Discussion Paper Details

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Title: Misallocation and Capital Market Integration: Evidence From India

Author(s): Natalie Bau and Adrien Matray

Publication Date: January 2020

Keyword(s): aggregating reduced-form estimates, foreign capital liberalization, India and Misallocation

Programme Area(s): Development Economics, Industrial Organization and Macroeconomics and Growth

Abstract: We show that foreign capital liberalization reduces capital misallocation and increases aggregate productivity using a natural experiment. The staggered liberalization of access to foreign capital across disaggregated Indian industries allows us to identify changes in firms' input wedges, overcoming major challenges in the measurement of the effects of changing misallocation. For domestic firms with initially high marginal revenue products of capital (MRPK)/high sales to capital ratios, liberalization increased revenues by 18%, physical capital by 60%, wage bills by 26%, and reduced the marginal revenue product of capital by 43% relative to low MRPK firms. There were no effects on firms with low MRPK. The effects of liberalization are largest in areas with less developed local banking sectors, indicating that foreign investors may substitute for an efficient banking sector. Finally, we develop a method to use natural experiments to estimate the lower bound effect of changes in misallocation on manufacturing productivity. We find that this liberalization episode increased the aggregate productivity of the Indian manufacturing sector by at least 6.5%.

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Bibliographic Reference

Bau, N and Matray, A. 2020. 'Misallocation and Capital Market Integration: Evidence From India'. London, Centre for Economic Policy Research.