Misallocation and Capital Market Integration: Evidence from India

68 Pages Posted: 14 Jan 2020

See all articles by Natalie Bau

Natalie Bau

University of California, Los Angeles (UCLA)

Adrien Matray

Princeton University

Date Written: January 2020


We show that foreign capital liberalization reduces capital misallocation and increases aggregate productivity using a natural experiment. The staggered liberalization of access to foreign capital across disaggregated Indian industries allows us to identify changes in firms' input wedges, overcoming major challenges in the measurement of the effects of changing misallocation. For domestic firms with initially high marginal revenue products of capital (MRPK)/high sales to capital ratios, liberalization increased revenues by 18%, physical capital by 60%, wage bills by 26%, and reduced the marginal revenue product of capital by 43% relative to low MRPK firms. There were no effects on firms with low MRPK. The effects of liberalization are largest in areas with less developed local banking sectors, indicating that foreign investors may substitute for an efficient banking sector. Finally, we develop a method to use natural experiments to estimate the lower bound effect of changes in misallocation on manufacturing productivity. We find that this liberalization episode increased the aggregate productivity of the Indian manufacturing sector by at least 6.5%.

Keywords: aggregating reduced-form estimates, foreign capital liberalization, India, Misallocation

JEL Classification: O11, O12, O16, O47

Suggested Citation

Bau, Natalie and Matray, Adrien, Misallocation and Capital Market Integration: Evidence from India (January 2020). CEPR Discussion Paper No. DP14282, Available at SSRN: https://ssrn.com/abstract=3518623

Natalie Bau (Contact Author)

University of California, Los Angeles (UCLA) ( email )

405 Hilgard Avenue
Box 951361
Los Angeles, CA 90095
United States

Adrien Matray

Princeton University ( email )

22 Chambers Street
Princeton, NJ 08544-0708
United States

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