The twin balance-sheet problem, of highly leveraged corporate entities and bad loan-ridden banks, has raised concerns about India’s future growth trajectory. If firms are not able to grow, and banks not able to lend, that trajectory will slow down. Is the solution a restructuring to address the twin balance-sheet problem or is it in addressing the deeper causal factors that gave rise to it? While the immediate policy focus on restructuring is well placed, the underlying causes behind financial misallocation cannot be ignored if the goal is to boost growth and job creation. Financial misallocation is a bigger problem in the manufacturing sector than in services in India. It is also a problem with large companies rather than small enterprises. So what gave rise to this misallocation?

Growth requires more efficient firms to produce more output and use more factors of production, including greater access to bank loans. Unfortunately, less efficient firms manage to access more bank loans, leaving less room for growth of more efficient firms. This is India’s financial misallocation problem. The underlying cause behind the financial misallocation is distortion in the land market, with less efficient firms accessing more land, and more bank loans. Access to bank loans is disproportionately tied to access to land, as land and buildings provide strong collateral support for most bank loans. This is not a problem for the service industry, which is less land-intensive.

We examined plant-level data on millions of formal and informal enterprises, in both the manufacturing and services sectors, in more than 600 districts in India. This provided important insights into the geographic and industry distributions of financial and land misallocation (“Effects Of Land Misallocation On Capital Allocations In India", World Bank, by G. Duranton, E. Ghani, A. Grover Goswami and W. Kerr).

Most bank loans in the manufacturing sector are taken up by large firms in the organized sector. 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. 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.

There is also huge spatial diversity in access to bank loans within India. Access to bank finance is significantly higher in the leading states compared to the lagging regions. This is true for manufacturing enterprises in both the organized and the unorganized sector. States like Gujarat, Haryana and Rajasthan have access to financial loans for over 95% of the organized sector plants. On the other hand, lagging states like Bihar and Uttar Pradesh perform poorly in access to bank loans.

There is considerable variation of misallocation across districts. The differences in misallocation within India are larger than the differences across countries.

Financial misallocation and growth

We computed an index of misallocation in manufacturing and services, and the organized and unorganized sectors, in the districts. The indices of misallocation for output, value added, and factors of production were computed individually for financial loans, land and labour.

India is one of the most land-scarce countries in the world. Land and financial misallocation trumps labour misallocation. The former appears to be at the root of much of the misallocation of output in the manufacturing sector.

Seen from a banker’s perspective, land can be contrasted with a piece of specialized machinery, for example, where the borrower could seek to hide it from debt collectors or where its sale to other parties after repossession is weak. This difference is visible in terms of the amount of loan collateral possible against asset classes. While borrowers can often pledge 80% of land values against loans, for most other forms of fixed investment, the loan-to-collateral value ratio is substantially lower (e.g. 25%). So, if land markets are highly distorted, then it is likely that the finance market is also distorted, given the misplaced collateral channel.

It is not surprising that financial misallocation has constrained the growth of the manufacturing sector. Rapidly growing firms in asset-intensive sectors require external finance due to their capital growth needs. If this is reduced due to financial and land misallocation, this would help explain why India’s manufacturing firms have trouble scaling up. Similarly, poorly functioning land and financial markets explain why India has so few start-ups; entrants are constrained by financial misallocation, and incumbents don’t grow in the manufacturing sector.

Looking to the future

Financial misallocation has constrained the growth of the manufacturing sector, a key driver of growth and job creation. It is less of a problem in the services industry. This is good news; services are now a bigger driver of growth and job creation in India. India has followed a different growth path compared to China.

India remains one of the fastest growing market economies. But growth cannot be taken for granted. A key challenge is to reduce financial misallocation to unleash the growth in the manufacturing sector. Policy makers need to pay more attention to addressing the underlying causes of financial misallocation. This would involve removing land market distortions, better land-use regulations, and more efficient taxation of properties. Faster growth requires marching ahead with even stronger policy reforms to promote competition and innovation, and enabling more efficient firms to grow faster.

Ejaz Ghani is lead economist at the World Bank.

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