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Banking Reform in India∗ - page 12 / 57





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but the difference is small, and not significant. The increase in credit did not cause an unusually large number of big firms to default.

Default rate, and the higher cost of lending to the firms in the priority sector, are not sufficient to narrow significantly the gap between our estimate of the rate of returns to capital and the interest rate. Using these estimates and our previous estimates of the cost of lending to small firms (from previous work14), we compute that the interest rate banks should charge to these firms is close to 22% (rather than the 16% they are charging on average). This means that the gap between the social marginal product of capital is at least 66%. These results provide clear evidence of very substantial under-lending: some firms clearly can absorb much more capital at high rates of return. Moreover the firms in our sample are by Indian standards quite substantial: these are not the very small firms at the margins of the economy, where, even if the marginal product is high, the scope for expansion may be quite limited.

These data do not tell us anything directly about the efficiency of allocation of capital across firms. However, the IV estimate of the effect of loans on profit is strongly positive, while the OLS estimate is not different from zero. In other words, firms that have higher growth in loans do not generate faster growth in profits, suggesting that normally banks do not target loans enhancements to the most profitable firms. This is consistent with evidence reported in Dasgupta15, that the interest rate paid by firms and by implication the marginal product of capital varies enormously within the same sub-economy.16 It is also consistent with the more direct evidence in Banerjee and Munshi showing that there is very substantial variation in the productivity of capital in the knitted garment industry in Tirupur17. Furthermore, while we have no direct data on this point, banker’s lore suggests that the firms that have relatively easy access to credit tend to be the bigger and longer established firms.

The underprovision of credit to small-scale industry was one of the key reasons cited for nationalization in 1969: thus, it might in fact be the case that while the public sector banks provide relatively little credit to SSI firms, private banks are even worse. In the next sub-section we examine the effect of bank ownership on bank allocation of credit.

14 Banerjee and Duflo (2001). 15 Dasgupta (1989). 16 Banerjee (2003) summarizes this evidence. 17 Banerjee and Munshi (2004).


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