Capital market integration can reduce misallocation: Evidence from India

Interesting research by Natalie Bau and Adrien Matray. They try and find out whether India’s capital market reform has helped firms increase output and productivity:

In a recent paper (Bau and Matray 2019), we leverage an unusual policy experiment to make progress on both these challenges. To quantify the effects of foreign capital liberalisation on misallocation and aggregate manufacturing productivity, we study a foreign capital liberalisation policy that took place in India in the early 2000s using detailed firm-balance sheet microdata. In 2001 and 2006, India removed restrictions on foreign investments in specific industries, introducing automatic approval of foreign direct investments up to 51% of domestic firms’ equity. This reform may have reduced capital market frictions. The staggered introduction of the policy across industries and over time allows us to compare the changes in the outcomes of firms in industries that did and did not liberalise and estimate the effects of foreign capital liberalisation on the growth of firms facing the greatest constraints on their access to capital. 

To measure the effects of foreign capital liberalisation, we combine this policy experiment with firm-level data from Prowess compiled by the Centre for Monitoring the Indian Economy (CMIE). The dataset contains information from the income statements and balance sheets of companies comprising more than 70% of the economic activity in the organized industrial sector of India. Thus, it is representative of large and medium-sized Indian firms.

To estimate the effect of opening up to foreign investment on capital allocation, we first determine whether a firm is ex-ante capital-constrained by ranking firms based on their pre-reform marginal revenue product to capital (MRPK). MRPK is the measure of the output per additional unit of capital used by a firm. It is often used to measure the degree of the capital constraints faced by a firm since capital should flow to the firms with the highest returns. Therefore, a firm ‘stuck’ with a large return on investment is likely to be prevented from growing because it faces a high cost of capital, leading to misallocation.

As a result of the liberalisation policies, we find that capital-constrained firms (those with MRPKs above the median in their disaggregated industry) differentially expanded their assets by 60%, spent more on labour (+24%), and increased their revenue by 18%. Overall, the MRPKs of capital-constrained firms fell by 45%. This indicates that the cost of capital fell for firms with initially high costs of capital and indicates that capital misallocation also fell. In contrast, firms that we identify as capital-unconstrained in the deregulated industries did not expand relative to similar firms in non-deregulated industries. 


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