These differences in financial misallocation within India are much larger than the differences found in other developing countries. Improving credit allocation
For Abhiman Das and Ejaz Ghani
The Reserve Bank of India (RBI) is exploring the possibility of allowing large industrial conglomerates to own banks. This will amount to the RBI influencing credit allocation, and a central bank should avoid this.
Lawmakers are concerned about the slow growth of credit volumes that has limited India’s growth trajectory. However, allowing industrial conglomerates to own banks will not lead to a sustainable increase in the volume of credit growth. India’s slowness in the volume of credit growth is due to connected lending that has resulted in large, less efficient companies accessing more capital, leaving less room for new and more efficient businesses to access bank loans.
Allowing large corporations to own banks will further deepen the existing problem of connected lending and displace younger and more efficient entrepreneurs. An increase in the volume of bank loans will occur only if banks lend more to more efficient companies, so that more efficient companies can grow faster and reverse the trend of non-performing loans. Faster credit growth and economic growth go hand in hand, and India will experience this virtuous cycle, only when connected loans are invested.
Global experience has shown that corporate ownership of banks increases the risk of connected loans, diversion of funds, corporate defaults, and the risk of spreading large corporate defaults to the entire banking system. Empirical evidence shows that connected lending in India has contributed to large corporate defaults in the past. The problem of connected loans and business default is much more pronounced in India compared to other developing countries. A large number of large private companies were already heavily in debt and stressed even before the pandemic. Many great corporate leaders – Vijay Mallya, Nirav Modi, Mehul Choksi, Jatin Mehta, Sandesara brothers – have already fled the country without paying their debts.
India’s twin balance sheet problem – large corporate defaults and badly lending banks – is related to and a consequence of the widely prevalent connected lending. Indian companies have already crossed the Lakshman Rekha that separates banks from private companies. Furthermore, RBI has been weak in the supervision and management of financial institutions.
How serious is the problem of connected loans and financial misallocation in India? Firms need three factors of production: capital, labor, and land, to produce products. We estimated the degree of financial misallocation in India, over the past two decades, using data from millions of companies in the manufacturing and service sectors in more than 600 districts in India (see Ghani et al, ‘A Detailed Anatomy of Factor Misassignment in India ”, Policy Research Working Paper, Series 7547, World Bank).
Financial misallocation is much more pronounced in India compared to land misallocation and the labor market. Most bank loans in the manufacturing sector are taken out by large and less efficient conglomerates that create less than 20% of jobs in the manufacturing sector. The smaller and more efficient companies, which create 80% of jobs in the manufacturing sector, have access to a very small share of bank loans. The value of bank loans for small businesses is only 2-6% of the value of total bank loans in the manufacturing sector.
There is also enormous spatial and geographical diversity in the allocation of bank loans within India. Bank loans go largely to Gujarat, Haryana and more developed states, and very little to lagging states like Bihar and Uttar Pradesh. There is also considerable variation in financial misallocation in 600 districts of India. These differences in financial misallocation within India are much larger than the differences found in other developing countries.
Improving credit allocation
We calculate an index of financial misallocation for the manufacturing and service sectors in India. The financial misallocation in India’s manufacturing sector is much higher than in the service sector. This may explain why the manufacturing sector has grown at a much slower rate compared to services. The empirical results also show that poorly performing banks have become much more involved in and connected loans. The two go hand in hand, hand in hand, and it explains why India has so few start-ups in the manufacturing sector, as poor allocation of bank loans has limited India’s entrepreneurship.
Banks can improve capital allocation through various channels, including better evaluation and monitoring of companies, lower transaction costs for financial intermediation, and internalizing externalities generated from information collected and processed in financial markets. The empirical evidence we examined from a large group of developing countries reinforces the classic theme of development economics: reducing financial market distortions and inefficiencies (see ‘How financial markets affect long-term growth: a comparative study of Countries’, Policy Research Working Paper Series 843, The World Bank).
This is also corroborated in one of our recent studies on India’s infrastructure development and finance. It is the initial development of the financial sector that decides the level of economic activity, not the other way around (See, Infrastructure and Finance: Evidence from India’s GQ Road Network, hbs.me/37s5gGH, 2019, Harvard Business School).
The future of India
Growth requires more efficient companies to access more bank loans to produce more production. Unfortunately, the connected lending that is widely prevalent in India has allowed large industrial conglomerates to access more bank loans. This has displaced access to bank loans for new, young and often more efficient companies. The problem of connected lending and misallocation of capital, which results in lower economic growth and lower job creation, will only get worse if large industrial conglomerates are also allowed to own banks.
Policymakers need to pay more attention to addressing the underlying causes of the misallocation of bank loans that have led to the volume of bank loans and high levels of non-performing loans. Accelerating India’s economic growth requires moving forward with stronger policy reforms to promote competition and innovation, and allowing more efficient companies to access more capital and grow faster, rather than allowing large conglomerates to continue to dominate.
Banks will need to rework their lending model and shift the less efficient approach to their lending from large companies to new and more efficient participants. Banks can play an important role in promoting entrepreneurship, growth and job creation. The RBI should avoid influencing credit allocation by allowing industrial conglomerates to own banks.
Das is Professor of Economics, IIM-A, and Ghani was a Senior Economist at the World Bank.
Views are personal
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