Misallocation and Capital Market Integration: Evidence from India

Abstract

We show that foreign capital liberalization reduces capital misallocation and increases aggregate productivity in India. The staggered liberalization of access to foreign capital across disaggregated 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), liberalization increases revenues by 25%, physical capital by 57%, wage bills by 27%, and reduces MRPK by 35% relative to low MRPK firms. There are no effects on low MRPK firms. The effects of liberalization are largest in areas with less developed local banking sectors, indicating that foreign capital partially substitutes for an efficient banking sector. Finally, we develop a novel method to use natural experiments to bound the effect of changes in misallocation on treated industries' aggregate productivity. Treated industries' Solow residual increases by 4-17%.

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

JEL Classification: O11, O12, O16, O47