Home / Opinion / Distorted factor markets in India

Firms need capital, labour and land to produce output. More efficient firms can produce more output if they have better access to factors of production. While there may not be such a thing as a perfectly efficient factor allocation, there are huge gains to be made by reducing factor misallocation.

Firms in India differ enormously in performance compared to the US. The productivity of a US firm in the top decile is usually twice as high as that of a firm in the bottom decile in a typical manufacturing industry. This increase is five times more so in India. This suggests considerable factor market misallocation within India. Policymakers, captains of industry and academics have long argued that Indian manufacturing productivity could be increased by more than 50% if the misallocation of factors of production in India was brought down to US levels.

Which factor of production is most distorted in India—capital, labour or land? We examined this issue in a recent paper (A Detailed Anatomy Of Factor Misallocation In India by Gilles Duranton, Ejaz Ghani, Arti Grover Goswami and William Robert Kerr). Although our understanding of factor allocation and growth is still at an early stage, some striking results have emerged.

First, there are considerable differences in misallocation within India. These differences are even larger than the differences that exist across countries. Second, land is much more distorted than capital and labour in the manufacturing sector (labour plays a fundamental role in misallocation in services). Land allocation is barely better than random at best, and probably worse than random in the manufacturing sector. Put differently, less efficient firms have better access to land and buildings than more efficient firms.

If land is misallocated, does this have repercussions on capital allocation through financial markets? The two are interconnected. Most bank loans require some form of collateral to guarantee the loan. Land is simply the best form of collateral due to its immobility (i.e., the debtor can’t run off with land). While borrowers can often pledge 80% of the land value against loans, for most other forms of fixed investment, the loan-to-collateral value ratio is substantially lower.

There is strong evidence to support the hypothesis that land misallocation is an important determinant of financial misallocation in India, due to the role of land as collateral against loans. Moreover, financial misallocation has worsened over time, with the gap between misallocation in output and access to external finance widening. Poor allocation in land collateral inputs has distorted access to finance. But misallocation in labour inputs has not had an impact on the allocative efficiency of financial loans.

India needs more efficient financial allocation for scaling up the entry of new firms, removing barriers to firm growth, and providing equal access to bank loans irrespective of firm size or gender. Unfortunately, enterprises in the organized and unorganized sectors do not have equal access to financial markets. Nearly 88% of entrepreneurs in the organized sector can access bank loans, but only 8% of firms in the unorganized sector are able to access bank loans. Although the unorganized sector accounts for half of the value of land and buildings held in the manufacturing sector, the value of financial loans reported in this sector is a very small share of the total loans reported in the manufacturing sector. This inequality in access to loans has worsened over time in India.

India has experienced huge urban-rural disparities in access to finance, with rural locations lagging behind their urban counterparts. Spatial disparities are also huge. Access to finance is significantly higher in the leading regions compared to those lagging behind. States like Gujarat, Punjab, Haryana and Rajasthan that have higher per capita income also have much higher access to financial loans. On the other hand, lagging states like Bihar and Uttar Pradesh perform poorly in access to loans, in both the organized and unorganized sectors.

There is also huge gender inequality in financial allocation in India. The disparity is tilted against women-owned enterprises and their access to loans. Although this gap is closing in the organized sector, it has widened in the unorganized sector.

While more productive establishments produce more output, they are constrained by factor misallocation. For any given amount of resources, the aggregate output is not maximized due to factor misallocation. Increasing factor productivity and fostering factor accumulation have long been recognized as key drivers of growth. A better factor allocation would also generate very large economic gains, equivalent to a sixfold increase in the land supply for manufacturing establishments. Although misallocation of other inputs has also constrained firm performance, land and building access are especially important in India.

Land plays a unique role as a factor of production in growth. Choosing a location for an enterprise is a decision that conditions many others and cannot easily be changed, especially in an environment with poorly functioning land markets. More productive establishments will have a tough time buying more machines or employing more workers if they have no room to accommodate them. Land may also be a uniquely important asset for establishments that seek to expand since it can be used as collateral for external financing.

Better land policies can make land more broadly available—crucial in India, the most land-scarce country in the world—and reduce the frictions associated with land transactions. Eliminating frictions in the land market would require more than better land-use regulations and more efficient taxation of properties. Better-functioning land markets also require clearly defined property rights, a reliable land registry, and a number of other institutional improvements. This will be a big challenge for India, where property rights for land and buildings are poorly defined, and often conflict with tenancy rights.

Ejaz Ghani is an economist at the World Bank.

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