(Photo: Bloomberg)
(Photo: Bloomberg)

How foreign capital can boost firm productivity

Foreign capital reduces fund misallocation and improves firm productivity, shows a new study

Last week, Moody’s Investors Service downgraded India’s outlook to ‘negative’ from ‘stable’ because they fear India’s credit squeeze is unlikely to be resolved quickly. Amid this credit squeeze, new research highlights the importance of foreign capital for India.

In the study, Natalie Bau of the University of California and Adrien Matray of Princeton University find that better access to foreign capital not only makes up for scarce domestic capital but also reduces capital misallocation and stimulates firm growth.

Studying the impact of staggered foreign direct investment (FDI) liberalization in India by collecting data on industry-level liberalization episodes in 2001 and 2006 and combining it with firm-level data from CMIE’s Prowess database, the authors find that FDI liberalization affected different companies differently, depending on the capital constraints faced by the firm. To capture the extent of capital constraints, the authors measure each firms’ returns and costs of capital since capital-constrained firms do not invest when the cost of capital exceeds the returns.

They find that, in response to easier foreign capital inflows, firms with initially high capital constraints increased their physical assets by 60%, revenues by 18%, and spent about 26% more on labour. In contrast, firms with weaker capital constraints were not affected.

Simply put, post-liberalization both the cost of capital and misallocation of capital fell for firms with initially high capital-constraints. The authors also find that such gains were the highest where local capital markets were least developed. This suggests that foreign investors could substitute for an efficient banking sector.

This reduction in capital misallocation, the authors show, increased the aggregate productivity of the Indian manufacturing sector by at least 6.5%.

Also read: Should low-income countries open up to foreign capital? The India experiment

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