Misallocation and capital market integration: Evidence from India

Institutions

Posted

January 2024

Natalie Bau

Adrien Matray

Research Paper

What is this research about and why did you do it?

This paper estimates the effect of foreign capital liberalization on misallocation in India.

FDI restrictions are widespread – three quarters of low-income countries have some restrictions -- but their effects are ambiguous. On the one hand, liberalizing FDI could decrease misallocation if foreign investors do not face the same regulatory, historical, or political constraints as domestic investors and can allocate capital to the firms with the highest marginal returns. On the other hand, if foreign investors have worse information, misallocation may increase. As countries consider liberalizing FDI flows, it is important understand how this will affect productivity and ultimately, economic development.

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How did you answer this question?

We exploit an unusual policy experiment in India, where access to foreign capital was liberalized in different disaggregated industries at different times. If misallocation fell due to liberalization, theory predicts that firms with high sales/capital ratios should grow in treated industries, and the opposite should be true if misallocation grew. Combining the policy variation with panel data on Indian firms allows us to test which is the case by causally estimating the heterogeneous effects of the policy on different of firms. We also develop a method to calculate the aggregate productivity effects of the policy using these firm level estimates.

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What did you find?

We find that misallocation fell. Capital grew substantially for firms in treated industries that had a high sales/capital ratio prior to the enactment of the policy, while the policy had little effect on firms intreated industries with lower sales/capital ratios. Exploiting a new method to translate our natural experimental estimates into bounds on the aggregate effect of the policy, we estimate that liberalization increased treated industries’ aggregate productivity by 3-16%.

This figure reports the effect of FDI deregulation for high and low sales to capital ratio firms (high and low MRPK firms, respectively) for log capital. The reform is normalized to take place in year 1. Each dot is the coefficient on the interaction between being observed t years after the reform and being in a treated industry. The confidence interval is at the 95% level.

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What implications does this have for the study (research and teaching) of wealth concentration or economic inequality?

Many commentators in India have criticized trade and foreign capital liberalization, arguing that these policies increased inequality. Similar concerns arise around the world as countries consider liberalizing. This study suggests that repealing FDI reforms (or failing to make additional reforms)could come at a substantial cost. These globalizing reforms had meaningful positive effects on the productivity of the Indian manufacturing sector, enabling economic growth.

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What are the next steps in your agenda?

We will continue to study the effects of globalizing reforms in India. In ongoing work, focusing on people instead of firms, we directly study the effects of the policies on inequality, incomes, education, migration, and structural change.

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