BANKING ON BANKING?

Where does misallocation come from? Indian firms grow much more slowly than US firms, but are also much less likely to shut down.¹⁰⁰ In other words, the United States is an “up or out” economy, where people try something new and either succeed and make it big or fail after a few years.

These two facts are probably closely related: the fact that good firms cannot grow fast enough also helps explain why bad firms can survive. If the best firms were to grow fast, they would drive down the price of whatever they sold and therefore force out everyone except those efficient enough to make money even when the prices were low. By the same token, they would drive up wages and the cost of raw materials, further discouraging bad firms. In contrast, if they remain small and service only the local demand, a less efficient firm can easily survive in the market next door.

One natural culprit is the capital market. It clearly plays a role in the Tirupur example, where the most productive entrepreneurs in the most productive T-shirt cluster in India cannot borrow enough to catch up in size with the less productive local firms. In India and China, estimates imply that simply reallocating capital across firms would erase most of the TFP gap created by misallocation.¹⁰¹

This interpretation dovetails with a generally shared sense that the banking sectors in both China and India have serious problems. Indian banks are famous for trying to avoid lending to anyone except blue-chip borrowers (usually without recognizing that yesterday’s blue-chip firms are often today’s disaster waiting to happen). Chinese banks have undergone significant reforms since the 1990s, with the goal of allowing for entry of different actors and improving the governance of the state-owned banks, but the “big four” state-owned banks still tend to be all too willing to lend to dubious projects with good political connections.¹⁰² Finding money remains difficult for a young and ambitious entrepreneur with a good idea but no powerful friends.

Indian banks have very much the same problem, and in addition they are reputedly extremely overstaffed.

In addition, companies need risk capital, funding that unlike bank funding protects them when they are hit by bad luck. Stock markets do this, but the Chinese stock market is yet to be widely trusted and the Indian one, while older and better run, is still very blue-chip dominated.

Poorly developed land markets are another reason why companies do not grow. In order to grow, a productive firm will need to acquire more land and buildings to make room to accommodate new machines and employees. In addition, land and buildings can be used as collateral for loans. This becomes a huge problem when land markets function poorly. To take a very common example, in many countries ownership of land and property is often disputed. A claims B’s land, the land gets placed under court authority, and it typically takes years to settle the dispute. A recent study suggests that in India land and buildings play a big role in misallocation.¹⁰⁵ In fact, in about half the districts in India, more productive firms tend to have less land and buildings than the least productive ones! This is likely to be a large problem in many countries where property rights on land are not very clearly defined.