term investment finance in a system of industrial licensing and controlled interest rates.<sup>19</sup> Mor, Chandrasekhar and Wahi (2005) describe the initial response to the post-1991 liberalization as follows: “In part led by the consortium financing system but largely because neither industrialists nor bankers had any experience in operating in liberalised environments, almost every project that was submitted for financing was accepted. As a consequence, the system created capacity (which is quite possibly what showed up as growth numbers) in industry after industry – steel, man-made fibre, paper, cement, textiles, hotels, and automobiles received a major share of the large loans given principally by the DFIs and partly by the CBs (commercial banks).”

**_Second stage_** In the second stage, which more-or-less coincides with the Ninth Plan period, there is a pull-back after the private investment spree of the Eighth Plan period.  Many of the positive trends that had been observed in earlier years were reversed during the second half of the nineties and investment intentions and levels declined significantly (Figure 3). Financial trends at the firm level were also reversed: aggregate leverage increased, and the maturity structure of debt shifted slightly towards short-term borrowing (Topalova 2004b) and companies also suffered from declining profitability (Figure 4). Importantly, a number of studies using disaggregated data point to significant differences across companies. For instance, foreign firms consistently perform better than domestic firms; and private firms perform better than public firms.<sup>20</sup> Moreover, these performance gaps appear to be increasing over time, suggesting that different firms are responding differently to the new challenges and opportunities provided by the reform process, and thus alluding to some process of creative destruction. (See more on this in the next section.)

We posit three reasons for the reversal in investment performance during the second half of the 1990s, all related to the complex transition process that took place in India.

- (i) the Eighth Plan investment boom was facilitated by established business relationships and did not reflect internationally competitive business fundamentals;

- (ii) large cuts in public investment which started during the Eighth Plan period, hurt private investment with a lag; and

- (iii) given India’s gradual approach, key structural reforms have taken time to reach a critical mass.  We consider these three issues in turn below.

<u>A Low-Quality Investment Boom.</u> NCAER (2001) shows that although the liberalization of the early 1990s led to some restructuring, this was of a limited nature and the investment decisions of the Indian private corporate sector were significantly different from foreign companies. The former essentially continued in similar activities as before – basic and intermediate commodities. These activities were not as profitable in the liberalized, more open economy, with large capacity additions further reducing profit margins. Foreign companies on the other hand, entered new areas like pharmaceuticals and certain consumer goods where profitability was higher thus improving their performance. According to CMIE data, the correlation of industry-wise distribution of gross fixed assets between 1992 and 1998 was 0.99 for domestic public firms; whereas it was only 0.79 for foreign firms.<sup>21</sup> While domestic and foreign investment surged

> 19 DFIs were established by the government to provide long-term project finance for investments, while working capital came from the banks.

> 20 As shown by Topalova (2004b), the interest coverage ratio (ICR, defined as earnings before interest, taxes, depreciation and amortization over interest expenses) dropped from 2.7 in 1996 to 1.9 in 1999, suggesting that Indian companies were facing increased strain in meeting their debt service obligations. The incidence of an ICR of less than one (the level at which a firm experiences difficulty in servicing its debt) was greatest among government-owned enterprises (55 percent).

> 21 The average for the whole sample, including domestic private firms, was 0.90.

13