[op-ed snap] Reducing financial misallocation in India

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Mains Paper 3: Economy | Mobilization of resources

From UPSC perspective, the following things are important:

Prelims level: Twin balance-sheet problem

Mains level: Financial misallocation and its effects


Context

Concerns about India’s future growth trajectory

  1. The twin balance-sheet problem, of highly leveraged corporate entities and bad loan-ridden banks, has raised concerns about India’s future growth trajectory
  2. If firms are not able to grow, and banks not able to lend, that trajectory will slow down

Financial misallocation in India

  1. Financial misallocation is a bigger problem in the manufacturing sector than in services in India
  2. Growth requires more efficient firms to produce more output and use more factors of production, including greater access to bank loans
  3. But, less efficient firms manage to access more bank loans, leaving less room for growth of more efficient firms
  4. This is India’s financial misallocation problem

Reasons behind misallocation

  1. The underlying cause behind the financial misallocation is distortion in the land market
  2. Access to bank loans is disproportionately tied to access to land, as land and buildings provide strong collateral support for most bank loans
  3. Less efficient firms have been accessing more land and thus more bank loans
  4. This is not a problem for the service industry, which is less land-intensive

Industry distributions of financial misallocation

  1. Most bank loans in the manufacturing sector are taken up by large firms in the organized sector
  2. The small firms in the unorganized sector, which account for nearly 80% of jobs, and about half of the value of land and buildings held in the manufacturing sector, pull in a very small share of bank loans
  3. The value of financial loans reported in the informal sector is barely 2-6% of the value of total bank loans reported in the manufacturing sector

Geographic distributions of financial misallocation

  1. There is a huge spatial diversity in access to bank loans within India
  2. Access to bank finance is significantly higher in the leading states compared to the lagging regions
  3. This is true for manufacturing enterprises in both the organized and the unorganized sector
  4. States like Gujarat, Haryana and Rajasthan have access to financial loans for over 95% of the organized sector plants
  5. Lagging states like Bihar and Uttar Pradesh perform poorly in access to bank loans
  6. The differences in misallocation within India are larger than the differences across countries

Financial misallocation and growth

  1. India is one of the most land-scarce countries in the world
  2. Land and financial misallocation trumps labour misallocation
  3. Financial misallocation has constrained the growth of the manufacturing sector
  4. Rapidly growing firms in asset-intensive sectors require external finance due to their capital growth needs
  5. This is reduced due to financial and land misallocation which explains why India’s manufacturing firms have trouble scaling up
  6. Poorly functioning land and financial markets also explain why India has so few start-ups

Way Forward

  1. India remains one of the fastest growing market economies
  2. Financial misallocation has constrained the growth of the manufacturing sector, a key driver of growth and job creation
  3. Policymakers need to pay more attention to addressing the underlying causes of financial misallocation
  4. This would involve removing land market distortions, better land-use regulations, and more efficient taxation of properties
Industrial Sector Updates – Industrial Policy, Ease of Doing Business, etc.
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