Column: What mid-sized firms in India crucially need 

By: | Updated: June 22, 2016 7:20 AM

India’s mid-sized firms need a much more robust set of financial institutions and intermediation practices

The lesson of all this is that in India’s case, focusing carefully on all the various segments of firms’ financing needs is vital for future industrial growth.The lesson of all this is that in India’s case, focusing carefully on all the various segments of firms’ financing needs is vital for future industrial growth.

Raghuram Rajan, Governor of India’s central bank, was a major presence at the Stanford Center for International Development’s annual conference on Indian economic reform in early June. He gave a talk exclusively for Stanford faculty and students, and an informal speech over dinner for conference attendees. In the latter, he provided an expectedly lucid summary of India’s economic challenges, and RBI’s role in moving things forward. The strategy for cleaning up banks’ bad loans, and the process of creating financial access for many millions of India’s households as well as for its smallest firms, stood out in his account.

My job at the conference was to provide comments on a presentation by Sergio Schmukler, lead economist at the World Bank’s Development Research Group. Schmukler is a prolific researcher in the area of international finance, including financial markets and institutions, financial development, and globalisation. He presented a comprehensive analysis of the access to, and impacts of external financing on emerging market firms, where “external” means external to the firm rather than “international.” Some striking patterns emerged from the data analysis. First, even though the samples were restricted to relatively large firms, which are the ones that have detailed data publicly available, only the larger firms within this restricted set were able to regularly access capital markets. These firms could issue long-term debt, and they could tap multiple sources of capital. The data showed that such firms (even after controlling for other factors) did better than firms which did not access capital markets, in subsequent growth of assets, sales and employment.

In a nutshell, being able to raise money allowed some firms to do better than others. The analysis covered many emerging markets, and the results held more or less similarly across them, including India and China. What do the results imply for policy? The answer to that question depends on having a better sense of why some firms are financially-constrained. They could be poorly managed (which might explain both their failure to secure capital and their inferior performance), or it could be that lenders or financial intermediaries are not able to make efficient decisions in the absence of good information about those firms, or there might be problems of enforcement for certain types of firms (where the borrowers might willfully default on loans or cheat minority shareholders). Or it could be all three. Capital markets are complicated and risky.

Country-specific answers are easier to explore, and this is what Schmukler’s analysis prompted me to do. It turns out that there is a lot that we do not know, but should. In the aggregate, overall assessments of India’s financial development are reasonably positive, with financial markets (such as the Stock Exchange) considered to be somewhat stronger than financial institutions (such as banks). But there are many dimensions of financial development, and India’s record is somewhat uneven (

When one looks at firm-level studies, several studies document that there has been some entry of new firms after liberalisation (now an astonishing 25 years ago), but also continued dominance of large firms, particularly public sector firms and the family-run business houses. Indeed, a recent paper by Laura Alfaro and Anusha Chari documented a shrinking middle in the size distribution of Indian firms over time. The large incumbents grew, and there were more small firms at the bottom, but those firms, along with medium-sized counterparts, seemed to face growth constraints.

Alfaro and Chari and others looking at such industrial dynamics do not identify all the constraints, though labour laws and corruption are well-known contributors to the problems small and medium firms face. What struck me, however, was that financing constraints did not receive much, if any, attention in these studies. Other, earlier studies echoed the work of Schmukler and his co-authors, showing that large firms could access and benefit from external financing. These studies also showed that India’s legal system puts very high costs on financial contracting, since enforcement is so costly and capricious. Small firms develop extra-legal methods for contract enforcement and these help somewhat, but they are inefficient and cannot scale up. Corporate bond markets are very under-developed, bank lending is distorted, and markets for short-term working capital (which can be critical for growth) also function poorly.

The lesson of all this is that in India’s case, focusing carefully on all the various segments of firms’ financing needs is vital for future industrial growth. The large firms take care of themselves, as do high-profile technology start-ups. Politicians pay attention to micro-enterprises as part of a strategy of financial inclusion for the poor. But the firms in the middle are relatively neglected, and they need a much more robust and well-developed set of financial institutions and intermediation practices to allow them to thrive. Even as the government pushes “Make in India” and large-scale Coastal Economic Zones, it needs to make sure that firms that can be part of an envisaged new industrial ecosystem are not choked by financial constraints.

The author is professor of economics, University of California, Santa Cruz

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