Misallocation and Capital Market Integration: Evidence From India

Misallocation is a leading explanation for income differences across countries, but the literature has two problems: measures built on cross-sectional dispersion in marginal revenue products are inflated by measurement error and model misspecification, and dispersion measures are largely silent about which policies would reduce misallocation. India’s staggered liberalisation of foreign equity investment addresses both. Over the 2000s the Indian government granted automatic approval of foreign direct investment up to at least 51 percent of domestic firms’ equity, industry by industry, in two waves (2001 and 2006), coded at the 5-digit NIC level. Combining that policy variation with a 1995-2015 panel of 5,013 large and medium-sized manufacturing firms across 337 industries from the Prowess database, the paper runs a difference-in-differences with heterogeneous effects: does the reform raise capital differentially for firms that had high marginal revenue products of capital before it? The identifying requirement is weaker than what cross-sectional work needs – not random assignment, nor balanced pre-reform levels, only that the high-versus-low-MRPK gap would have evolved similarly in treated and untreated industries. For the average firm, capital rose 32 percent and MRPK fell 18.7 percent, with revenues and wage bills positive but not significant. The heterogeneity is the result: relative to low-MRPK firms, high-MRPK firms raised physical capital by 53 percent, revenues by 23 percent and wage bills by 28 percent, and cut MRPK by 33 percent, while low-MRPK firms were essentially unaffected – so dispersion in MRPK narrowed without shrinking anyone, and at least some of India’s observed MRPK dispersion is real misallocation rather than noise. Effects build slowly: they take three to four years to reach those magnitudes and reach +79 percent capital and -46 percent MRPK by ten years. The same pattern holds for labour, with high-MRPL firms raising wage bills 24 percent and cutting MRPL 28 percent, closing about a fifth of the MRPL gap. Effects are largest where the pre-reform state banking sector was least developed, which the paper reads as evidence that domestic banking inefficiency is part of the source. Product-level data show prices falling 17 percent on average and 21 percent for high-MRPK firms, with output up and product portfolios expanding for those firms. Aggregating with a first-order Solow-residual decomposition that avoids the usual lognormality and returns-to-scale assumptions, the treated industries’ Solow residual rises by at least 3.4 percent, 6.2 percent once the policy’s growing effects over five years are cumulated, and 16.3 percent under the conventional cross-sectional way of inferring baseline wedges – the range the paper reports as 3 to 16 percent, with the low end its deliberate lower bound.

Adrien Matray | Macro Paper Warehouse

Misallocation and Capital Market Integration: Evidence From India