VoxEU Column Development

The transformation of India: Incumbent control, reforms, and newcomers

What microeconomic forces drove the structural transformation of India’s economy in recent decades? This column studies firm-level data and portrays a dynamic economy driven by the growth of private and foreign firms. But the Indian economy did not go through an industrial shakeout phase driven by creative destruction. The endurance of incumbent firms prevented a dramatic microeconomic transformation.

The end of the license Raj and implementation of pro-market reforms in the 1980s and 1990s had far-reaching implications for India’s industrial structure. Significant sectors of the economy were opened up to private participation through industrial de-licensing and de-reservation measures. India began to integrate into the world economy as import licensing was abolished in many sectors, import duties were sharply reduced, and many restrictions on FDI were lifted.

India’s annual growth rate accelerated from an unspectacular average of 3.5% between 1960 and 1980 to over 9% per annum by 2005. Investment increased from 23% of GDP in 1985 to 38% in 2005. India attracted more than $70 billion in FDI between 2000 and 2005 (in contrast to less than $1 billion during the 1980s), the bulk of which was concentrated in IT services, construction, and telecommunications sectors. New firms emerged, and many Indian firms established an international presence. The economy transitioned from being mainly dependent on agriculture and manufacturing to a services-oriented structure over the 1990s.

Numerous views have been put forth about the driving forces behind the transformation of India’s growth landscape (see Bosworth, Collins, and Virmani 2007, Kochhar et al. 2006, Panagariya 2008, and references therein). Some stress the role of “pro-business” reforms that began in the early 1980s (Rodrik and Subramanian 2005), while others note the importance of the systemic reforms in the 1990s and 2000s in sustaining and accelerating the growth rate (Panagariya 2008, Srinivasan and Tendulkar 2003).

The debate is far from settled. Thus far, the extensive empirical literature has focused on characterising India’s aggregate economic performance. However, aggregate data do not shed light on the channels through which policy reform can transform the economy at the micro-level. Data at the firm or plant level offer an opportunity to do so.

Identifying firm-level evidence of creative destruction

In Alfaro and Chari (2009), using a firm-level dataset, we take a step in this direction by documenting detailed stylised facts about the evolution of India’s micro-economic industrial structure against the backdrop of the reforms (albeit piecemeal in nature) that began in the mid-1980s.

Schumpeter (1942) argued that creative destruction, the replacement of old firms by new firms and of old capital by new capital, happens in waves. We argue that a system-wide reform or deregulation, such as the one implemented in India, may be the shock that prompts a creative destruction wave and therefore provides an ideal backdrop against which to investigate the firm-level response to a changing economic environment.

Firm-level data from the Prowess database are collected by the Centre for Monitoring the Indian Economy from company balance sheets and income statements. Prowess covers both publicly-listed and unlisted firms from a wide cross-section of manufacturing, services, utilities, and financial industries beginning in 1988. About one-third of the firms in Prowess are publicly-listed firms. The companies covered account for more than 70% of industrial output, 75% of corporate taxes, and more than 95% of excise taxes collected by the Government of India. Prowess covers firms in the organised sector, which refers to registered companies that submit financial statements.

The main advantage of firm-level data is that detailed balance sheet and ownership information permit an investigation of a range of variables such as sales, profitability, and assets for an average of more than 15,500 firms across our sample period. Firms are classified by 3-digit industries covering agriculture, manufacturing, and services. The coverage of the services sector is a particularly attractive feature of the data.

Firm entry and earnings

In Alfaro and Chari (2009), we present information about the average number of firms, firm size (assets, sales) and profits for the firms in our sample by sector as well as by owner-category of firm: state-owned enterprises, private firms incorporated before 1985 (old private firms), private firms incorporated after 1985 (new private firms), and foreign firms. For expositional purposes, we present the evidence across five sub-periods that broadly match the different liberalisation waves.

Overall, the data portray a dynamic economy driven by the growth of private and foreign firms. Consistent with the rapid growth observed after the mid-1980s, overall firm activity measured by the number of firms grew substantially relative to the beginning of the sample period. While one cannot infer causality from our results, the increasing number of private and foreign firms suggests that the liberalisation measures enacted to allow domestic entry through de-licensing and de-reservation, combined with the liberalisation of FDI, promoted greater dynamism in new entry by firms other than the incumbents of the pre-reform period (state-owned and traditional private firms incorporated before 1985). Indeed, the doubling of the average number of foreign firms in this period suggests substantial foreign entry, albeit from very low levels in the pre-reform period. This pattern is broadly mimicked for average assets, sales, and profits by ownership type and sector.

A more subtle picture emerges when we examine the return on assets. While there is some cross-sectional variation in rates of return across ownership groups and sectors, there is relatively little dispersion in the rates of return (Figure 1). The narrow range and low coefficient of variation in returns across ownership-groups and sectors are striking when compared to the large variations we see in terms of new firm-entry by foreign and private firms and in the growth of their assets, sales, and profits compared to the lower rates for state-owned and traditional private firms.

Figure 1. Average return on assets

Liberalisation was not a dramatic transformation

On further examination, what emerges is not a story of dramatic transformation in India’s micro-economic structure following liberalisation. The data suggest that incumbents, state-owned firms, and to a lesser extent, the traditional private firms, continue to overshadow the shares of assets, sales and profits in the economy (Figure 2). Between 1988 and 1990, state-owned and traditional firms accounted for 94%, 87% and 91% of total assets, sales and profits. Between 2003 and 2005, these fractions stood at 77%, 73% and 78%, respectively.

Figure 2. Number of firms, assets, sales and profits by ownership group (share of total)

The exception to the pattern of incumbent firm dominance is seen in private-firm growth in the services industries (Khanna and Palepu 2005). In particular, the assets and sales shares of private new firms in business and IT services, communications services and media, health and other services show a substantial increase over the sample period. This pattern coincides with the reforms in the services sectors after the mid-1990s and is also consistent with the growth in services documented in the aggregate data.

The endurance of incumbent firms

In the Schumpeterian framework, creation in India appears driven by new entrants in the private sector and foreign firms. The economy does not however seem to have gone through an industrial shakeout phase in which incumbent firms are replaced by new ones.

An explanation for our findings, perhaps not sufficiently stressed in the debate about Indian growth, is the enduring influence of incumbent firms. Sectors in which incumbent firms dominated prior to liberalisation continue to do so even twenty years after the reforms began. In particular, the importance of the state-owned firms remains extraordinarily high. After a short spell in the early 2000s, privatisation efforts were abandoned, and sectors such as manufacturing and financial services remain largely under state control. For example, the share of state-owned firm assets was close to 70% of total assets in 1988-1990 and stood at a little over 60% by 2005. The extent of state control makes India an outlier in the world, with the exception of China, of course (Chong and Lopez-de-Silanes 2004).

Political economy explanations emphasise the role of entrenched incumbents firms who may have incentives to oppose the liberalisation efforts (Stigler 1971, Rajan and Zingales 2003a, b). The firm-level evidence we uncover suggests that both industry concentration and state-ownership are inversely correlated with the probability of liberalisation. Focusing on FDI liberalisation in India, Chari and Gupta (2008) find that reforms may have been captured by powerful interests, particularly by firms in profitable, concentrated industries and in industries with substantial state-owned firm presence.

Recent literature highlights the idea that economic growth may be impeded not simply because of a lack of resources such as capital and skilled labour but also because available resources are misallocated (Alfaro, Charlton, and Kanczuk 2008, Banerjee 2006, Hsieh and Klenow 2009). The high levels of state ownership and ownership by traditional private firms in India raise the question of whether existing resources could be allocated more efficiently. We show that rates of return across ownership groups do not display significant dispersion. However, it is not clear whether the rates of return for the incumbent groups are being driven by monopoly power that comes with high industry concentration or through inherent efficiency.


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