Banking and Misallocation in India

Banking and Misallocation in India

India has not only been one of the fastest growing economies in the world in the past two decades, but has also been a major growth engine for the world economy through a series of crises and prolonged business cycle fluctuations. During this period, India has also graduated to becoming one of the biggest
economies, emerging market and otherwise, and has been touted as one of the “vibrant spots” in the faltering global economy since the onset of the 2007-08 Financial Crisis, accounting for almost 15 per-cent of the global growth as recently as 2018.

One of the principal sources for this transformation of India’s economic story has been a massive policy transformation, pushing towards integrating growth with trade and increased economic liberalization, as an exit strategy from its Balance of Payments crisis in 1991. The 1980s and 1990s marked a period of widespread economic reforms consisting of industrial de-licensing, along with trade and investment liberalization in 19911.

While a lot of India’s recent growth has been at the convergence of manufacturing and services, with liberalization of India’s markets and industries, the economy has also witnessed a rise in foreign capital complimenting the role played by domestic capital as a source of economic growth. Since India’s
original push towards liberalization, it has steadily risen to become of the most prominent destinations of FDI investments across the globe, and the stock markets in India have also experienced growing turnovers in the volumes of FPIs that have been entering the Indian economy not just due to the
financial liberalization in the country but also because of global investors wanting to take a share in India’s growth story.

While there has been a rising clamour to attract greater volumes of capital flows into the economy so as to leverage India’s generally phenomenal growth rates, the Indian economy has not been isolated from the declining global growth slowdown, showing signs of faltering notably over the past couple of
years. India’s organized manufacturing sector output experienced high rates of growth between 2003 and 2009, with an average growth rate of around 15% largely made possible by rising private investments and exports. This phase however began to come to a halt with the onset of the Financial crisis in 2008.
India’s export growth plummeted drastically and never gained momentum due to sporadic episodes of slowdown in different parts of the global economy. Domestic economic growth also plummeted due to a rise in unemployment among a number of other institutional reasons. All of this resulted in the decline
of output, employment and productivity in India’s manufacturing sectors for almost the entirety of the last decade, since 2009-10.

Notwithstanding these developments over the past decade, India’s overall impressive growth record has prompted a number of papers to shed light on the sources of rapid increase output among developing economies (for example Bosworth and Collins, 2008). One natural question in this regard has been as to whether the observed growth in such emerging markets are driven by their ability to infuse larger amounts of inputs into the production process or their ability to enhance the efficiency in using their inputs (reflecting in a higher Total Factor Productivity), or a combination of both. A number of papers have looked at the role of distortion in the allocation of factors of production across industries, firms and sectors to explain sources of potentially lower output (Restuccia and Rogerson, 2007; Hsieh and Klenow, 2009). In explaining the role of TFP in the growth of emerging market economies, these papers open up a key relatively unexplored linkage between productivity growth slowdown (Figure 1 2 and India’s overall manufacturing stagnation for the last few years).

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