India - Second Industrial Development Bank of India Project

Report No. 1158-IN FIL CA hpy Appraisal of a Proposed Loan to FILE CUOY India for a Second Line of Credit to the Industrial Development Bank of India for the State Financial Corporations May 6, 1976 Agriculture Credit & Development Finance Companies Division South Asia Projects FOR OFFICIAL USE ONLY Dpcument of the World Bank This document has a restricted distribution and may be used by recipients ont', in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS US$1.00 = Rs 8.0 * Rs 1 - US$0.125 Rs 10 million - US$125,000 Rs 1.0 billion - US$125 million Until September 24, 1975, the Rupee was officially valued at a fixed Pound Sterling rate. Since then it has been fixed against a 'basket' of currencies. As these currencies are floating, the US Dollar/Rupee exchange rate is subject to change. Conversions in this report have been made at US$1 to Rs 8.00, which was the short-term average rate prevailing at the time of appraisal. FISCAL YEARS GOI, SFCs: April 1 - March 31 RBI, IDBI: July 1 - June 30  FOR OFFICIAL USE ONLY LIST OF ACRONYMS APSFC - Andhra Pradesh State Financial Corporation AFC - Assam Financial Corporation BITCO - Bihar Industrial and Technical Consultancy Organization BSFC - Bihar State Financial Corporation CGAC - Capital Goods Adhoc Committee DCSSI - Development Commissioner of Small Scale Industry DFC - Delhi Financial Corporation DGTD - Directorate General of Technical Development GNP - Gross National Product GOI - Government of India GSFC - Gujarat State Financial Corporation HFC - Haryana Financial Corporation HPFC - Himachal Pradesh Financial Corporation HSC - Hindustan Steel Corporation ICICI - Industrial Credit and Investment Corporation of India IDBI - Industrial Development Bank of India IFCI - Industrial Finance Corporation of India IFD - Industrial Finance Department (of RBI) IIG - Inter-Institutional Group IRCI - Industrial Reconstruction Corporation of India J&KSFC - Jammu & Kashmir State Financial Corporation KFC - Kerala Financial Corporation KSFC - Karnataka State Financial Corporation KITCO - Kerala Industrial and Technical Consultancy Organization LIC - Life Insurance Corporation LRS - Liberalized Refinanced Scheme MPFC - Madhya Pradesh Financial Corporation MSFC - Maharashtra State Financial Corporation MMTC - Metals & Minerals Trade Corporation NCAER - National Council of Applied Economic Research NEITCO - North Eastern Industrial & Technical Consultancy Organization NSIC - National Small Industries Corporation OSFC - Orissa State Financial Corporation PFC - Punjab Financial Corporation RBI - Reserve Bank of India RFC - Rajasthan Financial Corporation SBI - State Bank of India SFC - State Financial Corporation SI - Small Industries Service Institute SSI - Small Scale Industries SSIC - Small Scale Industries Corporation SSIDC - State Small Industries Development Corporations SSIDO - Small Scale Industrial Development Organization STC - State Trading Corporation SIDA - Swedish International Development Agency TIIC - Tamil Nadu Industrial Investment Corporation UPFC - Uttar Pradesh Financial Corporation UTI - Unit Trust of India WBFC - West Bengal Financial Corporation This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   INDIA APPRAISAL OF A SECOND LINE OF CREDIT TO THE INDUSTRIAL DEVELOPMENT BANK OF INDIA FOR THE STATE FINANCIAL CORPORATIONS TABLE OF CONTENTS The Main Report Page No. SUMMARY AND CONCLUSIONS .............................. i-iii I. INTRODUCTION ......................................... 1 II. THE INDUSTRIAL SECTOR ................................ 1 Historical Performance ..... ............. 1 Industrial Policy ............................... 2 Recent Performance ..... ............... 3 Recent Changes in Policy and Procedures ......... 4 The Role of the Small and Medium Scale Sectors 5 The Financing of Small and Medium Scale Industries ................................. 6 III. INSTITUTIONAL FRAMFWORK .............................. 8 Organization .................................... 8 Utilization of IDA Credit ....................... 11 Characteristics of IDA Financing .... ............ 12 SFC Inspections ................................. 12 Credit Guarantee Scheme ......................... 13 IV. THE STATE FINANCIAL CORPORATIONS ......... .. .......... 14 The Role of the SFCs ............ .. .............. 14 SFC Upgrading Program ............ .. ............. 16 Summary Evaluation of SFC Operations ............ 16 Resource Mobilization ........................... 19 Policies and Procedures ........... .. ............ 20 Resource Allocation ............. .. .............. 22 Characteristics of Portfolio ........ .. .......... 23 Financial Performance ............ .. ............. 24 Relations with State Governments ........ ........ 27 Reporting Requirements ........... .. ............. 27 Prospects ....................................... 28 The report is based on an appraisal mission consisting of Messrs. M. Rowat, E. Elejalde, N. Fostvedt and E. Njomo that visited India in May/June 1975.  Page No. V. OBJECTIVES OF THE CREDIT ......................... 29 VI. THE PROPOSED LENDING SCHEME ......... ............. 29 Volume I - INDUSTRIAL DEVELOPMENT BANK OF INDIA* Volumes II and III - ASSESSMENT OF INDIVIDUAL SFCS* *Volume I contains an assessment of the present position, prospects, and role in the economy of the Industrial Development Bank of India to complement the analysis of its refinance activit:Les presented in this main report. It also analyzes the institutional framework for industrial financing in India. Volumes II and III evaluate separately each of the 18 State Financial Corpora- tions and contain specific recommendations for improving their activities. All the issues that are relevant to the proposed credit are discussed in this main report. Therefore, Volumes I to III will be made available only on request.  ANNEXES 1. State-wise position of Term Loans (including installment credits) granted by scheduled commercial banks to small scale industries 2. IDBI - Organization Chart 3. Summary Statement showing progress in the utilization of IDA Credit as on February 29, 1976 4. Classification of Refinance Assistance sanctioned by Size and Industry under the IDA Line of Credit as of June 30, 1975 5. SFC-wise break-up of applications received/sanctioned/withdrawn rejected and closed/pending under IDA Credit as on February 29, 1976 6. SFC-wise break-up of assistance disbursed by SFCs under IDA Credit upto February 29, 1976 7. IDA Credit - Proposals cleared by CGAC upto meeting held on February 29, 1976 8. SFCs - Financial and Economic Data on a Sample of IDBI Subprojects 9. Position of claim applications (Credit Guarantee Scheme) from State Financial Corporations as of June 30, 1975 10. Summarized list of main shareholders for all SFCs as of March 31, 1975 11. Summary of SFCs Staffing Pattern as of December 31, 1974 12. Summary of Financial Resources as of March 31, 1975 13. Summary of Operations FY73-FY75 14. SFC Loans sanctioned by size of unit and by State (FY75) 15. Analysis of Arrears to SFCs as of March 31, 1975 16. Summary of SFC's Comparative Operational Ratios, FY73-FY75 17. Estimated Disbursement Schedule for the Proposed Loan.   INDIA APPRAISAL FOR A PROPOSED LOAN TO INDIA FOR A SECOND LINE OF CREDIT TO THE INDUSTRIAL DEVELOPMENT BANK OF INDIA FOR THE STATE FINANCIAL CORPORATIONS SUMMARY AND CONCLUSIONS i. GOI has placed considerable emphasis on the promotion of small scale industry (SSI) since the mid-1950's as a means of increasing employment particularly amongst new entrepreneurs, income distribution and regional dev- elopment. This has included the provision of substantial incentives such as lower interest rates and margin on loans, a list of 124 industries reserved exclusively for SSI, and a generous credit guarantee scheme. The SSI sub- sector was the subject of a Bank Study in 1971 though much of the data col- lected was considered unreliable. GOI is presently completing a new census on SSI which should be available in the middle of 1976. This should form the basis for a study which GOI will carry out to determine the financial and economic efficiency of selected industrial subsectors reserved for SSI in relation to the level of Government incentives. ii. GOI's initial instruments for financing the small scale industrial sector defined as investment in plant and machinery of less than Rs 1 million) were the State Financial Corporations (SFCs), most of which were established in the late 1950s to provide financing to the small scale as well as the lower portion of the medium scale sector. During the 1960s, the commer- cial banks also became actively involved in financing SSI primarily through working capital loans. Nevertheless, term lending by commercial banks was only 75% that of the SFCs in 1974. iii. Until 1973, Bank Group financing of industrial investment has consisted of medium and large scale units either through direct financing or through the financing of the Industrial Credit and Investment Corporation of India (ICICI). However, in view of the importance of SSI, a new project was developed to reach this industrial sub-sector for the first time. Speci- fically, an IDA Credit of $25 million was channelled through the Industrial Development Bank of India (IDBI) to 18 SFCs for relending to small and small- medium scale industry. A second and equally important objective of the Credit was to upgrade SFCs through specific institution-building programs. This report appraises a repeat project involving a $40 million proposed Bank loan. The objectives of this Loan are (i) to expand financial assistance to the small and medium scale industrial sectors and (ii) to contribute to the on- going institutional upgrading of the SFCs. iv. IDBI is the largest industrial development bank in India and is GOI's instrument as the apex institution for all other financial intermedi- aries. Aside from its many other activities, IDBI provides refinance  - ii - facilities to SFCs as well as other financial institutions. Under the existing Credit, IDA finances the estimated average foreign exchange content (60%) of SFC loans refinanced by IDB[. As of April 21, 1976, slightly less than $23 million had been authorized for some 400 subprojects, and $6.1 mil- lion disbursed. v. SFCs are responsible for providing medium and long term finance, underwriting facilities and guarantees to small and medium scale industrial units, and had total outstandings of Rs 2.8 billion as of March 31, 1975. At the time of the first Credit, SFCs suffered from a number of weaknesses, including shortcomings in the qualityr of management and staff, inadequate procedures and appraisal standards, high arrears and inadequate provisions for possible losses. In order to provide for improvements, specific up- grading programs were developed by I)BI, and the Industrial Finance Depart- ment (IFD) of RBI which until recently was responsible for the inspection of SFCs. These were agreed with IDA during negotiations in 1972. Since then, considerable progress has been made, particularly in management, general operational procedures, and appraisal standards. However, other areas such as the quality of portfoliLo have shown little improvement largely due to the general economic downturn in 1974. vi. In addition, over the past two years the upgrading programs them- selves have been found to be insufficiently detailed and not broad enough in scope. Accordingly, revised upgrading programs were prepared by IDBI/IFD in March/April 1975 based on recommenidations by IDA. These programs, along with the debt service coverage limitation (para 4.35) will form the basis for an agreement between IDBI and each SFC to enable the latter to be eligi- ble for withdrawal under the proposed loan. In addition, the Bank has spelled out a number of recommendations tailored to the needs of each SFC. These recommendations will not form a part of the upgrading program per se, but IDBI and the SFCs will implement the recommendations to the maximum extent feasible and IDBI will include a revi.ew of them in its annual reports to the Bank on the SFCs. On February 16, 1976, the ownership of IDBI passed from the Reserve Bank of India (RBI) by GOI. With this change, most of IFD's activities have been transferred to I:DBI, and this should provide a more effective means to monitor the performance of SFCs. IDBI is in the process of reorganizing and decentralizing its operations. This should improve its capability to fulfill its functions in an effective way. vii. The proposed Bank loan of $;40 million is expected to meet the estimated foreign exchange requirements of the SFCs for the two-year period beginning July 1, 1976, the date by which the first Credit was expected to be fully committed. As of April ?1, 1q76, there was slightly more than US$2 million left uncommitted. The proposed project would be similar to the present Credit except that it is recommended that (a) the free limit be increased to Rs 2.5 million for selected SFCs where IDA has authorized at least two projects above the present free limit of Rs 1 million and (b) in  - ili - the case of loans to SSI, technician entrepreneurs and for projects in back- ward areas, the proceeds of the loan would be onlent by IDBI to the SFCs at 8.0%, and relent to SFC borrowers at not less than 11.5%. In the case of all other lending, the corresponding rates would be 8.75% and not less than 12.0%. GOI would onlend the Bank loan to IDBI on terms satisfactory to the Bank which are proposed at 7.75% (excluding 0.25% rebate for prompt payment) for all types of lending.   INDIA APPRAISAL FOR A PROPOSED LOAN TO INDIA FOR A SECOND LINE OF CREDIT TO THE INDUSTRIAL DEVELOPMENT BANK OF INDIA FOR THE STATE FINANCIAL CORPORATIONS I. INTRODUCTION 1.01 The Industrial Development Bank of India (IDBI), which is fully owned by the Government of India (GOI) 1/ has requested through GOI a loan for a second line of credit to be relent to 18 State Financial Corporations (SFCs) for refinancing the estimated foreign exchange content of SFC loans for small and medium scale industry. The loan would also assist in the continuous upgrading programs of individual SFCs. As of April 21, 1976, slightly less than US$23 million of the initial $25 million (Credit 356-IN) had been authorized by IDA for some 400 subprojects and $6.1 million dis- bursed. It is expected that the balance will be authorized by May/June 1976, and that by June 1976 disbursements of approximately $7 million will have taken place. 2/ Consequently, a second project of $40 million to meet the estimated foreign exchange content of SFC loans for the two-year period beginning July 1, 1976 is recommended. Such a loan would be consistent with GOI1's obJectives of promoting the small and medium-scale industrial sectors and at the same time, would continue to support the institution- building efforts within SFCs presently being undertaken by IDBI. II. THE INDUSTRIAL SECTOR 2.01 An assessment of India's present economic position is contained in the Bank's latest Economic Report No. 1073-IN dated March 29, 1976. In addition, an evaluation of the overall framework for industrial financing is contained in Volume I to this report. Historical Performance 2.02 India's industrial output has grown on average by little more than 3% per annum since 1965, which is almost the same growth as that of NNP. Both demand and supply factors have constrained the sector's expansion. Of the four possible engines of growth on the side of demand, namely exports, import substitution, derived demand from the growth of other major sectors, 1/ Previously, IDBI was a wholly owned subsidiary of the Reserve Bank of India (RBI), but ownership was transferred to GOI as a result of the implementation of the Public Financial Institutions Law (Amendment) Act on February 16, 1976 hereafter referred to as the IDBI Act. 2/ The final date for acceptance of subproject applications was extended from June 30, 1975 to March 31, 1976.  and government investment, all have been weak. Import substitution, where reasonably simple, was virtually compllete by the middle 60s; exports have never been a major factor, accounting even now for only 10% of the output of engineering goods, for example; the relatively slow growth trend of agri- culture of little more than 2% has restricted growth in demand for consumer goods; and, finally, government real investment has remained stagnant. Industrial growth has also been periodically constrained by transport bottlenecks, and by shortages of power, which was especially severe in 1973 and 1974, and of raw materials siuch as steel, other metals, and agri- cultural inputs like cotton. Since these raw materials are tradeable goods, the latter shortages are merely a specific manifestation of the scarcity of foreign exchange. 2.03 The Government dominates production in steel, heavy plant and machinery, mining, power generation, and increasingly in aluminum, ferro- alloys, machine tools, fertilizers, and other "basic" industries. Con- sequently according to the 1970 Annual Survey of Industry, the public sector accounted for 60% of productive capacity. However, it generated only 22Z of value added. This relationship cannot be explained solely by the capital intensity of these industries, but is also the result of low capacity utilization - itself partly caused by poor management. However, low capa- city utilization has also been a problem in the private sector, mainly as a result of supply shortages and to a certain extent from lack of demand especially for capital goods. 2.04 There have been slow shifts in the structure of industrial pro- duction, in accordance with the aims of industrial strategy. In 1960, 40% of output was of textiles and processed foods. This had fallen to 25% by 1970. Instead "basic industries", engineering goods and chemicals, had risen to 40%. However, since 1965 the structural change has been quite slow, and there has even been a decline in the share of capital goods in industrial production. Industrial Policy 2.05 The Government has placed central emphasis on rapid industrializa- tion as the key to development. Its goals in industrial policy have also included both greater equality and national self-sufficiency. The aim of inhibiting concentration of economic lpower has been approached through ex- panded public ownership, restrictions on the growth of "large houses" and "dominant undertakings"; reservation of many products to the small-scale sector as well as special assistance to it; and, finally, support for development in backward regions. The aim of self-sufficiency has largely manifested itself in the relentless pursuit of import substitution, as well as curtailment of foreign owned firms and other forms of foreign involve- ment in industry. 2.06 The last decade must be regarded as a disappointment, as far as the achievement of the key aim of rapiLd growth is concerned. While there has been some progress towards the other goals, it is far from evident  - 3 - that, in a wider context, such progress should be regarded as conducive to production. Import substitution was clearly a major and successful spur to growth up until the middle 1960s, but since then the high cost inefficient industries that have been created have acted as a major impediment to ex- pansion of exports. Since the latter offers one of the few means of accelerating growth, this is a significant cost. The emphasis on indepen- dence from outside technology, when combined with the fragmentation of industry and consequent limitations on domestic product development, has frequently resulted in the production of outmoded industrial goods. Al- though such goods may often not be inappropriate for Indian circumstances, they are difficult to export. The control of large houses and the encourage- ment of the small-scale sector has had effects on income distribution which are simply unknown. 2.07 The main instruments of industrial policy have been central licensing of investment and imports, as well as physical allocation of "scarce" domestically produced raw materials, and controls on industrial prices. This system has itself tended to conflict with other aims, especially that of curbs on economic concentration since large firms are much better able to bear the overhead costs of dealing with a centralized bureaucracy. Controls have also restricted the ability of firms to respond to changed opportunities, especially in overseas markets, and thus hampered exports. The extent of excess capacity indicates that the planning supposed to underlie the industrial licensing system has been far from fully success- ful. Finally, price controls appear to have had a harmful effect on invest- ment and modernization in such crucial industries as cotton textiles, sugar, and cement. Recent Performance 2.08 In 1973/74 industry grew by 1%, and in 1974/75 growth was 2.5%. Through these years, the major effective constraint appears to have been that of raw material supply. However, the situation changed rather dramatic- ally during 1975 and demand is currently the more serious problem. The improvement in supply of inputs has been partly the result of large increases in the output of key public industries, especially steel and coal. Steel ouput rose from 4.5 million tons in 1973/74 to 4.9 million tons in 1974/75 and is expected to rise by a further 1 million tons in1975/76. After years of stagnation, coal output rose by 13.5% in 1974/75, or by about 10 million tons, and is expected to rise by a further 10 million tons in 1975/76. (This improvement in performance has, in fact, been a feature of quite a large number of public sector enterprises). The rise in production of coal combined with good rains has led to increases in power generation which are expected to be of the order of 20% in 1975/76. Finally, increased aid disbursements as well as improved export performance have been the main factors in reducing the foreign exchange constraint, as perceived by the Government and have allowed a marked liberalization of import controls.  2.09 Thus, major constraints on supply have been reduced or removed, while 1975/76 is clearly going to be a record year for agricultural pro- duction. Industrial growth for 1975/76 should reach 4 to 5%. While a major expansion of intermediate output has occurred, there has been a fall in the domestic demand for many industrial goods. However, this conjunction has at least had a positive effect on. exports, especially of steel, which will be about one million tons. Weak domestic demand has been partly the result of a tight credit policy motivated by the overwhelming desire to curb inflation. Commercial credit during the first part of 1975/76 grew by only 2%. In addition, the very success of counter-inflationary policy has in- creased enormously the real cost of holding inventories and this, in combina- tion with action against "smugglers, hoarders, and black-marketeers", appears to have led to a marked fall in holding of stocks. At the same time, there has been a lag between increased agricultural income and a rise in consumer demand. Export demand has been weak and in some sectors, such as jute and cotton textiles, disastrously so. Finally, increased real public sector development expenditures have not yet significantly affected the capital goods sector, and private investment demand continues to be in the doldrums. However, in 1976/77 increased consumer demand, required by tax reductions in the budget, and increased public development expenditure, combined with the easy availability of raw materials could lead to accelerated growth. Recent Changes in Policy and Procedures 2.10 In the face of poor industrial performance and much underutilized or inefficiently utilized capacity, the Government has been reconsidering parts of its strategy. It is increasingly acknowledged that existing capa- city must be utilized more efficiently; that public sector enterprises should be expected to meet more commetrcially oriented criteria for output, price, and profitability; and that with the slow growth of the domestic economy, industry can only expand at a reasonable rate through exporting. 2.11 The process of revising policy has been taking place for some time, but the first discernible signs; emerged in 1972. Subsequently, the Government has introduced measures to simplify procedures and to introduce more flexibility. By now, licensing of new capacity and of expansion for exports is freely available; in the case of enterprises belonging to large industrial houses and foreign majority companies, export obligations are set. For the domestic market, licenses are also freely available, except for industries reserved for the small scale sector, and except for the large industrial houses and foreign miajority companies which are confined to a priority list of industries, which has, in fact, been fairly broadly defined. Processing time for license!s has been very much reduced so that the obstacle posed by licensing procedures has been virtually eliminated for all except the large houses and foreign majority companies, and even for them there are fewer hurdles. By the beginning of 1975, price control had been lifted from all finished manufactures. Certain intermediate products are still subject to formal price controls largely as a result of the fact that the Government is the main producer. Distribution control on industrial materials has been lifted for almost all items.  - 5 - 2.12 These various changes mark a significant effort on the part of Government, but the major structural problems of the sector remain. In summary form, these are that many public sector undertakings still have a long way to go before they become efficient producers. The private sector will be the main source of exports. Thus, structural changes to improve competitiveness will be vital. These may require adjustment in policies that lead to industrial fragmentation and inadequate expansion of efficient firms. The dilemma before the Government is to formulate this strategy in a way that is still consistent with its social goals. The Role of the Small and Medium Scale Sectors 2.13 GOI has placed considerable emphasis on promoting both of these sectors, particularly the small scale sector 1/, to increase employment 2/, income distribution, and regional development. 2.14 The small-scale industrial sector (SSI) in India was the subject of a Bank study in 1971 in cooperation with the Swedish International Develop- ment Authority (SIDA) and the National Council of Applied Economic Research (NCAER) of India. Report No. SA-33a entitled "Small Scale Industry in India" dated May 22, 1972 summarized their findings. This report described the industrial sector (SSI), its present source of financing, made an assessment of its economic importance in relation to the total industrial sector and attempted to evaluate the policy framework for SSI. Most of the data per- taining to SSI are based on the Annual Survey of Industry (1970) which is now considered to be unreliable. However, GOI is presently conducting a census of the small-scale sector, the results of which should be available in the middle of 1976. 2.15 This is of critical importance since there is insufficient informa- tion available at present on the size, structure, growth and economic effi- ciency of SSI in order to evaluate in a meaningful way GOI's policies in this subsector. Specifically, SSI units have been granted a variety of incentives including lower rates of interest and security margin on loans, government procurement of SSI output at favorable prices, simplified licensing pro- cedures, and the availability of a Credit Guarantee Scheme (para 3.20-3.22). In addition, GOI has reserved a list of 124 manufactured items exclusively for SSI. It is possible that GOI's overall incentive scheme has perhaps been over-generous. To explore this question further, GOI will complete within a year a study of the financial and economic efficiency of SSI in selected subsectors in relation to the level of incentives SSI presently receives. GOI has also launched a "Program of Modernization for Selected Small Scale Industries" with the objective of improving the productivity of small scale 1/ In June 1975, GOI amended its definition of SSI to include units with investment in plant and machinery of less than Rs 1 million (excluding cottage industries) and Rs 1.5 million for ancillaries. The "old" definitions of Rs 750,000 and Rs 1 million respectively are used in the statistical references throughout the report. 2/ It is estimated that SSI employes about 4 million people.  - 6 - enterprises (including quality improvement and cost reductions) to contri- bute to a better export performance. The total cost of the program would be Rs 4.9 billion over 5 years to finance the purchase of equipment, raw materials and technical assistance. This would also be more effectively evaluated once the new census is available. 2.16 Investment, however, cannot and should not come to a standstill while studies are conducted to assess and evaluate the impact of Government policies. To the extent that there are questions and doubts about policies, however, it is all the more important to ensure that new investments are directed to activities which are economically sound and financially viable. The experience under the first IDBI/SFC project has demonstrated that such projects exist in the small and mediumn scale sector and that properly strengthened State Financial Croporations (SFCs) can be instrumental in identifying and appraising these projects. Ultimately, of course, the ex- perience of the SFCs (their successes as well as their failures) will pro- vide valuable data by which to assess the effectiveness of the policy frame- work. Indeed, the study referred to (para 2.15) should make considerable use of the data already accumulated by the SFCs. The Financing of Small and Medium Scale Industries 2.17 State Level Institutions. The financing of small-scale and the smaller end of medium-scale industry has largely been undertaken by State- level institutions and the commercial banks 1/. The State Financial Corpora- tions (SFCs) have been the most important sources of term loans over the years, having accounted for Rs 2.8 billion in outstanding as of March 31, 1975 2/. Moreover, the Small Scale Iridustrial Corporations (SSICs) also provide a modest amount of financial aLssistance through hire purchase finance. Hire purchase finance for bcoth imported and domestic equipment is also provided by the National Small Industries Corporation (NSIC) on an all-India basis, and amounted to Rs 47.2 million in FY75. 2.18 Commercial Banks. Historically, commercial banks in India have played an important role in financing industry, both medium- and large- scale as well as small-scale. Since 1969, when 14 commercial banks were nationalized, lending by commercial baLnks has become a more direct instru- ment of Government industrial policy (though this emphasis had already begun several years before nationalization) in that priority has been given to financing the small-scale sector, and also to establishing a sufficient branch network to cater to this group. At the same time, outstanding credit to the small-scale sector increased from Rs 2.9 billion in June 1969 to Rs 7.5 billion as of September 1973. The proportion of total bank lending to small industries increased from 7.9% in June 1969 to 11.9% in September 1973. In the case of branch development, commercial banks had 8,632 branches in 1969, and in the past five years the number has doubled to 16,936. 1/ The all-India financial intermediaries (para 2.20) also finance medium scale industry but have tended to finance only those projects that are beyond the limit of the SFCs (paras 3.05 and 6.04). 2/ A detailed discussion of the SFCs is contained in Chapter 4.  2.19 The commercial banks have also become active in term lending. As of June 1974, the scheduled commercial banks had Rs 1.6 billion in term loans outstanding to the small-scale sector, which is about one-half the Rs 2.8 billion in total outstanding financial assistance by the SFCs at March 31, 1975 (Annex 1). The former represented loans to about 45,000 small-scale enterprises. The rate of interest charged by commercial banks has gradually increased over the past few years, ranging between 12.5% and 15% in FY75, the lower rate representing the minimum that can be charged except for some specific priority sectors. Penalty fees in some cases were as high as 4%. For term loans, maturities were generally up to seven years. The higher interest rates stem from GOI's policy of credit restraint, which has forced commercial banks to make more active use of IDBI's refinance facilities (para 3.09). 2.20 Given the perhaps excessive number of financial intermediaries, there is considerable need in most states for improved coordination amongst state-level institutions involved in small and medium scale assistance including SFCs, SSICs, commercial banks, SIDCs 1/, SISIs, as well as with the all-India financial intermediaries including ICICI, 2/ IDBI, IFCI, 3/ LIC 4/, UTI, 5/ and NSIC. GOI and IDBI intenid as a first step to revive Inter- Institutional Group (IIG) meetings (in those states where they are dormant). Secondly, mechanisms for coordination at the small-scale level will be adopted, including cross-representation on Boards of Directors and periodic meetings to review joint financing proposals and clients in arrears, when this is not already being done. 2.22 Technical Assistance. SSI technical assistance is available from a variety of sources. A Ford Foundation recommendation in 1954 led to the establishment of a GOI project authority for SSI which came to be known as SSIDO 6/, headed by a Development Commissioner for Small-Scale Industry (DCSSI). This institution was designed to coordinate the development of SSI through promotional work, training, publicity and export promotion, though the institution has never had more than an advisory role. SSIDO is represented at the State level by 16 Small Industries Service Institutes (SISI), as well as by the State Director of Industries, the former providing technical and economic assistance to entrepreneurs. In a few States, the quality of work appears to be reasonably good, though by and large the SISI units including their branches and extension centers need improvement. This should be accomplished in conjunction with the Modernization Program (para 2.15). Commercial banks have also begun to become active in technical assistance of a managerial nature which has been pioneered by the First National City Bank and the State Bank of India. Finally, the SFC's pro- vide a modest amount of technical assistance as part of their routine follow-up work. 1/ State Industrial Development Corporation. 2/ Industrial Credit and Investment Corporation of India. 3/ Industrial Finance Corporation of India. 4/ Life Insurance Corporation. 5/ Unit Trust of India. 6/ Small Scale Industrial Development Organization.  - 8 -- III. INSTITUTIONA]. FRAMEWORK Organization 3.01 Prior to the implementation of the revised IDBI Act in February 1976, the institutional mechanism for providing assistance to the small and riedium-scale sectors involved the RefiLnance Department of IDBI, 1/ the Industrial Finance Department (IFD) of- RBI, and the SFCs themselves. In summary, the Refinance Department was responsible for the full processing of all SFC loan applications, while IFD was responsible for the inspection of SFCs through periodic visits, for iinstitution building and for operation of the Credit Guarantee Scheme (paras 3.20-3.22). 3.02 At the time of the first project the plan was to create three divisions wThin the Refinance Department in the Bombay Office (Appraisal, Operations, and Follow-up). However, up to the time of the implementation of the IDBI Act, IDBI had created only an IDA cell to handle those applications falling under the IDA Credit, while no other reorganization had taken place based on the uncertainty of the then pending IDBI Bill. IFD's reorganization was likewise postponed. 3.03 As a result of the implementation of the IDBI Act, the functions of IFD, except for the operation of the Credit Guarantee Scheme, have been transferred from RBI to IDBI. At the same time, IDBI has been reorganized. The new organization chart is shown in Annex 2. There are now three depart- ments of special importance for the SFCs. (a) The SFC Department, covering the SFCs and other State level agencies, which will be responsible for policy questions and inspections; (b) The Refinance Department, covering domestic refinance projects; (c) The Import Loans Department, covering, inter alia, all refinance in foreign currency, including the Bank/IDA projects. In addition, IDBI has decentralized iits operations to a considerable extent. For refinance cases, the regional offLces have now been delegated authority up to Rs 3 million, compared to Rs 300,000 2/ previously. Since, under the SFC Act, the SFCs cannot sanction loans of more than Rs 3 million, all re- finance cases will be decided in the regional offices, which should greatly assist the implementation of this project. 1/ A detailed discussion of the IDBI is contained in Volume I. This volume reflects the position prior to the implementation of the revised IDBI Act. A report, discussing the present status of the IDBI, is under preparation in connection with the proposed Credit to IDBI for its direct lending operations. 2/ The Deputy General Manager at the New Delhi regional office had sanctioning powers up to Rs 500,000.  - 9 - 3.04 IDBI refinances loans with a minimum maturity of 3 years (since amended, para 3.10, footnote 1) granted to industrial concerns by SFCs, com- mercial banks, cooperative banks and any other notified institutions. Historically, SFCs have been the largest users of the facility, though com- mercial banks have had to make more use of it recently on account of the credit squeeze. It is anticipated that once the credit squeeze has eased, the commercial banks will, by and large, revert back to using their own funds to finance industrial investment. 3.05 Policies. IDBI's policies on refinance are as follows: (a) The extent to which it refinances a single financial institution is normally limited to three times the institution's equity. (b) All types of industrial enterprises are eligible. However, primary consideration is given to private sector enterprises with a net worth of less than Rs 25 million. (c) The purpose of the loan to be refinanced is normally limited to the acquisition of fixed assets, but a portion of the loan may also be for working capital required on a term basis. (d) The minimum size of loans to be refinanced is Rs 0.2 million in normal cases, Rs 20,000 for loans to small road transport operators, and Rs 10,000 for loans to small-scale enterprises guaranteed under the Credit Guarantee Scheme. (e) It normally refinances up to 80% of the original loan amount but the coverage can go up to 100% for small- scale enterprises and projects in backward areas. (f) The credit risk is fully assumed by the financial institution which directly lends to the industrial enterprise. 3.06 Staff. Over the past two years, the professional staff in the old Refinance Department (excluding Regional Offices) had increased from 29 to 39. However, it was still understaffed, not only in terms of original expectations, but also because of the enormous increase in applications in the past year due to the credit squeeze (para 3.09). Thus, it was considered essential that IDBI increased the staff doing refinance work to handle the increased workload. The implications in terms of staffing requirements of IDBI's reorganization are not yet clear. However, the decentralization should reduce significantly the burden on the Bombay office, whereas the need for staff in the regional offices has increased (para 3.07).  - 10 -. 3.07 Regional Offices. IDBI has three regional offices, plus the Bombay Office. Now, a new regional office in Ahmedabad, to cover the country's Western Region will be established. These offices are responsible for ongoing contact with SFCs in their respective regions. Included in this are the receipt, processing, ratification and follow-up action on all applications for refinance. Previously, regional managers had sanctioning powers on appli- cations up to Rs 300,000 (New Delhi Rs 500,000), while all other applications were forwarded to Head Office. Now, all sanctions except in special cases will be decided in the regional offices. In 1976 IDBI introduced a liberalized refinance scheme (LRS), which enabled It to grant on a near automatic basis refinance of loans up to Rs 200,000 to SSI units covered under the Credit Guarantee Scheme and to small road transport operators. This was extended to commercial banks on February 1, 1975. 3.08 Before the reorganization, the number of staff devoted to refinance activities at the regional offices appeared to be grossly inadequate, and had led to a large backlog in the processing of applications (para 3.09). The New Delhi, Calcutta, and Madras Offices had only two staff each devoted to the processing of refinance cases. The reorganization will lead to an even greater need for additional staff in the regional offices. IDBI has confirmed that these offices will be strengthened with more technical and financial officers, as well as with other supporting staff. This will be done gradually on the basis of the work load. An export credit cell, hand- ling, inter alia, Bank/IDA refinance cases, will be set up immediately in all regional offices. There will be at least two officers in each regional office handling Bank/IDA cases which appears sufficient. 3.09 Refinance Operational Results. 8,870 applications under the refinance scheme were received in FY75, or more than double the level in FY74 (4,353). 1/ Thus, total sanctions increased from Rs 419 million (2,665) in FY74 to Rs 1.1 billion (6,390) in FY75. Disbursements increased from Rs 277 million to Rs 524 million. This substantial growth placed an usually heavy burden on the staff. During FY75, 1,481 applications were either rejected or withdrawn compared to 1,144 in FY74. At the end of March 1975, there were 1,802 refinance applications pending with IDBI (including Regional Offices) compared to 778 at the same time the previous year. The only region to show an absolute improvement in processing was the New Delhi Office where the Deputy General Manager had the highest sanctioning power and had also attempted to streamline processing procedures. 1/ SFCs accounted for 73% of such assistance in FY75 with the balance represented by commercial banks, t;he latter the result of the credit squeeze.  - 1 1 - Utilization of IDA Credit 3.10 Procedural Reform. GOI procedures for clearance of the importation of capital equipment under the IDA Credit were considerably improved and liberalized in 1972/73. Their main aspects are: 1/ (a) Irrespective of the size of the loan or the value of imports, all proposals are now considered by the Capital Goods Ad Hoc Committee (CGAC) which meets every week; (b) Applications involving imports of small value (Rs 0.75 million or less) bypass the advertising procedure which was previously required to certify domestic non- availability of the machinery; (c) The SFC concerned is now entitled to issue the "essentiality certificate" 2/ for the proposed machinery in lieu of the State Government; and (d) IDBI's New Delhi Office is assigned the secretarial work for the CGAC, preparing a summary for each application, attending the CGAC meetings and keeping liaison with the Government Ministries, SFCs and applicants. 3.11 Operational Results. On the basis of the estimates of the foreign exchange content of the first 150 subprojects under the first Credit, IDA agreed to increase its refinance percentage from 40% to 60% in March 1975. At the end of February 1976 SFC sanctions for projects eligible under the IDA scheme amounted to Rs 370 million (551 projects). IDBI's refinance of such projects amounted to Rs 314 million (416 projects), for which it had obtained authorization of about US$19.4 million equivalent. A detailed statement of the progress in the utilization of the IDA Credit is contained in Annex 3. As of April 21, 1976, the authorizations had increased to slightly less than US$23 million, and the remainder was expected to be authorized by May/June 1976. As of February 29, 1976 disbursements by SFCs amounted to Rs 124 million, while IDA disbursements as of April 21, 1976 amounted to $6.1 million. 1/ In addition, IDBI itself has instituted a few reforms under the IDA Credit including: (i) reduction of the minimum limit of loan for availability of refinance for medium-scale units from Rs 200,000 to Rs 10,000; (ii) reduction of the minimum period of loan from 3 years to 12-18 months and (iii) allowing refinance for acquisition of second-hand machinery. 2/ Provides specific reason for the need to import a certain type of equipment.  - 12; - Characteristics of IDA Financing 3.12 Size of Assistance. A breakdown of IDA assistance by size of loan is contained in Annex 4, and indicates that 80% of all sanctions (gross) by number and 63% by amount iLnvolved assistance of less than Rs 1 million. 3.13 Industrial Distribution. The distribution has been reasonably diversified with the engineering subsector accounting for 25.7% of the total by amount followed by electrical machinery and appliances with 15.8% (Annex 4). 3.14 SFC. The largest recipienit of the IDA Credit has been MSFC (Maharashtra), which has accounted for sanctions of Rs 80.7 million (189 projects), followed by TIIC (Tamil Nadu) with Rs 68.4 million (85 projects). At the other end of the scale, J&K SIFC (Jammu and Kashmir) has sanctioned only two loans for Rs 0.6 million (Annex 5). The breakdown of disbursements follows a similar pattern (Annex 6), except that KSFC (Karnataka) has dis- bursed the most assistance so far. The number of import license applications cleared by the CGAC as of February 2'9, 1976 is given in Annex 7. 3.15 Size of Unit. As of April 30, 1975, 59% by number and 38% by amount of IDBI sanctions under the IDA Credit involved small-scale units. 3.16 Economic Impact. Annex 8 shows the ex-ante financial and economic data on a sample of 68 subprojects submitted to IDA for prior approval under the first line of credit. The internal rate of return was expected to be above 20% in 75% of the cases, with an unweighted average of 29%. The domestic resource cost (US dollar earned/saved) was calculated at below Rs 6.00 in 25% of the cases, and above Rs 9.00 in only 16%, with an un- weighted average of Rs 6.90. The average cost per job was $10,700; how- ever, it was below $5,000 in 29% of the cases. In addition, in a sample study of 76 projects accounting for about 49% of the total IDA refinance up to June 30, 1975, IDBI estimated that the total value of output per annum at full capacity would be expected to reach Rs 677 million with a net value added of Rs 162 million, while exports should reach Rs 37 million/ annum. SFC Inspections 3.17 Timing. When the IDA Credit was negotiated, it was understood SFCs should be inspected once every two years. For the period July 1973 to May 1975, IFD was able to mount 15 inspection visits. Three SFCs (Punjab, Uttar Pradesh, and Haryana) were not inspected over this period, though this overall record is still a substantial improvement over past performance. After the reorganization, inspections are the responsibility of IDBI.  13 - 3.18 Procedures. Previously, SFC inspections were undertaken by the Regional Office staff of IFD. Now, they will be conducted mostly from the IDBI Head Office. To begin with, there will be four inspection teams of three men each (two for small SFCs). The SFCs will be inspected once every two years. However, short on-the-spot inspections of the SFCs may also be carried out from time to time. Previously, it took about 16 months on average from inspection to finalization of the report, which was then sent to the respective State Government/SFC and all regional offices for implementation. The intervening steps included inspection (1-1/2 months), report writing (three months), report editing at Regional Office (two months), review and approval at Central Office (one month) and approval by RBI Deputy Governor (2-1/2 months). Clearly, the time taken to provide feedback to the SFCs was excessively long. Now IDBI intends that the inspection procedures will be completely reorganized and the inspection reports standardized. It is the intention that the inspection time, from the commencement of the inspection to the finalization of the report, will not normally be more than six months. 3.19 Inspection Substance. Past inspection reports have suffered from a lack of coverage on major issues (general policies of SFC, organi- zational structure, appraisal standards), and have rather focussed on more detailed accounting issues, reflecting the "inspection" bias of RBI (para 4.04). Further, IFD did not make sufficient effort to provide timely and substantive feedback to SFCs on their progress in fulfilling the up- grading program. However, IFD recently developed new, broader inspection guidelines which have been reviewed by IDA and were found satisfactory. Credit Guarantee Scheme 3.20 The Scheme was enlarged in 1970, and at present roughly 200 financial institutions make use of it to cover credit risks related to working capital and term loans, letters of credit, and guarantees for all industries, except transport and electric power. The Scheme provides for a payment of up to 75% of the amount in default or the amount guaranteed, whichever is lower. However, the maximum amount receivable is Rs 750,000 for working capital 1/ loans and an additional Rs 250,000 for term loans. A guarantee fee of 0.1% is required, and is normally absorbed by the financial institution rather than passed on to the ultimate borrower. Guarantees outstanding increased from Rs 10.3 billion as of March 1973 to Rs 16.1 billion as of December 1974. Rs 12.3 million was paid to credit institutions covering 983 claims between July 1960 (when the Scheme was introduced) and December 1974. There was an increase in claims pending from the end of December 1972 (Rs 13.5 million or 7.6Z of total advances in default) to the end of December 1973 (Rs 25.5 million or 9.7% of total advances in default). In April 1974, the Scheme was again liberalized for technician/entrepreneurs whose cover was increased to 90% from 75% for the first five years after disbursement, subject to a maximum loan of Rs 300,000 per borrower. Further, the Scheme was extended to cover 1/ Increased to Rs 1.25 million in 1975 on a two-year experimental basis for financing in conjunction with IRCI.  - 14 - industrial cooperative societies functioning as production cum-sales units provided the original investment in plant and machinery of the society and all its members did not exceed Rs 750,000. This latter liberalization is expected to increase the flow of institutional credit to a large number of handloom and powerloom societies. 3.21 At the end of 1975 IFD had 84 professional staff assigned to credit guarantee work, of whom 71 were in the regional offices. Claims are initially handled in IFD's regional offices and are then transmitted to the Central Office for approval. There have been a number of complaints about the functioning of the Scheme on the grounds that it took too long for IFD to clear claim requests because of its predilection to ask an excessive number of questions. Part of the problem related to the inadequacy of IFD's claim forms, which are under review by IFD. Further, until recently it was un- clear to SFCs what steps they had to take with a defaulting client prior to claiming through IFD. This was clarified by IFD in a 1974 circular to all SFCs, though some confusion still persists. To speed up processing to a certain extent, IFD recently authorized its Regional Offices to sanction claims where the aggregate claim per borrower does not exceed Rs 15,000. 3.22 All SFCs are currently using the Scheme. Up to the end of March 1975, SFCs as a group had filed 116 claims amounting to Rs 9.0 million. Claims paid amounted to Rs 1.6 million (30 cases), while Rs 7.0 million (81 cases) were still pending (Annex 9). Nevertheless, there is still room for greater use (claim filing) on the part of SFCs as well as greater promptness in clearing claims by IFD (para 3.21). The responsibility for the credit guarantee scheme remains with RBI. IV. THE STATE FINANCIAL CORPORATIONS The Role of the SFCs 4.01 The majority of SFCs were established in the 1950s, 1/ to fill an important gap in India's industrial financing structure by providing term finance to small- and medium-sized enterprises, hitherto somewhat neglected by existing financial institutions. SFCs were also permitted to underwrite and to give guarantees. It was expected that a State level institution would be in a better position to meet the specific needs of the local industrial community than IFCI, the only all-India term-lending institu- tion then in existence. Over the years SFCs grew in importance, though their quality varied a great deal. 4.02 A substantial change began to take place in the late fifties and early sixties when the commercial banks, in particular the State Bank of India (SBI), became much more active in financing small-scale industry. 1/ TIIC (Tamil Nadu) was established in 1949 under the Companies Act, but is treated by RBI/IDBI as an SFC.  - 15 - With aggressive management, competent staff, and an abundance of branches, commercial banks began to offer, at least in the more industrialized States, significant competition to SFCs. It appears that this trend is begin- ning in the more backward States as well. With the nationalization of 14 commercial banks in 1969, the situation changed even more, in that GOI began to urge the newly-nationalized banks to give the SSI the highest priority in their lending operations. 4.03 In December 1972, the SFC Act was amended to broaden its ob- jectives. 1/ The main amendments include: (a) the creation of Special Capital which would be contributed equally by the State Government and IDBI; the shares of each would not attract dividends, and the proceeds of the issue would be used to finance risky ventures as equity financing. Assistance would be restricted to new industrial units which are private or public limited companies with paid-up capital not exceeding Rs 500,000. Preference would be given to industries in backward areas, industries set up by technician entre- preneurs or other artisans, and sophisticated types of industries. The extent of capital participation should not exceed the promoters' contribution or 20% of the paid-up capital of the company whichever was lower. To date, however, only a few SFCs have actually raised Special Capital, while others have declined on the grounds that they feel that there is insufficient demand for such assistance or that such assistance is already available under other schemes in the State. Also, since Special Capital is restricted to corporate bodies, 2/ a very large percentage of the potential SFC clientele is excluded. On the other hand, SFCs could try to turn partnerships and pro- prietorships into corporate bodies, using Special Capital as a lever. (b) the scope of SFCs' activities would be widened to include the financing of industries engaged in the maintenance and repair of machinery; and (c) SFCs' individual lending limit would be raised from Rs 2 million to Rs 3 million for corporations and cooperatives, and from Rs 1 million to Rs 1.5 million for all other entities. 1/ The Act was subsequently amended again in a few minor ways under the Public Financial Institutions Laws (Amendment) Bill of 1975. 2/ Such things as partnerships and proprietorships are excluded since in the absence of limited liability, SFCs could be forced to absorb an entire loss to creditors.  - 16 - SFC Upgrading Program 4.04 In an effort to improve certain aspects of the working of SFCs, individual upgrading programs were developed by IFD/IDBI on the basis of discussions with SFCs, and were agreed by IDA in 1972 as part of the first Credit. It has since been concluded by IDA and IDBI/IFD that the substance of the upgrading programs themselves was insufficient in scope. Thus, on the basis of previous IDA end-use missions, and subsequent visits by IFD/IDBI representatives, revised upgrading programs have been developed for each SFC with a much broader focus. The programs include detailed recommendations on management, organization and staffing, policies and procedures, appraisal standards, improvements in portfolio quality and financial management and planning. Also, each revised upgrading program will be supplemented with proposals to: (a) increase the role of the Boards of Directors and the sanctioning authority of the Executive Committee (para 4.06); (b) provide the continuity and smooth turnover of top management and the strengthening of the second layer of management (para 4.02); and (c) streamline interest rate structures (para 4.14). These revised upgrading programs, along with the debt service coverage limit- ation (para 4.35) will form the basis for an agreement between IDBI and each SFC to enable the latter to be eligible for withdrawal under the proposed loan. In addition, the Bank has spelled out a number of recommendations tailored to the needs of each SFC (Volumes II and III 1/). These recommenda- tions will not form a part of the upgrading programs per se, but IDBI and the SFCs will implement the recommendations to the maximum extent possible and IDBI will include a review of them in its annual reports to the Bank on the SFCs. Summary Evaluation of SFC Operations 4.05 Ownershio. The composition of the shareownership of the 18 SFCs varies considerably, often because of the timing of their establishment. 2/ As of March 31, 1975, the aggregate plaid-in capital of all SFCs was Rs 305.7 million. Annex 10 shows that the respective State Government is usually the largest shareholder, ranging from 36% (Rajasthan) to 89% 1/ Paras 4.05 to 4.43 highlight the most important points made in Volumes II and III. In addition, these paragraphs have taken into account the changes resulting from the implementation of the IDBI Act. 2/ The authorized capital of any SFC is limited to between Rs 5 million and Rs 100 million, the latter limit having been increased from Rs 50 million under the SFC Act Amendments in 1975.  - 17 - (Himachal Pradesh). IDBI is a shareholder in all the SFCs, with holdings ranging from 3.8% (Himachal Pradesh) to 42.5% (Gujarat). These figures include RBI's shareholdings, which have now been transferred to IDBI as a result of the IDBI Act. By virtue of its substantial shareholding, each State Government is in a position to play an important role in influencing its SFC's policies (para 4.39), though this is counter-balanced by RBI/IDBI's importance in providing funds (para 4.14), and in their influence in selecting the Managing Directors (para 4.08). 4.06 Board of Directors. With the exception of TIIC and the Assam Financial Corporation (AFC), the composition of individual SFC Boards reflects the SFC Act which stipulates that of the 11 Directors of each Board, four be appointed by the State Government, that IDBI nominate two Directors, and that four be elected by the remaining shareholders and that the Managing Director also sit on the Board 1/. In most cases, the Boards meet at regular monthly intervals wita reasonably high attendance records. Each SFC also has an Executive Committee, consisting of four Directors in- cluding the Managing Director, that has delegated authority to approve individual projects with various limits, ranging between Rs 100,000 and Rs 500,000. A number of SFCs are also assisted by Advisory Committees that have special expertise in certain industrial fields. As a general policy, greater sanctioning authority should be delegated to Executive Com- mittees. Further, greater effort should be made by SFC management and staff to provide Boards with better and more timely information on SFC activities. 4.07 Organization. One of the primary weaknesses of past IFD inspections of SFCs (para 4.04) was the absence of any attempt to assess the adequacy of their organizational structure. The IFD/IDBI visits early in 1975 attempted this with considerable success, and IDBI will now standardize its procedures accordingly. In essence, the new structures provide for a more logical division of labor, a streamlining of appraisal and follow-up pro- cedures, and an appropriate level of decentralization in decision-making. A common trend in the past year has been the significant expansion in SFCs' branch network which now totals 93, though this is far short of the total of the commercial banks as of June 1974 (16,936). However, SFCs should be careful not to over-extend the establishment of branches, nor to expand both staff and branches at such a rate that they cannot be effectively absorbed (as has happened in Madhya Pradesh). 4.08 Management. SFC Managing Directors are appointed by the State Government in consultation with and after obtaining advice from IDBI. 2/ The historical problem of a rapid turnover of Managing Directors has somewhat abated, although there is still difficulty in ensuring adequate continuity of management, particularly when the incumbent is seconded from the Indian Administrative Service (IAS), as happens in about 50% of cases. Overall, 1/ Before the recent amendments to the SFC Act, the state government had three representatives, IDBI and RBI one each, out of a total of ten directors. 2/ Previously RBI.  - 18 - the quality of SFC management has improved significantly over the past two years. It would be desirable to eliminate the use of one-year terms for Managing Directors in favor of a minimum of three or four years. By the same token, when Managing Directors have been very effective after serving several four-year terms, there should be no need to insist on a change per se. Moreover, to ensure adequate continuity, the successor to any Managing Director should be taken on roughly six months prior to the departure of the previous Managing Director. In addition, IDBI and the State Governments should, where no suitable candidates are available, continue to agree to second outside personnel as Managing Directors (as in the case of Jammu and Kashmir and Orissa SFCs). The second layer of management also needs considerable st3rengthening, either through appropriate appointments from within the State or again through secondment of staff from the all-India institutions for fixed terms (e.g. Punjab, Assam, West Bengal) (para 4.13). 4.09 Staff. The original upgrad:Lng programs provided specific targets for recruitment of both professional and non-professional staff for each SFC. Because of the numerous definitional problems that devel- oped, and because the targets themselves did not appear to be based on an adequate analysis of the needs of the SFC, more systematic recruitment programs have been developed. 4.10 Annex 11 shows the growth in professional and other staff from March 31, 1973 to December 31, 1974, for each SFC. The only SFC that did not register an increase in professional staff was Maharashtra SFC, given the adequate size of its existinig staff. There is still need for additional recruitment, particularly to strengthen follow-up work, and to provide more technical and legal expertise. 4.11 A serious recruitment constraint affecting virtually all SFCs has been the pay scales, which are linked to State Government levels, and which are low in comparison with those of other financial institutions. In many States, SFC pay scales were 25% - 50% lower than those of com- mercial banks, the most important competitors in the recruitment of good staff. In a few instances (e.g. Haryana), SFCs have succeeded in mitiga- ting the effects of such disparities by the use of "advanced increments" for new recruits, to increase starting salaries. However, this requires the active support of the State Government, and is not always forthcoming. SFC staff quality is now the subject of continuous review by IFD particularly the area of training requirements. 4.12 For the past few years, considerable effort has been devoted to the training of professional staff, and up to the end of December 1973, 123 had undergone training in specific courses related to project appraisal work sponsored by IDBI. In addition, the Bankers Training College of RBI has also conducted special courses for SFC staff. Thus, at least some 20% of SFC professional staff have undergone some outside professional training. Further, SFCs should make much greater efforts to use existing staff more effectively, given the strong academic backgrounds of many non-professionals.  - 19 - 4.13 A recent development in upgrading individual SFCs has been the practice by some of the all-India financial institutions (IDBI and IFCI) to second experienced staff members to SFCs as advisors or in senior line positions (para 4.08). In addition, IDBI will also consider the secondment of staff members for short intervals (3-6 months) with SFCs to work on clearly defined areas such as assistance in project appraisal (paras 4.19-4.20). Resource Mobilization 4.14 A summary of financial resources of all SFCs as of March 31, 1975 is contained in Annex 12, which shows that the SFCs as a whole have relied primarily (excluding loan collections) on bond issues with State Govern- ment guarantees to finance their operations (38.7%). Of less importance has been IDBI refinance facilities (29.2%) and share capital (10.2%). 12 SFCs have also collected deposits with maturities in excess of one year in amounts limited to the size of their individual share capital. 1/ Though interest rates have varied, in most circumstances the cheapest funds (exclud- ing share capital) have come from IDBI. Thus, IDBI's ordinary refinance operations give spreads to SFCs of 3.5% for loans to the small scale sector and/or to backward districts, as well as for loans for medium-scale projects. However, in the former case, SFCs borrow from IDBI at rates of 6 to 7.5% and on-lend at 9.5 to 11.0%. In the latter case SFCs pay 9.0% and relend at 12.5%, a rate which makes them less competitive with commercial banks. The revised upgrading programs (para 4.04) will include proposals to streamline the SFC's interest rate structures, including proposals to reduce the excessive number of interest rates. 4.15 It should be stressed that the SFCs themselves have very little independence in raising resources, since RBI determines annually the amount, term and maturity of all bond issues, including the ad hoc bonds, 2/ which the SFCs are permitted to float. Moreover, the refinance facilities of IDBI are generally limited to three times the SFCs' equity, though tem- porary exceptions are sometimes made. Aside from planning to have sufficient resources available to meet operational commitments and disbursements, it is somewhat difficult for an SFC in the short run to change materially its resource position, given the constraints in which it operates, even if it so desires. Even with such constraints, however, there is some scope for an SFC to improve resource planning through greater use of IDBI's 1/ A recent ruling by RBI states that SFC deposits should not be consi- dered as trustee securities on the part of investors for purposes of calculating reserve ratio requirements, though this is still under discussion. 2/ SFCs can borrow from RBI in maturities up to 90 days against trustees securities or commercial bills, and with a maturity of up to 12 months against government securities or the SFCs own bonds up to 90% of their paid-up capital.  - 20 - refinance facilities and the avoidance wherever possible of relatively high cost borrowings such as time deposits. In addition, two SFCs (Gu- jarat and Bihar) have overcommitted themselves in the absence of sufficient resources, a situation which could have been avoided through proper fore- casting. Further, SFCs in general are making increasing use of ad hoc bonds from RBI to meet short-term (less than 12 month) resource require- ments, the bonds having grown from Rs 62 million in FY73 to Rs 213 million in FY75. In some instances, SFCs have been using the facility on a more or less permanent basis, indicating a lack of adequate planning. Policies and Procedures 1/ 4.16 Lending Terms. SFCs' lending terms vary from State to State, though the spreads under the IDBI refinance scheme are fixed. Nevertheless, certain priorities are readily apparent through the different rates charged for specific activities. In particulaLr, SFCs usually give lower rates of interest, longer maturities, and lower margin ratios to projects in backward areas and to projects in the small-scaLle sector. The individual terms of lending for each SFC are contained in Annex 6 of each appendix in Volumes II and III. Loans are usually restricted to financing fixed assets, though some SFCs are prepared to finance working capital in conjunction with fixed asset financing. Working capital loans are not eligible for refinancing. 4.17 Where IDBI refinancing is inIvolved, a lower rate of interest is available to entrepreneurs, usually of the order of 1% to 3% less than would otherwise be payable. However, IDBI charges a commitment fee of 1% per annum, beginning six months from the date of IDBI's approval for loans not then disbursed. 2/ Under the liberalized refinance scheme (LRS), nine- months grace is given irrespective of the status of the loan disbursement. Until recently, not all SFCs were charging commitment fees, while in many instances IDBI waived such fees to SFCs. Over the past year, IDBI agreed with IDA not to waive commitment fees to SFCs and to insist that the latter charge the maximum commitment fees. 4.18 Appraisal procedures and standards. SFCs have often been criti- cized for taking too much time to process loans. On average SFCs require an estimated four to five months to process an individual loan application which is somewhat long, though a small percentage of applications have taken over two years. However, this performlance has improved in the past year. According to SFCs, much of the blame should be placed on the entrepreneur, 1/ The policies of the SFCs are contained in the SFC Act as well as in guidelines from RBI/IDBI. The State Governments, though empowered to issue guidelines to the SFCs in consultation with RBI/IDBI had not done so to any great extent. 2/ Or three months from the date of IDBI's approval on the undisbursed portion for loans already disbursed.  - 21 - who is slow to provide the necessary information, and on cumbersome Government procedures. Nonetheless, when undue delays occur it is clearly due at least in part to staff shortages or inadequate procedures within SFCs. In some, a system of sequential appraisal has been adopted even where the total number of staff was small. Where not already undertaken, SFCs should be encouraged to establish appraisal teams to speed up the processing of applications. 4.19 Given the small size of projects and the lack of good data, it is not surprising to find that appraisal standards are not of the same quality as is possible for medium and large-scale industry. Nonetheless, the SFCs have made considerable progress in the past year as a result of a continuous dialogue with IDBI and IDA. The areas of analysis that have undergone improvement have been (a) marketing, (b) financial projections including working capital requirements, (c) management and (d) project implementation schedules. 4.20 Until a few years ago, most SFCs had no qualified staff for the technical aspects of project appraisal and were forced to rely mainly on SISIs, which act as an arm of the State Governments in providing technical- economic expertise in project appraisal. With the exception of one or two SISI units in the major cities, most SFCs felt that the quality of such assistance was inadequate. Partly for that reason, SFCs recruited a number of technical staff to undertake this kind of work. However, many still lack experience. The Kerala and Assam SFCs are fortunate to have available the technical expertise of KITCO1/ and NEITCO 2/ res- pectively. A third institution in Bihar (BITCO) 3T was recently established to undertake this function. IDBI intends to establish consultancy organiza- tions in less industrialized states. This will be beneficial to the SFCs for assistance in project preparation. 4.21 Follow-Up Procedures. Probably the weakest part of SFC activities is the follow-up work, where the shortage of staff has resulted in a general neglect of clients, contributing to the high level of arrears. Nearly all SFCs tend to concentrate on appraisal at the expense of follow- up work. Follow-up visits are often limited to clients with known diffi- culties, though in some cases such clients account for 80% of the SFC's total portfolio. More branches, adequately staffed, would help to allevi- ate this problem, which is aggravated because SPCs generally cater to the small-scale and particularly the non-corporate sector, where little in- formation of an operational and financial nature is willingly made available by clients, and even where it is, is not submitted regularly. Thus, it is important that the SFCs accord high priority to timely field visits. 4.22 Procurement and Disbursement. Historically, SFCs' review of pro- curement practices, hampered by lack of appropriate technical expertise, 1/ Kerala Industrial and Technical Consultancy Organization. 2/ North Eastern Industrial and Technical Consultancy Organization. 3/ Bihar Industrial and Technical Consultancy Organization.  - 22 - has not been particularly thorough. Rather, the entrepreneur's judgement has been the major factor in determininag equipment requirements. However, as part of the upgrading program, SFCs have in principle adopted the procedure of requiring price quotations from at least three suppliers as well as considering the quality of the equipment and the availability of spare parts. At least one SFC (Maharashtra) has, in conjunction with the State Directorate of Industry, assumed responsibility (wlhich has been vested in all SFCs, in line with a recent GOI directive) for providing the "essentiality" clearance for particular applications. This serivice should increase as SFCs build up their engineering staff. 4.23 Few SFCs have established deitailed, systematic disbursement pro- cedures, though the practice of ensurinxg that the entrepreneur puts in his part of the capital cost first is common. Overall, however, disbursement procedures are reasonably adequate. Nevertheless, SFCs, as a group, should put greater emphasis on establishing sound disbursement procedures with regular "verification visits". SFCs continue to experience lags in dis- bursements due partly to delays over licensing, information from client, verification of legal title, and over their own documentation, which should be rectified. Resource Allocation 4.24 Operational Results. A statement of each SFC's operational re- sults for the fiscal years 1973 to 1975 is contained in Annex 13. Their loan sanctions grew from Rs 789 millioni in FY73 to Rs 1,415 million in FY75, or by 79% in nominal terms. With the exception of Assam, Uttar Pradesh and Jammu and Kashmir, which recorded declines, each SFC experienced some increase in its lending operations. MaLharashtra continues to be the largest sanctioner with Rs 221.7 million (15.6% of the total) in FY75, followed by Gujarat (Rs 188.0 million). Overall di.sbursements grew from Rs 449 million in FY73 to Rs 738 million in FY75. Gujjarat showed the largest single annual disbursement (Rs 144.7 million). However, loan collections actually fell from Rs 248 million to Rs 222 million over the same period. Thus, total SFC outstandings increased from Its 2.2 billion to Rs 2.8 billion in FY75. 4.25 SFCs as a group have been inactive in making equity investments,1/ bond subscriptions and guarantees. At the end of FY75, equity investments and bond subscriptions represented 0.5Z of total operations while guarantees represented about 3%. The one exception has been TIIC which, since not legally an SFC itself, is atypical. As of March 31, 1975, 20% of its total portfolio (outstanding) was represented by equity investments. TIIC's weak investment portfolio amounts to almost twice its own net worth which is an alarming situation. With the availability of Special Capital, it 1/ SFCs are not allowed to subscribe to the shares of a company unless they have underwritten the issue and may not hold such shares for more than seven years, though exceptions are granted by RBI. Moreover, SFCs cannot hold more than 30% of the total shares of any company, or more than 30% of its own net worth in a company, whichever is less.  - 23 - would be desirable for the SFCs to become more active in equity investments, if there are appropriate opportunities, within the limits set out in the Act. Characteristics of Portfolio 4.26 (a) Size of Loans. The weighted average size of approvals was Rs 230,000 during FY75 (Annex 14). In some SFCs, the trend has been towards smaller loans, though in others (e.g., Maharashtra) an attempt has been made to finance larger loans in order to increase net income and, thereby, obtain a more profitable operation. The minimum loan amount varies from one SFC to another but is usually around Rs 10,000. (b) Regional Distribution. SFCs have adopted various measures to promote industrial development in backward districts in- cluding loans at reduced margins, concessional rates of interest and reductions in processing and legal fees. As a result, the proportion of such loans sanctioned has grown from 28% of total sanctions in FY72 to 43% in FY74. (c) Maturities. SFC maturities range generally from seven to twelve years (excluding transport operators, who receive considerably shorter loans). It is only recently that most SFCs began carefully to determine maturities on the basis of the debt service capability of the individual client as opposed to arbitrary "rules of thumb." (d) Size of Industry. Over the years SFCs have become important sources of funds for the small-scale sector, and in FY75, an estimated 54% of loans by amount and 90% by number went to the small-scale sector. (e) Industrial Distribution. SFCs' portfolios tend to reflect the distribution of the industrial activities in their particular States, though in most cases they are well distributed amongst many sub-sectors. The most important industries are food manufacturing, basic metals, chemicals, and metal products. In certain instances (e.g., Orissa, Assam) SFCs tend to be over-exposed in particular sub- sectors such as rice milling (Orissa) and the tea industry (Assam). In such circumstances, SFCs should make every effort to diversify their portfolios wherever possible. 4.27 Technician Entrepreneurs Scheme. In order to reach the smaller and newer elements of the small scale sector, and thereby reduce unemploy- ment, sixteen of the eighteen SFCs have developed schemes for providing  - 24 - assistance to tzzhnician entrepreneurs. 1/ The scheme generally provides lower rates of interest, reduced margins on security, and longer grace periods. Up to the end of September 1974, 14 SFCs had sanctioned 874 loans amounting to Rs 162 million under the scheme. Financial Performance 4.28 Quality of Loan Portfolio. As part of the upgrading program SFCs were expected to conduct a case-by-case review of their entire port- folios. As of March 31, 1975, the review had been completed in 15 of the eighteen SFCs, while in the remainder the review was in progress. The general quality of the SFCs' portfolio, however, remains weak. An analysis of the arrears of etch SFC is contained in Annex 15. This shows that only six improved their rrears position in FY75 over FY74 using the "infected" portfolio criteria (column 3), while only eight showed an improvement in actual arrears of principal and interest (column 4). In the former case, the ratios ranged from 15% (Rajasthan) to 61.9% (West Bengal), while the actual arrears varied from 2.1% (Punjab) to 36.7% (Assam). Nevertheless, considering the difficult business condition experienced by industry in 1974 these results are reasonably satisfactory. 4.29 After analysing all loans in arrears for more than two years, and the twenty largest loans in arrears for each SFC, the following general reasons for high arrears were identified: (a) environmental factors such as power shortages, raw material shortages and labor problems, resulting in delays in implementation of certaLn projects; (b) SFC institutional factors as in the absence of an adequate penalty fee, inadequate follow-up work and (c) specific project reasons such as managerial incompetence and, in a minority of cases, lack of markets. SFCs have taken some steps to try to reduce arrears, including rescheduling (on justifiable grounds) as well as suit filing in chronic cases, and claims under the Credit Guarantee Scheme. 4.30 In a few SFCs in the eastern region, Default Committees, consist- ing of a small group of Board members, have been set up to review all accounts in arrears beyond a certain time. Individual entrepreneurs are invited to attend committee meetings to explain the reasons for their defaults. Against the background of generally weak portfolios, very few loans have been written off in the past five years; 2/ SFCs claim that, in nearly all cases, collateral is sufficient to cover potential losses. 4.31 A special problem has emerged in the case of "sick" textile mills previously financed by certain SFCs. These were amongst the 103 textile mills taken over by GOI under the Sick Textile Undertaking (Nationalization) Act, 1974 and placed under the National Textile Corporation. As of June 30, 1974, nine SFCs had Rs 45.3 million oustanding to 23 such units. The Act 1/ Defined as graduates or diploma holders and certified technician and/or those having adequate experience in a particular field. 2/ SFCs are reluctant to write off since no tax deductions are available until all other remedies are exhiausted.  - 25 - has set out the amount of compensation that will be paid by GOI and also the order of priority of such payments arising out of the liabilities. The "opost-takeover management" claims will take precedence over the "pre-takeover" claims and at the same time, workers' back wages will be given overriding priority. Thus, it is highly questionable whether SFCs can be adequately compensated under the circumstances. If not, write-offs will be required which, in a number of SFCs, may seriously jeopardize their financial position. GOI has appointed Compensation Commissioners to sort out the claims on the assets of the various textile mills. Once the Commissioners make their decisions, the SFCs concerned should make the necessary adjust- ments in their portfolios through write-offs. This may entail the need for the SFCs' shareholders to increase the SFCs' equity base so as to stay within their debt-equity limit of 10:1, as stipulated under the SFC Act. 4.32 Any attempt to improve the arrears position of most SFCs will require a substantial effort. Nevertheless, all SFCs should put increasing emphasis on follow-up work through systematic visits to all clients to ascertain the exact position of each operation, particularly before problems develop. Secondly, appraisal standards need to be improved to reduce the likelihood of problems at a later date (e.g., working capital shortages). Further, SFCs should make greater use of the Credit Guarantee Scheme, judicious rescheduling and suit filing where appropriate. In addition, the penalty fees for clients in arrears and/or rebates for prompt payment should still be increased further from their present level in order to eliminate, as far as possible, the phenomenon of willful defaulters who prefer to repay in the first instance loans from commercial banks since they carry interest rates of 3% to 4% above those of the SFCs. 4.33 Quality of equity portfolio. Given the small size of SFCs' equity portfolios, they do not materially affect the overall financial position of the SFCs, with the exception of TIIC. Nevertheless, for many SFCs, the dividend yield has been extremely low because of the poor finan- cial performance of the individual clients. The return for FY75 on the total equity portfolio of SFCs (excluding those with no equity investments) ranged frow 2.68% in Punjab to 24.2% in Andhra Pradesh. 4.34 Profitability. A statement showing the financial performance of the eighteen SFCs on the basis of a variety of ratios is contained in Annex 16. Profit after tax as a percentage of year-end share capital ranged from 0.2% (Assam) to 35.5% (Bihar). From FY74 to FY75, fifteen SFCs showed an increase in this ratio. The nominal financial spread ranged from 0.6% (Assam) to 5.0% (Himachal Pradesh). 1/ Administrative expenses as a percentage of average total assets ranged from 0.7% (Andhra Pradesh) to 2.2% (Maharashtra) in FY75. The relatively high ratio for Maharashtra reflects the SFC's considerable efforts to establish regional offices and branches, and to carry a significant portfolio of very small 1/ Income from term loans as a percentage of average term loan portfolio minus cost of term debt as a percentage of average term debt.  - 26 - loans. 1/ In most cases, after a SFC has allocated 40% of its gross income to reserves, encouraged by tax exemption, and has paid the required taxes and dividends, little is left over for the provisions that should have been a first charge on earnings. In FY75, the net profit of all SFCs taken together was Rs 68.1 million, based on total assets of Rs 3.35 billion. 4.35 Capital Structure. The SFC Act limits the debt/equity ratio of all SFCs to 10:1. At the end of FY75, this ratio ranged from 2.5:1 (Jammu and Kashmir) to 8.2:1 (TIIC). Under the existing Credit Agreement, an additional covenant ensures that the debt service coverage of each SFC based on the combination of an estimate of results for the subsequent six months as well as actuals from the past six months should be not less than 1:1 as of October 1, 1973, not less than 1.1:1 as of April 1, 1974 and not less than 1.25:1 as of April 1 of any succeeding year. For FY75, actual debt service ratios ranged from 0.78:1 (TIIC) to 2.8:1 (Jammu and Kashmir) with 8 of the SFCs below the 1.25 target. 2/ A number of difficulties emerged in the interpretation of the ratio. In the absence of sinking fund pro- visions, most SFCs repaid previous bond issues in lump sums, so that on a specific date the debt service coverage position might appear unfavorable. Further, RBI's practice of providing iso-called "ad hoc" bond funds to SFCs (para 4.15) in temporary resource difficulties also resulted in uneven ratios for short periods. In addition, the use of a combination of six months fore- casts and six months actual figures iinserted an arbitrary quality into the calculations. Finally, the targets themselves were open to question in that in the short-term there was very little an SFC could do to rectify a low ratio, since the only items used in ilts calculation that were capable of improvement in the short run, were loan collections and gross income. For the proposed loan the debt service covenant will be modified to include only actual results; the 1.25:1 limit as oJE April 1 each year will be retained, but be calculated on the basis of assumming sinking fund provisions for bond redemptions (to avoid large fluctuations). 4.36 With one or two exceptions, SFCs do not have adequate provisions for doubtful loans, though reserves plus provisions as a percentage of year end portfolio in FY75 ranged from 3.0% (Gujarat) to 9.6% (West Bengal). IDBI should review the adequacy of provisions (including provisions for equity investments) with the auditors and managements of the individual SFCs. 1/ Which explains its present efforts to now finance l1Tger loans and improve profitability (para. 4.26(a)). 2/ Without adjustment as described below.  - 27 - 4.37 Dividends. SFCs pay fixed dividends under the Act 1/ to their shareholders, usually at a rate of 3.5%, this has resulted in pay-out ratios ranging from 10% (Bihar) to 46.3% (Orissa) in FY75. At the same time, year-end book value per share as a percentage of par value ranged from 130 (Gujarat) to 207 (Andhra Pradesh). 4.38 Audit. As a result of an amendment to the SFC Act in 1972, there is now only one auditor for each SFC, appointed by the State Government in consultation with the Comptroller and Auditor-General of India. The right of the private shareholders to appoint an additional auditor has been abrogated. The quality of the audit has varied considerably. In some cases, the auditors' letters to management indicated significant quali- fications to some of the figures in the financial statements. On the other hand, the audits of some SFCs indicated that the auditors had over- looked shortcomings in the financial statements. Under the proposed loan, the SFCs audits will be undertaken in the long form, but schedules 2 and 3 2/ (analysis of quality of loan and equity portfolios, respectively) will be produced only for outstanding loans/equity investments in excess of Rs 200,000. This modification has been introduced to take into account the mall-scale nature of SFC portfolios. Relations with State Governments 4.39 The State Governments are closely associated with each SFC through their involvement in fixing the amount of authorized and issued capital, nominating three Board directors, and appointing the Managing Director in consultation with RBI. State Governments are also important in terms of granting incentives, promoting backward regions particularly through the establishment of industrial estates, and guaranteeing SFC bonds and dividends. In a few states, SFCs are used as channels for special State Government funds for specific industries. Thus, State Gov- ernments exert some influence over SFCs, and, to a significant extent, the success of the upgrading programs, particularly of management and staff, will continue to depend on the degree of commitment of the State Governments. Reporting Requirements 4.40 Aside from IDBI's normal reporting requirements, IDBI will prepare annually detailed evaluation reports for each SFC by September 30 3/ of 1/ Until FY71, some SFCs (Orissa, Jammu and Kashmir) still received finan- cial assistance from State Governments to pay such dividends, and a number are still repaying such assistance received earlier. Because of the introduction of an interest suspense account, Assam will probably require a subvention from the State Government to pay its dividend in FY75. 2/ As per "Illustrative Form of Audit Report for Development Finance Companies". 3/ For 1976: October 31.  - 28 - each calendar year for forwarding to the Bank for review along the lines presented in Volumes II and III. This will take the place of semi-annual and quarterly data reporting by SFCs to IDA under the first credit, which would now be restricted to IDBI only. In addition, the SFCs will prepare, with the assistance of other State level bodies, a review of the industrial sector (small and medium scale) of their respective States to be forwarded through IDBI to the Bank for review also by September 30 each year. Prospects 4.41 The difficulties experienced by the industrial sector in India in 1973 and 1974 have been somewhat alleviated. They were largely due to shortages of raw materials, labor unrest, power cuts, and transport bottle- necks which led to significant underutilization of capacity. Since then, however, a very favorable monsoon has reduced the level of power cuts, and labor unrest has also reduced. Further, GOI has recently streamlined procedures for the allocation of raw materials, particularly for the small scale sector. Coupled with this GOT has been successful in reducing the rate of inflation. As a result, the overall prospect for new investment in the industrial sector appear to be more promising than in previous years. Given GOI's priority emphasis on the small scale sector and the proposals to launch a modernization program in thiLs area, the demand for foreign exchange from SFCs should be substantial. 4.42 Five-year forecasts have been prepared for each SFC (balance sheet, income statement, sources and uses of funds). These reflect the particular industrial prospects in each State as well as the processing capacity of the SFC. In addition, detailed forecasts for IDBI's overall operations have been prepared and are contained in Volume I. The Bank/IDA refinance scheme forecasts are sunmmarized below: IDBI Refinance of Industrial Loans (Bank/IDA Credit Component) (Rs million) 1974 1975 1976 1977 1978 --- Actuals -- Approvals 51 96 214 252 302 Commitments - 126 183 242 289 Disbursements - 31 141 195 251 4.43 From the above, IDBI is likely to sanction refinance of the entire first Credit by May/June 1976 on the basis of total sanctions of Rs 361 million. Disbursements under the existing Credit are expected to increase substantially over the next two years. Thus, on the assumption that there is sufficient staffing and reorganizaLtion in IDBI's Refinance Department and its Regional Offices (paras 3.04 and 3.07), IDBI is likely to sanction about an additional Rs 550 million for the two-year period beginning  - 29 - July 1, 1976. This represents 1/ $40 million in eligible foreign exchange requirements. A disbursement schedule for the proposed loan is contained in Annex 17. V. OBJECTIVES OF THE CREDIT 5.01 To date, Bank Group involvement in the small and medium-scale industrial sectors in India has been confined to the existing line of credit through IDBI to the SFCs. That Credit had two basic objectives, namely the financing of the import component of sound, high-priority industrial projects in the small and medium-scale sectors and the upgrading through specific programs of the operations and procedures of SFCs. Based on the experience under the first project (para 3.15) and as a result of the change in definition of SSI (para 2.13, footnote 1), approximately 90% by number and 65% by amount of the proposed credit would go to the small scale sector. 5.02 The proposed Loan would provide continuity to these objectives and at the same time expand on them. In the first instance, it would, through project financing, contribute to a multiplicity of objectives in- cluding the modernization of SSI, the development of new entrepreneurs, backward districts, employment generation both in rural and urban areas, and an increase in exports. Secondly, the upgrading of the SFCs that has begun over the past several years, particularly improvements in the quality of management and staff, the streamlining of procedures (including those involving GOI), and improvements in appraisal standards would continue. Moreover, since then, the upgrading programs have been revised and expanded to include more detailed recommendations involving the SFCs. Thus, the proposed Loan would provide the vehicle for the Bank's continued involve- ment in the upgrading of the SFCs, particularly through more comprehensive and detailed action programs for individual SFCs. However, it is expected that in future IDBI would assume more of the final responsibility for in- specting and upgrading the SFCs as well as monitoring appraisal standards through subproject reviews. VI. THE PROPOSED LENDING SCHEME 6.01 General. As in the previous Credit (356-IN), the proceeds of the proposed Bank Loan would be re-lent by GOI to IDBI for the exclusive use of SFCs, through IDBI's refinancing scheme. The number of sub- projects financed by the loan would be large (estimated at about 1,000). In view of its objectives to upgrade the standards of SFCs and to support small- and medium-sized industries, the lending scheme continues to call for special arrangements to ensure effective use and efficient administra- tion of the Loan. The main points are presented below: 1/ Assuming 65% refinance, 50% of loans in backward areas, and an exchange rate of Rs 8.0 = US$1.  - 30 - 6.02 On-lending Terms. The principal terms and conditions of on- lending of the proceeds of the Loan would be as follows: (a) GOI would lend the proceeds to IDBI on term satisfactory to the Bank. The present rate of interest would be 7.75% less a rebate of 1/4% for prompt payment. The foreign exchange risk (para 6.09) would be borne by GOI, and amortization would be on a fixed schedule approximating the estimated amortization pattern of sub-loans (extending over 18 years including 3 years of grace; (b) IDBI would lend the proceeds to SFCs at an interest rate of not less than 8.0% per annum to small-scale units covered under the Credit Guarantee Scheme, technician-entrepreneurs and units in specified backward districts and not less than 8.75% for other cases. Amortization would be on a project-by-project basis conforming to IDBI's normal procedures for refi- nancing, subject to a period of not more than 15 years; (c) SFCs would lend to enterprises at an interest rate of not less than 11.5% per annum in the case of loans made to SFCs at 8.0%, and 12.0% in other cases, plus the SFCs' current commitment charges. Thus, the SFCs would enjoy a higher spread (3.5% compared to 3.25%) to cover the more costly and riskier loans to SSI while at the same time charging a higher final rate (12.0%) on other loans. SFCs would onlend to enterprises on terms and conditions that give adequate protection to SFCs, IDBI and the Bank. 6.03 This interest rate structure would allow SFCs a spread of between 3.25% and 3.5%, which is necessary to enable them to cover their costs and to improve their financial positions. IDBI's spread would be adequate to cover its expenses in administering the loan. Though inflation rate pro- jections are difficult given the present negative rates (1975/76), it has been assumed that the rate of inflation will average about 5-7% over the next five years. Thus the SFC final lending rates will entail real posi- tive rates of 5-7%. Further, the SFC rates would be in line with ICICI's foreign currency rate of 11%, where the sub-borrower bears the exchange risk. 6.04 Projects Eligible for Loans. IDBI has established basic financial and economic selection criteria for projects, and these have been approved by the Bank. Under the SFC Act, SFC subloan are limited to size to Rs 3 million, and eligible enterprises must have a total equity (paid up share capital and free reserves) of no more than Rs 10 million. 6.05 Use of Loan Proceeds. The proposed Loan would be used to finance imports. For that purpose, the Bank would reimburse 65% of IDBI's re- finance disbursements for SFC-projects with import components. 1/ Since the import requirements for capital goods of SFC-financed projects are estimated at about S40 million for two years through June 30, 1978, the Loan proceeds would be principally used for financing caoital goods 1/ Under Credit 356-IN, the estimated foreign exchange content of the SFC loans was 62%. In addition, it is considered likely that there will be a higher average foreign exchange component under the proposed Loan because of the expected increase in the relative prices of imported goods due to the present negative rate of inflation in India.  - 31 - and services imports. However, given the need of small-scale enterprises for imported raw materials, the proceeds would also be available for such purchases, provided the sub-borrower's need is for permanent working capital as in the case of the first credit. 6.06 Eligibility of SFCs and Institution-Building. To ensure effective use of Bank funds, the proceeds would be available to only those SFCs which continue to meet the requirements of the revised upgrading programs. 6.07 Authorization of Sub-Projects. IDBI would forward to the Bank for its prior approval, any sub-project whose loan amount exceeds Rs 2.5 million, including local currency component. However, for those SFCs that have not yet submitted at least two acceptable cases for prior review, the free limit of Rs 1 million under Credit 356-IN would be retained, but would be raised to Rs 2.5 million on an individual SFC basis once two acceptable prior review cases per SFC have been processed by the Bank/IDA. Appraisal reports prepared by the SFCs concerned and IDBI's review of the appraisal would accompany the request for the Bank's approval. It is estimated that the Bank would review about 50 projects requiring its approval, accounting for 20% by amount of the proposed Loan. 6.08 Disbursement. The Bank would finance 65% of IDBI's disbursements to SFCs for projects which include a component for the import of machinery and equipment and services for expenditures incurred up to 180 days prior to receipt of applications. The percentage thus represents an estimated average of the eligible foreign exchange component in SFC projects. Since disburse- ments would be first made by IDBI, reimbursements would be obtained from the Bank at agreed intervals. Reimbursement to GOI would be made against IDBI's certificate of expenditure, the documents for which would not be submitted for review but would be retained by SFCs for submission to and inspection by the Bank as and when deemed necessary. 6.09 Foreign Exchange Risk. Both IDBI and SFCs would be protected against foreign exchange risks. In addition, small scale units should not be expected to bear the risk themselves. Thus, as in the previous project the risk would be borne by GOI.   State-wise position of Term Loans (including instalment credits) granted by scheduled ccsmercial banks to small scale industries (Amount in million of rupee7s) Name of the State/ AS O N T H E L A S T FRIDAY O F Union Territory June 1972 June 1973* June 1974* No. of Limits Balance No. of Limits Balance No. of Limits Balance Units sanctioned outstanding Units sanctioned outstanding Units sanctioned Outstanding Andhra Pradesh 2740 156.o 113.6 3151 130.6 105.3 3453 145.3 123.6 Assam 468 9.7 6.8 569 11.6 '8.2 724 16.9 11.7 Bihar 652 48.6 26.6 802 40.0 29.3 1448 60.0 h1.2 Gujarat 1927 104.7 76.8 2310 130.8 93.9 2690 168.1 127.5 Haryana 412 26.6 19.0 602 37.9 30.7 1008 62.1 46.7 Himachal Pradesh 16 .1 .1 27 .4 .2 71 2.6 1.7 Jamnu & Kashmir 62 3.4 1.8 181 5.0 3.1 293 6.2 4.4 Karnataka 4676 145.2 126.5 5496 180.5 156.3 6239 227.9 197.1 Kerala 1616 84.2 57.6 2287 54.o 50.0 2453 63.6 54.4 Madhya Pradesh 986 57.1 31.1 1230 68.3 38.6 1547 63.3 43.o Maharashtra 5278 306.5 243.1 6576 373.7 294.7 7502 435.9 352.2 Manipur 1 - - 16 .2 .1 67 .7 .2 Meghalaya 4 - - 12 .2 .1 18 .3 .3 Nagaland 2 - - 2 - - 1 - _ Orissa 189 5.8 4.2 290 6.5 4.8 350 9.8 7.5 PUnjab 445 27.8 12.6 804 24.0 20.4 1235 48.8 40.3 Rajasthan 397 11.9 8.7 457 17.5 12.1 856 29.3 18.1 Tamil Nadu 5209 170.1 130.1 6439 222.6 178.7 7635 290.7 227.2 Tripura 9 .4 .1 2 - - 4 - - Uttar Pradesh 1047 44.o 29.3 1569 51.6 37.6 2847 99.6 78.8 West Bengal 1192 48.6 38.3 1466 60.9 47.9 3031 144.4 110.2 Union Territories Andaman & Nicobar - - - 11 - - 13 - - Arunachal Pradesh - - - - - - - - Chandigarh 24 .8 .4 51 2.1 2.3 92 5.0' 4.5 Dadra & Nagar Haveli 3 .1 .1 2 .1 .1 3 .1 - Delhi 1034 64.6 54.7 1015 69.2 49,9 1367 84.4 70.9 Goa, Daman & Diu 198 8.5 7.7 205 8.7 7.4 195 9.8 9.3 (Pondicherry 58 1.5 .9 86 3.1 2.5 149 4.8 3.8 (Mahe - - - - - - - - (Lakshadweep _ _ - _ _ (Minicoy 1 - - - - - - - Mizoram - - - - - - - - - Grand total 28646 1326.9 990.2 35658 1499.6 1170.6 45291 1971.7 1574.8 * Provisional April 21, 1976  ORGANISATION CHART INDUSTRIAL DEVELOPMENT BANK OF INDIA I BOARD OF DIRECTORS _EXECUTIVr COMMITTEE CHAIRMAN AND MANAGIN'G DIRECTOR REGIONAL COMMITTEES EXECUTIVE DIRECTOR EXECUTIVE DIRECTOR CHAIRMANS SECRETARIAT II ( INC LU 01Ir MANAGE MENT DOMEc:c r;M :C - lvING INTERNAT:3:.'At.L '::AuCE .INGA s s r"42P5. 7 deR T-CiN,CAU AZVISE GENCRAL MANAGER GENERAL MANAGER ECONQMIC ADVISER A __ 1 i. ,P LT P!GfONAL D AL~R AREA 7) DGM EX~PORT LOANS DEPARTMENT DYGM PYGM DYGM L:)A'.,' LEPARTMENT &ACkWAR M ~~~~~~~(INCLLOING EXP9ORT RE;INANCE) I _~~~~~~~~~ --- LCAN DEpAro-z^4r I :)y GMY DEVILOPM M,NT DPARrTeE tNr } DYGM ' OV&wSts5 tsOEEA REAS DIR[CT LOANS DEPAGtMENr L~AI4 -PMENT D ' STATE FINANCIAL COJRPORATIONS DY GM AIISF LOA- eLFAQREN E AND CTI4ER STATE LFEVL IMPORT LOANS DEPARTMENT } YGMp LEGAL ADISER LOAN _-IP MT.N r v D V IAN TPR E- I S A TITJI N L------E _ __ _ _ _ _ _ _ LOAN C9tARSnE~r v13_ c. c*tDINAT'ON DRPr RTMEN? DY GM CREDIT tNTELLIGENCE ; L INTERNAL AUDITORJGl LOAN ,AMEI VI (;rl~~~~~~~.I.~~e .~~,i AND bANWS) )INVESTI(ATION DEPARTMENT YG TEflN*NCE or INDUSTRIAL DY GM ADMINISTRAriON , ACCOuNTS J ADMINISTRATION.ACCOUNTS L art LCAI4E DkPARTP.IEN? TJ - BUDGETING 73 ATETGEEA AAE v 6~~~~~~~~~~~~~~~~~~~~~~~ENERAL M"ArAER COUNSELLING SERViCes & _ . * r: $ ~ : 9 .tx *:Ir,.L - .; ,, *:I N e > ;'' ':T ' PULBLIC RELAriON5 73Et^PAYEIT). : 'EA'_tSERS : rErwliEs X srE 5TELS 3. AsLCYS *X'~5 OS~ A.A..^r&SS, t 5v^S-W-EC FlF2tS 2- ASTIIAS. OR OREIS65 ADMINISTRAriONm ECRETARY A.C :5 E-151 ,_5 :t-;rcts 3sAf I ANE WtRES PERSONNEL, 4ttNEF ACCeCUNTtN' AiL Fe_4O.C., ASL(14t I. I1CC PA!CO.jCTS SUGGIE RC0 TRAINING AND ICARSON Pt5Lc;95ftt LASTIC$ S V m-NUFACTVI6 IE4 C PREMISES r CrTEI CA[C4L PAcDUCTI r . EA.r, 5E TAL DYGM --CA PRDU(TS GL Sj'& e, PA-AC CL'iAleS NS STACS rAYG LAC.ALI4A. Er6IICALS ECA TC'OT*L ' iNsLLARDS CHAIRMAN'S SECRETARIAT I*oA6QtELS,L'A LFa.I A' rIsVTIPUFrs A tocts1 ( INCLUDING tAANAGE_E'NT LEA?-# tCo:;e'S a REFRACTORIES SERVICE D:vISION ) LI C,Ss FR' I S I-Lk i -L. q.ENr,fES, PuIS EVE- _ . . .: - . . :; F I c D: . ' S laaA. E SE atAs / A u DE S | F ^:' f -t' Ol'I.~C'S EASES 6Ar^z , Ss~se>< ,NrSsTrlES .............. TRE CHAIRMAN'S SECREtARIAT WILL CCNSISr OF Six 3!tIEC stl^4L lFr_t 5-RLtSZ SE.NIOR OFFICERS WHO I.4LL Se WELL CO'4'ERSANIT leaos:'. leAr^e^aC"DRS WITH THE fUNNCTIONI NS OF THE OPERATIV9 A"rE IOF DivISIO NS ArRD WILL MONPIOR OPFRATfONS AS *..IC~ C'l. 'AC4'"I8rY _______________________ WELL& AS HELP EvOLVE POLICIES FOR Tr.E O8l. A rv A * Cr -r - V S ORN eFPlFTMDNT \'; THE N^AACE mrENT SErrvSC DI-vSION WILL as A '-m LOAN Ec.I,' VI RE SP cs5,.SLE FOR PREPARIN PitEOGA* CE 1 _ NU ? - P NIILTSS MA SlE --.Er AUDCT, REFOrReE PLANNING. s.t ^ * ' 5 EAFL5rEo 70IC' By DEPARTI4ENT WILL POLICY FORMULAT10N APECTlG A. ACFIVITIES 0U 6~'NF 3^- "U _ FEAtIO~ . TlTrNEKT S A AS TAr_ CARE OF WEAkER 4 CR1 ESvI Er; VL e-c i,ATATIOM 713 S s rAR.S TC'T'4.ES * CEMENTS. .NITS DER lEmoNTORING SYSTEM, PUBL^ IC REL