendly foreign countries at concessional rates of interest, to finance the imports from the donor country. Under the bilateral credit, the procurement source is tied to goods and services of the donor country. In this scheme the exporter gets paid by the donor country against shipments or progress bills as the case may be and the donor country treats payments to exporters as disbursements under the bilateral credit to the borrowing country. These credits are not available for commercially viable projects, so that the funds meant for development of basic needs are not diverted to subsidize exports from a country.


This credit is generally given to the government of the donee country and is passed on in a combination of the below three forms and the grant element cannot exceed 35% in a mix of the below three packages taken together as per the OECD guidelines: Grant - This is a type of bilateral credit, provided by a friendly country at zero rate of interest under a protocol signed by the two countries. Soft Loan - These loans are given at a rate, which is much below the prevailing market rate of interest. These loans have longer maturity periods. Export Credit - Export credit loans are given at the interest rates prevailing in the market. These loans are given at commercial reference interest rate. With a view to stimulate the export the export of goods and services major export credit agencies have been set up by governments across the world. Government supported export finance is an attractive financing alternative for companies seeking to expand into international markets.

35.32 Suppliers Line of Credit

Another source of finance are the export credit agencies of the different countries interested in supplying equipment. It is always possible that a proportion of the cost of particular project will be provided by the sponsoring government.

35.33 Special Economic Zones

A special economic zone (SEZ) is a specially demarcated area and special policies and laws are framed for it, which are not applicable to other areas of the country. The rationale behind the establishment of SEZs is to boost economic liberalization with primary focus on the promotion of export-oriented production in the country. An SEZ is a geographical region that has economic laws that are more liberal than a country's typical economic laws. The SEZ is a new concept increasingly seen as an alternative way of economic growth through exports and duty exemption. In India, Special Economic Zones Act, 2005 was enacted to create specifically delineated duty-free enclaves.


The promotion of SEZ is an attempt to deal with infrastructural deficiencies and procedural and bureaucratic complexities caused by monetary, fiscal, taxation and labour laws. An SEZ can be defined as 'an industrial zone with special incentives, set up to attract foreign investors, in which imported materials undergo some degree of processing for value addition before being exported again.' An SEZ is a modification of concept 'Export Processing Zone'.

35.34 Objectives of Setting up of SEZ

to attract investment to the country, particularly, foreign investment. to create employment and to improve living standards of the people. to enable transfer of improved technology to the country. to enable economic development of the country. to foreign exchange out of export of goods manufactured from SEZ units. to attract foreign direct investment to boost the process of creating infrastructure and for creating new industrial enterprise. to enhance the competitive ability of products manufactured in India.

35.35 Preconditions for Setting up of SEZ

Units approved under SEZ scheme would be permitted to set up SEZ. The SEZ units shall abide by local laws, rules, regulations or byelaws as exacted by the government. They shall also comply with industrial and labour laws which are locally applicable. Security arrangements will be provided by the SEZ. The SEZ should have a minimum area of 1000 hectares and at least 25% of the area is to be earmarked for developing industrial units. Minimum area will not be applicable to product specific and port/airport based SEZs. Wherever the SEZs are land-locked, an Inland Container Depot (ICD) will be an integral part of SEZs.

35.36 Acquisition of Land for SEZ

SEZs should be set up only on barren land. Acquisition of land in critical conditions should be limited to single crop agricultural land. In case of any double crop agriculture land has to be acquired to meet the minimum area for SEZ and it should not be more than 10% of the total area.

35.37 Exemptions, Drawbacks and Concessions under SEZ Act

Exemption from any duty of customs, under the Customs Act, 1962 or the Custom Tariff Act, 1975, on goods imported into, or services provided in a SEZ or a unit in it. Exemption from any duty of Customs Act 1962 or the Customs Tariff Act, 1975, on goods exported from, or services provided from a SEZ or from a unit. Exemption from excise duty under the Central Excise Act, 1944 or the Central Excise Tariff Act, 1985, on goods brought from Domestic Tariff Area (DTA) into SEZ or unit. Drawback or such other benefits as may be admissible from time to time on goods or services provided from DTA into SEZ or unit. Exemption from Service Tax under Chapter V of the Finance Act, 1994 on taxable services provided to a developer or unit in SEZ.


Exemption from the Securities Transaction Tax levied under section 98 of the Finance Act, 2004 in case the taxable securities transactions are entered into by a non-resident through the International Financial Service Centre. Exemption from the levy of taxes on the sale or purchase of goods under the Central Sales Tax Act, 1956.

Chapter 36

Financial Management in Public Sector

36.1 Accounting and Financial Reporting in PSEs36.2 Objectives of Accounting and Financial Reporting36.3 Efficiency Audit36.4 Propriety Audit36.5 Budgeting and Revision of Budgets36.6 Strategic Financial Planning36.7 Financial Advisor36.8 Working Capital Management36.9 Reasons for Poor Working Capital Management in PSEs36.10 Objectives of Capital Budgeting in PSEs36.11 Steps in Public Investment Decision Process36.12 Cost-Benefit Analysis36.13 Financing Policies36.14 Impact on Pricing Policy of PSEs36.15 Causes of Sickness in PSEs36.16 Greenfield Privatization36.17 Reforming Process of PSEs36.18 Disinvestment Contd. on next page ……

36.19 Approaches to Disinvestment Program36.20 Criteria for Privatization or Liquidation36.21 Objectives of Disinvestment36.22 Disinvestment Strategy36.23 Methods of Valuation of Shares in PSEs Disinvestment36.24 Methods of Disinvestment36.25 Argument in Favour of Disinvestment Process36.26 Arguments Against Disinvestment Process36.27 Steps in Disinvestment Process

36.1 Accounting and Financial Reporting in PSEs

A public sector enterprise (PSEs) is a business undertaking owned, controlled and managed by the state, on behalf of and for the benefit of the public at large. The basic objective of public enterprising is to achieve the strong industrial base and to provide infrastructure for the development of the economy of the state. The concepts of Financial management are equally applicable to both private sector undertakings and PSEs, but the rules, procedures, accountability of financial decisions are more rigid in PSEs, as they are financed by the government out of taxes collected from the public.


The nature of public sector accounting is quite different from that adopted by the private sector. The majority of the public sector industries are budget financed by the Central or State Governments depending on the ownership and also receive the largest portion of their funds in the form of grants from the government. They are subject to a high degree of direct and indirect regulation as regarding funding and pricing policies. The public sector accounting information need to prepare to the requirements of wider and more diverse group of interested parties than in the private sector.

36.2 Objectives of Accounting and Financial Reporting Financial information useful for making economic, political and social decisions and demonstrating accountability and stewardship. Information useful for evaluating managerial and organization’s performance. Information useful for planning and budgeting, and for predicting the impact of the acquisition and allocation of resources on the achievement of operational objectives. Financial information useful for determining and predicting the flows, balances and requirements of short-term financial resources of the public sector unit.

36.3 Efficiency Audit

It is the audit which ensures that every rupee invested yields optimum results. The main objective of efficiency audit is to ensure that: - there is most optimum utilization of investment, and - that investment is channelized in most profitable lines. Efficiency audit indicates towards appraisal or scrutiny of actual performance with reference to expected efficient standards. The parameters based on which efficiency audit is conducted are: - return on capital

- capacity utilization- optimum utilization of men, machines and materials- export performance and import substitution- liquidity position- payback period etc.

36.4 Propriety Audit

It is an examination of actions and decisions to find out whether they are in public interest and meet the standards of proper conduct. The propriety audit is concerned with examining that there is no leakage of revenue or wastage of funds by mistake or fraud. It is concerned with ascertaining appropriateness from legal, financial or economic point of view. The use of public money in PSEs, requires proper utilization. Each PSE will have to follow clearly laid down rules, procedures and authorizations while spending the funds. The approval of expenditures is governed by the principle of ‘propriety’ which requires to answer the following questions:


- whether the proposed expenditure is justified. - whether the alternative ways exists in minimization of cost. - impact of the expenditure on the overall business. - whether the expenditure is properly authorized as per the internal procedures laid down. - whether the expenditure is incorporated in the budget approved by board of directors. - whether the expenditure to be incurred in exceptional cases, proper authorization and financial concurrence is obtained from the competent authority.

36.5 Budgeting and Revision of Budgets

The budget of PSE is prepared on the basis of ‘zero based’ concept by the Budget Officer of the Accounts and Finance Department and placed before the board of directors for approval. The approved budgets forms the basis for approval of expenditures incorporated in the budget subject to procedural authority. Sometimes, mismatch of cash inflow and cash outflow arises, then the expenditure is controlled to bring balance with cash inflow. If there is any substantial change take place after completion of first or second quarter, the revised budget is submitted to the board of directors for approval. The revised budget is adopted only when there is a gross failure to achieve the original budgeted results. The deficiencies in original budget may be covered up while preparation of revised budget.

36.6 Strategic Financial Planning

The strategic financial planning in PSEs requires to concentrate in aligning the conflicting financial objectives. For PSEs seeking to make investment decisions, the concept of NPV may not be regarded as entirely appropriate. That is, the principle of discounting remains valid but, since the objective is no longer simply profit maximization, what are regarded as the cost and benefit of a project must be re-specified. In business organizations, investment decisions can be evaluated using discounted cash flow techniques and a project might be adopted if it will add to the wealth of the organization and its owners. But in case of PSEs, there are social objectives for investment decisions and investments are required to be measured in terms of social costs and social benefits.


For a private sector project, the rate of discount is the marginal or weighted average cost of capital for the business. In public sector, the selected discount rate of discount must reflect the cost of investment funds to society as a whole, so it is generally referred to as a ‘social rate of discount’. A market rate of interest forms the starting point for determining a social rate of discount and this will then be adjusted to a level which ensures an optimal consumption, investment ratio, this optimum is government determined. PSEs are organized mainly as departmental enterprise or statutory corporation or companies. The strategic financial planning in public sector requires to consider the following: - The development of an adequate financial information system which would enable them to monitor and forecast external parameters and assessment of internal capabilities. - The existence of clear strategic financial objectives. - The coordination of the plant with the government’s economic, social, fiscal and monetary policies.

36.7 Financial Advisor

The Financial Advisor occupies a pivot role in management of PSEs. He acts as a principal advisor on financial matters to the chief executive of the enterprise and renders financial advisory services to the committees. The Financial Advisor will help the PSEs in the following matters: - Estimation of short-term and long-term financial needs of the enterprise. - Formulation of financial policies and authorization procedures. - Determination of the level of activity and setup of cost-volume-profit relationships of different activity levels. - Evaluation financial and economic viability of the project, feasibility reports, social costs and benefits. - Review of cash flow and operational performance on periodical basis.


- Advising on capital expenditure proposals. - Conduct of special studies on cost, reporting on feasibility of cost management and control programs. - Submission of periodical reports on operational and financial performance of the enterprise to the Chief Executive. - Analysis of financial results of all operations and advising on future operations of the enterprise.

36.8 Working Capital Management

In PSEs, the gross working capital i.e. the investment in current assets is considered. The size of working capital and the level of current assets is used for optimization of productivity of other assets, and estimation is made to support a given volume of output or prescribed level of activity. While determination of size of working capital, the management’s attitude towards risk and the operational aspects are taking into account. The sources available for working capital finance is restricted in case of public sector and operates in a typical decision environment.


The investment policy is dependent on social and economic policy of the government. The retained earnings and depreciation are a permanent source of working capital, which can be used only when the unit is in operation. Trade credit is not considered as a source of finance, since the working capital of PSEs are considered under the ‘gross’ concept.

36.9 Reasons for Poor Working Capital Management in PSEs Over stocking of inventory in PSEs resulting in blockage of funds and consequently causes disruption in production schedules. Generally, the cost of project do not make any provision for working capital margin. If the long-term sources are not generated for working capital, it is required to rely on short-term sources. The PSEs are generally capital intensive projects and its current assets to fixed assets ratio is very low. There is a need for selling the products in bulk, obviates the need for discount and credit policies. The opportunity cost of idle resources is neglected. The lead times in procurement of material is inordinately long and excessive inventories are carried to ‘play safe’, which occupies substantial space.


The production cycle is often much longer due to process imbalance, causing huge stocks of work-in-process, and operating cycle of working capital also tend to be longer. There would be substantial under utilization of capacity, but the stock levels are maintained at very optimistic levels. PSE much rely on short-term sources for financing working capital. Commercial banks supply major quantum of working capital since the risk involved is less. The concept of ‘return on investment’ is totally neglected. The cost of production is substantially high in PSEs as compared to private sector. The monopoly market, often encourages to continue its operation.


Its major customers would include other government departments and agencies, causing substantial delay in collection of receivables. Due to working capital shortage, the units may have to lookup for special grants from government, ultimately leads to industrial sickness.

36.10 Objectives of Capital Budgeting in PSEs

To express in financial terms capital works necessary to meet the objectives expressed or implied of an organization within an accounting period or periods. To set out the agreed priorities of capital schemes. To facilitate coordination of plans and resources by: - allocating the financial resources between departments. - assisting in implementation of capital expenditure schemes. - providing a basis for forecasting cashflows and financial requirements. - providing a basis for forecasting revenue implications. - providing a basis for budgetary control. - to satisfy government control requirements.

36.11 Steps in Public Investment Decision Process

The Planning Commission formulates the five year plan indicating the broad strategy of planning, the role of each sector, the physical targets to be achieved by each sector and the financial outlays to be made available for the development of each sector. The administrative ministries develop sectorial plans. It is in these plans that the projects of the PSEs are identified. The identification of a project provides the green signal for the preparation of its feasibility report. The concerned PSE prepares the feasibility report and forwards it to its administrative ministry.


The administrative ministry carries out a preliminary scrutiny of the feasibility report and sends copies of the same to the various appraising agencies viz., Planning Commission, Department of Economic Affairs, Plan Finance Division of the Finance Ministry and the Bureau of Public Enterprises (BPE) for their comments. The Project Appraisal Department (PAD) of the Planning Commission carries out a detailed appraisal. The Investment Planning Committee of the Planning Commission discusses the appraisal note of the PAD and recommends to the PIB the view of the Planning Commission on whether the project should be accepted, rejected, deferred, or redesigned.


The Public Investment Board (PIB) considers the: - Appraisal note of the PAD along with the view of the Planning Commission. - The comments of the BPE. - The comments of the Plan Finance Division of the Ministry of Finance. - The note of the Administrative Ministry. If the PIB clears the project, it sends to the Cabinet for its approval. The Cabinet generally accepts the recommendations of the PIB and approves the implementation.

36.12 Cost-Benefit Analysis

The basic notion of investment appraisal is very simple. It involves defining the objectives of the organization, identifying the capital projects that will achieve the objectives, evaluating the costs and benefits of each project, making a decision on whether to accept or reject the project. In public sector investment appraisal, social cost-benefit analysis is used. Under CBA, the decision criterion is that a project should be undertaken providing that the discounted value of the social benefits attributed to the project exceeds the discounted value of the social costs attributed to the project. Social benefits are not solely restricted to cash returns but include any favourable effects that may affect members of the community at large.


Many of the costs and benefits of PSEs are not directly measurable in money terms, that the techniques of cost-benefit analysis are appropriate. Cost-benefit analysis is concerned with assessing all of the economic and social advantages (benefits) and disadvantages (costs) of a project and then quantifying these in monetary terms. If the social benefits exceed social costs then project would be sanctioned.

36.13 Financing Policies

Capital structure decisions - The capital structure decisions in PSEs involves the identification of various sources of finance. In practice, the government finances PSEs half the requirements in the form of capital and the balance half in the form of loan. Sources of funds - The sources of funds in PSEs, more or less similar to private sector undertakings, can be classified into: (a) internal sources, and (b) external sources. The internal sources of funds include retained earnings, depreciation provision etc. Non-plan funds - In case if PSEs are incurring cash losses or suffering for payment of wages, the government may provide non-plan fund to sustain its day-to-day operations and for payment of wages. The non-plan funds are provided by government only when justification is given by PSEs to the concerned administrative ministry.


Supplementary grant - The supplementary grant is provided by the government if the actual requirement of funds exceeds the estimated amount. This supplementary grant is provided when full justification is given by the PSEs to the concerned administrative ministry.

36.14 Impact on Pricing Policy of PSEs

Administered and controlled pricing by the government Socioeconomic objectives to be achieved Subsidies available to the public enterprise Subsidies available to the users of the enterprises products State of financial health of the enterprise Degree of control on the enterprise by the government Impact of liberalization policies of the government Government attitude towards the enterprise Nature of product/service relevance to economic condition The market structure for the product Goals of the enterprise i.e., profitability of social goal etc.

36.15 Causes of Sickness in PSEs

Short tenure of managers appointed by Government to manage these units - thus they take steps for short-term gains ignoring long-term implications - e.g. buying industrial peace ignoring long-term effects of indiscipline, giving wage rises without consideration of productivity rise, ignoring quality for production etc.A really sick company without any hope of revival cannot be kept alive for long by artificial means. Government was indeed never serious about making the PSEs profitable as the main emphasis was on employment generation and employment protection. Hence, many PSEs are highly overstaffed.


PSEs were treated as ‘state’ under Article 12 of Constitution by Supreme Court and hence employees got much more protection than that is available to other employees, which consequently led to indiscipline and low productivity. Less flexibility prevails in PSEs. Business needs quick decision and action. This is not possible in a bureaucratic organization. Psychology of human beings is basically selfish, and he can work best only when he has something personally to gain. Constant fear of CAG audit queries and parliamentary questions, which increases tendency of ‘passing the buck’ and delaying decisions.


Due to a judgment of Supreme Court, many contract labourers had to be absorbed. This has abnormally increased wage costs and efficiency is lowered. Political interference and corruption is high in PSEs.

36.16 Greenfield Privatization

The concept of ‘greenfield privatization’ refers to the following elements - reforming of PSEs, - reduction of state involvement in PSEs - reduction of PSEs involvement in nation’s economic activities and - division of industries between public sector and private sector, and - allocation of strategic activities to public sector and economic activities to private sector. The new economic policy of 1991 first introduced the break through concept of ‘greenfield privatization’, advocating the privatization of PSEs to improve its efficiency and to reduce the budgetary support and involvement of state in PSEs.

36.17 Reforming Process of PSEs De-licensing - The new industrial policy introduced by Government in 1991 has taken bold steps in liberalizing licensing policy of private sector and now many a industry need not obtain industrial licence except fulfillment of bare formalities and procedures. Reduction in Budget Allocation - Previously the inefficiency crept in PSEs has caused substantial budget allocations to meet working capital needs. Now, the PSEs are informed of self sustenance by increasing profitability and to reduce dependence on budget allocations. Anomaly in Duty Structure - The reduction in customs and excise tariff allows the indigenous industries to meet the global competition, integrating the Indian industry with global economy to enable free trade in compliance with WTO trade agreements.


Decision Making Systems - The current economic and business conditions require a quick decision making system to enable the PSEs to respond to fast changing business and market conditions. The reforming process considering the importance of decision making systems, allows the PSEs to evolve their own policies for procurement of material, investment decisions, financing decisions, pricing of products, wage structure etc. The measures for reforming the PSEs include the following: - Reforming PSEs by signing Memorandum of Understanding (MoU) and Green Field Privatization. - Selling the shares of PSEs, partly or wholly, to the private sector or to general public. - Allowing to close down PSEs, which cannot be revived.

36.18 Disinvestment

The public sector is now concentrating on selective activities and investments are focussed on strategic high-tech and essential infrastructure. Now the PSEs are signalled for self sustenance and to stop relying on government’s budgetary support. Disinvestment is a process in which the holding concern reduces its portion in equity by disposing its shareholdings. ‘Divestment’ as per SEBI (Substantial Acquisition of Shares) Guidelines, means the sale by the Central Government/State Government, of its shares or voting rights and/or control, in a PSE. Privatization means giving the entire management control over the PSE to private enterprising.


In disinvestment process, the government may retain partial control with it and disposing its holding to some extent. The disinvestment reduces the government participation in the company. Privatization is just opposite situation of nationalization. Under process of privatization, government sells their equity shares to employees, mutual funds, individual persons and their organizations. Disinvestment always forms part of privatization.

36.19 Approaches to Disinvestment Program

According to first approach, wherever government sells its equity holding in PSEs to public or private parties, financial institutions and mutual funds etc. It is called as disinvestment. According to second approach, when PSEs are generally directed by the government to issue their equity shares to the public, private parties, financial institutions and mutual funds with a view to reducing its control, that is also taken as disinvestment.

36.20 Criteria for Privatization or Liquidation

whether the objectives of the company are accomplished whether there is any decrease in number of beneficiaries whether serving the national interest will be affected on disinvestment whether the private sector can efficiently operate and manage the enterprise whether the original rate of return targeted could not be achieved whether the socioeconomic objectives lost its purpose.

36.21 Objectives of Disinvestment

Revenue collection - The government is making a way out of necessity to raise revenues for bringing down the fiscal deficit as commitment made to the IMF. Improvement in efficiency - This is being undertaken to ensure greater accountability and improved efficiency. These financial institutions and mutual funds are expected to off load them into the secondary market. Market discipline - Disinvestment is resorted to meet budgetary targets and to bring the PSEs to meet the market discipline, competitiveness and to emphasize on profitability and maximization of shareholders wealth. Resources mobilization - With the help of disinvestment program, government would be in a position to garner sufficient resources. Out of such funds, government can make available some funds as loan to PSEs.


Direct participation of public - Such disinvestment would enable the public, to participate in the equity of PSEs. Encourage employee ownership - This would encourage the employees to buy shares of PSEs and thereby become their owner also. This would ultimately develop the sense of belongingness among them. It may motivate them to work harder and improve the work culture. Reduction of bureaucratic control - With the reduced holding of the government in the equity of PSEs, the bureaucratic hold and control would also be reduced considerably.

36.22 Disinvestment Strategy

Selection of companies to be offered - The list of companies offered in the first phase of disinvestment had to be limited to those companies whose investments in market appreciates without much difficulty and price reasonably. Later on companies were categorized in three categories - A, B and C. Pricing of the equity - The pricing formula adopted for the referral price was average of NAV (Net Assets Value) and PECV (Profit-Earning Capacity Value) at 10% industry capitalization rate. This was as existence at that time. Rationale for disinvestment mechanism - A direct offer of shares to the public was not feasible because even with the most sophisticated valuation skill a fair issue price on company by company basis was possible to determine since the PSEs were unknown to the market.

36.23 Methods of Valuation of Shares in PSEs Disinvestment

Net assets value (NAV) Profit-earning capacity value (PECV) method at capitalization rate of 4% to 8%. Discounted cash flow (DCF) method based on about 5 years discounted rate.

36.24 Methods of Disinvestment

Trade sale - This recommendation involve 100% change of ownership through direct sale of shares at a fixed price. Depending on the size of the offer and the state of the capital markets, the process may need to be phased over a period of time. Strategic sale - The strategic sale transaction of a government company will consist of two elements: (a) Transfer of a block of shares to a strategic partner, and (b) Transfer of management control to the strategic partner. A strategic sale may involve selling of a (i) substantial stake with management control, or (ii) minority stake supplemented by technology transfer arrangements.


Offer of shares - This measure involves partial sale of equity ownership at a fixed price by a book-building process. The need of the PSEs for additional capital will also be taken into account by creating additional shares. The commission recommended reservation of a sizeable quantity of shares for offer to the small investors and PSE employees. Closure or Sale of assets - In case, there is no ‘investor interest’ in the company, the commission is of the view that there would be no option but to close down the operations of the company and liquidate all its assets and liabilities.

36.25 Argument in Favour of Disinvestment Process

The basic problem with PSEs is neither the quality of assets nor the skilled manpower, but the overall decision making system. These enterprises would realize true potential only when they are privatized. In private sector, the decision making process is quick and decisions are linked with the competitive market changes. The disinvestment and privatization process would bring in better corporate governance, transparency, corporate responsibility, exposure to competitive forces, improvement in work environment etc.


The market participation in capital of PSEs through stock exchanges would enable the market to discover the latent worth of PSEs. The market capitalization also increases. The loss making PSEs can be successfully revived by asking the strategic partner to infuse fresh capital and by exercising excellent management control over sick PSEs.

36.26 Arguments Against Disinvestment Process

Selling of profit making and dividend paying PSE would result in loss of regular source of income to the government. There would be chances of ‘asset stripping’ by the strategic partner. Most of PSEs have valuable assets in the shape of plant and machinery, land and buildings etc. It may be possible that the strategic partner may very well dispose of these assets, make money, leaving the PSEs as a sick enterprise. The government’s policy of disinvestment includes the disposal of both profit making, as well as, potentially viable PSEs.

36.27 Steps in Disinvestment Process

Proposals for disposal of any PSE, based on recommendations of Disinvestment Commission (DC) or Cabinet Committee on Disinvestment (CCD). After CCD clears, selection of Advisor through competitive bidding process. The Advisor assists Government of India in the preparation and issue of ‘Expression of Interest’ in newspapers. After receipt of ‘expression of interest’ from interested parties, prospective bidders are short-listed. ‘Due diligence’ by the concerned PSE.


Based on ‘due diligence’ by PSE, the Advisor prepares ‘Information Memorandum’ for giving it to the short listed bidders who has entered into a ‘Confidentiality Agreement’. Advisor, with the help of Legal Adviser, prepares Share Purchase Agreement. Discussions among Advisors, Government and Representatives of PSE. Valuation of the PSE in accordance with the standard national practice. The ‘share purchase agreement’ and ‘shareholder’s agreement’ are finalized, based on the reactions received from the prospective bidders. These agreements are then vetted by ‘Minister of Law’ and are approved by Government.


Thereafter, these are sent to prospective bidders for inviting for final bidding. The bids received are examined, analyzed and evaluated by the ‘Inter Ministerial Group’ and placed before the CCD for final approval of bids. After the transaction is completed, all papers and documents relating to it are to be turned to the ‘Comptroller and Auditor General of India’, to enable to undertake an evaluation of the disinvestment, for placing it in Parliament and releasing it to the public.


In the disinvestment process mentioned above, the ‘Department of Disinvestment’ is assisted, at each stage by ‘Inter Ministerial Group’ comprising officers from the ‘Ministry of Finance’, Department of Public Enterprises, The administrative Ministry, Department controlling PSEs (Department of HI and PE) and Officers of Department of Disinvestment and Advisors.

chapt 34

Documents

external political risk

internal political risk

high political risk

foreign bonds34

political risk34

foreign companies

country risk rating34

foreign state