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«Last Revised: October 2007 Abstract This paper uses a single-country setting, India, to examine the complex linkages between legal and business ...»

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Financing Firms in India∗

Franklin Allen Rajesh Chakrabarti Sankar De

Finance Department Finance Area Centre for Analytical Finance

The Wharton School Indian School of Business Indian School of Business

University of Pennsylvania Hyderabad 500 032, India Hyderabad 500 032, India

allenf@wharton.upenn.edu rajesh_chakrabarti@isb.edu Sankar_De@isb.edu Jun “QJ” Qian Meijun Qian Finance Department Finance Department Carroll School of Management NUS Business School Boston College National University of Singapore qianju@bc.edu bizqmj@nus.edu.sg Last Revised: October 2007 Abstract This paper uses a single-country setting, India, to examine the complex linkages between legal and business environments, financing channels, and growth patterns of different types of firms. Despite the English common-law origin, a British-style judicial system and a democratic government, Indian firms appear to be beset by weak investor protection in practice and poor legal and government institutions characterized by corruption and inefficiency. With extensive country- and firm-level data sets, including both cross-country and within-India firm samples and our own surveys of small and medium firms, we find that to a large extent Indian firms conduct business outside the formal legal system and do not rely on formal financing channels from markets and banks for most of their financing needs. Instead, firms across the board, and in particular, small and medium firms, use non-legal methods based on reputation, trust and relationships to settle disputes and enforce contracts, and rely on alternative financing channels such as trade credits to finance their growth.

The scope, methodologies, and results of our paper paint a more complete picture of the law-finance-growth nexus and how businesses and investors respond to the limitations of legal system and formal financial system than existing studies.

Keywords: India, law and finance, institutions, growth, banks, markets, SME sector.

JEL Classifications: O5; K0; G0.

∗ We appreciate helpful comments from Reena Aggarwal, Peter Bossaerts, Charles Calomiris, Asli Demirgüç-Kunt, Mihir Desai, Joshua Felman, Nandini Gupta, Ravi Jagannathan, Mudit Kapoor, Raghuram Rajan, Stefano Rossi, Rohan Williamson, Leslie Young, and seminar/session participants at Brandeis, Chinese University of Hong Kong, Columbia, Gothenberg University, Indian School of Business (ISB), National University of Singapore, Stockholm School of Economics, Wharton, the Darden-World Bank conference on emerging markets 2006, the European Finance Association meetings 2006, and the Western Finance Association annual meetings 2007. For assistance with collecting financial data and conducting firm surveys, we wish to thank Sankar De’s associates at ISB’s Centre for Analytical Finance (CAF).

We are grateful to Gaurav Khurana, Narender Khurana, Tridip Ray and Mausumi Das for their contribution to our surveys in New Delhi, Deepika Luke (CAF) for research assistance, and P. G. Shinde (Centre for Monitoring Indian Economy) for providing data. We wish to acknowledge outstanding research support and other contributions from Leena Kinger Hans (CAF). Sankar De gratefully acknowledges the financial support from the Goldman Sachs and Citi Foundations. The other authors thank their respective institutions and the Wharton Financial Institutions Center for financial support. We are responsible for all the remaining errors in the paper.

I. Introduction Understanding mechanisms that contribute to sustainable long-term economic growth has long been one of the central missions for economists. In recent years, several related strands of literature in law, finance, and economic growth have significantly advanced our knowledge of growth mechanisms.

First, the law and finance literature (pioneered by La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997, 1998); LLSV hereafter) finds that countries of English common-law (French civil-law) origins provide the strongest (weakest) legal protection to both shareholders and creditors, and that stronger legal protection of investors is associated with more efficient institutions and better financial and economic ‘outcomes.’ A second strand of literature suggests that the development of a financial system that includes stock markets and financial intermediation contributes to a country’s overall economic growth (e.g., McKinnon (1973)). Recently, researchers have strengthened this view with supporting empirical evidence at the country level (e.g. King and Levine (1993); Levine and Zervos (1998)), as well as at the industry and firm levels (e.g. Rajan and Zingales (1998); Jayaratne and Strahan (1996)). The third strand provides evidence linking law, finance, and growth at the country, industry, and firm levels (e.g., Demirgüç-Kunt and Maksimovic (1998); Levine (1999); Beck and Levine (2002)).1 While the existing literature has advanced our understanding of the nexus between legal and financial mechanisms in many parts of the world, the knowledge comes with certain limitations. Most existing studies use cross-country datasets and, in the process, accord each country in the sample an equal weight. We might expect that, compared to large and diverse countries (e.g., India), small homogeneous countries (e.g., Singapore) would have more effective formal legal and financial institutions, because they can be tailored to the needs of the domestic economy at relatively low costs. Further, many cross-country studies treat each country in the sample as a monolithic unit, obscuring possibly considerable variations between financing and legal practices between sectors (such as large and small firms). In addition, most 1 There are notable alternative approaches to the law and finance literature. For example, Rajan and Zingales (2003a;





2003b) suggest that development of formal financial system may trigger political economy costs, causing a disconnection between the level of financial market activity and economic development. Acemoglu and Johnson (2005) find that “contracting institutions,” or laws protecting contracts between individual parties, do not affect long-term growth.

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countries, and typically focus on formal legal mechanisms (courts) and formal financing channels (stock markets and banks), to the exclusion of all other financing and dispute resolution options.

By contrast, our paper uses a single-country setting, India, to examine the linkages between legal and business environments, financing channels, governance mechanisms, and growth patterns of different types of firms. At the end of 2006, with a population of almost 1.1 billion (the second largest in the world), India had the world’s fourth largest economy measured in Purchasing Power Parity (PPP) terms (see Table 1). During the period 1990-2006, India had the fourth highest annual GDP growth rate (6.1%) and the fifth highest per capita GDP growth rate (4.2%) in the world. Unlike most of the existing research, we examine the entire corporate financing system in India, including formal and alternative financing channels at both aggregate and firm levels. We also examine the use of formal legal channels and their substitutes by Indian firms.

We employ three types of large and extensive data sets to conduct our analysis. First, we compare country-level data in India and a large sample of countries studied in the law, finance, and growth literature. Second, we compile a sample of over 2,700 non-financial Indian firms, both large corporations and small and medium enterprises (SMEs), from the Prowess database of the Centre for Monitoring the Indian Economy (CMIE).2 Finally, to overcome the lack of publicly available firm-level data for the SME sector, we design and conduct two extensive surveys of SME firms, including their ownership structure, financing channels, and governance mechanisms. These surveys cover 212 entrepreneurs and senior executives of SME units located in and around the city of Hyderabad in southern India (76 firms) and the Delhi-Gurgaon area in northern India (136 firms).

While the scope and methodologies of our paper extend the existing literature, our results offer significant new insights on the linkages among law, finance, institutions, and economic growth. First, 2 CMIE is a Mumbai-based economic and business information and research organization. Its Prowess database provides financial statements, ratio analysis, funds flows, product profiles, returns and risks on the stock markets, etc., for over 9,000 Indian companies.

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conducting business as long as there exist effective, non-legal ‘institutional’ substitutes. With its English common-law origin, legal protection of investors by the law in India is one of the strongest in the world.

For example, India had a perfect score on the Creditor Rights index (4 out of 4),3 and has a score of 5 out of 6 on the Anti-Director Rights index, the highest among more than 100 countries studied in Djankov, La Porta, Lopez-de-Silanes, and Shleifer (hereafter DLLS (2007)). Moreover, India has had a British-style judicial system and a democratic government for a long time. However, all of our evidence, including aggregate evidence and firm-level evidence from both the Prowess sample and our surveys of the SME sector, uniformly suggests otherwise. Based on several widely used aggregate measures, the effective level of investor protection and the quality of legal institutions in India is far below the average for English-origin countries, though slightly higher than the French-origin countries and other emerging economies.4 The reasons for the wide gap between investor protection on paper and in practice include a slow and inefficient legal system and corruption within government in India. Our empirical tests using firm-level evidence from the Prowess sample confirm poor investor protection and legal institutions in India. We find that Indian firms have much lower dividend payout and valuation (as measured by market-to-book ratios) than similar firms operating in countries with strong investor protection, but are closer to the firms in countries with weak protection judging by the findings in LLSV (2000b, 2002). We also find that equity ownership is highly concentrated within the founder’s family and/or the controlling shareholder, more so than even firms in other Asian countries (e.g., Claessens, Djankov, and Lang (2000);

Claessens, Djankov, Fan, and Lang (2002)). Further, smaller firms in India exhibit symptoms of a low investor protection regime (e.g., ownership concentration, dividend ratio, and valuation) more than the large firms. Consistent with these findings, our surveys indicate that the small firms, regardless of age and industry, rely little on the legal system. Over 80% of the respondent firms preferred not to seek legal 3 This score was revised from 4/4 in LLSV (1998), based on the Company’s Act (1956), to 2/4 in Djankov, McLiesh and Shleifer (hereafter DMS (2007)), based on the Sick Industrial Companies Act (1985).

4 Other studies also document this. For example, DLLS (2007) construct the anti-self-dealing index (control of corporate insiders) for more than 100 countries. India’s score of 0.55 (out of 1) is lower than the average (0.67) of English common-law countries.

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the other hand, non-legal sanctions in various forms, such as loss of reputation or future business opportunities or even fear of personal safety, are far more effective deterrents against contract violations and non-payment of dues than legal recourses, and are employed widely.

Second, we find that formal financing channels based on stock markets and banks are not essential for corporate operations and investments as long as alternative financing sources pick up the financing slack. Our methodology, whereby we examine the entire corporate financing system in India, enables us to examine the relations between formal and alternative financing channels, including substitutions and complementarities between them that have been missed by much of the existing literature with its focus on formal finance. Our aggregate evidence suggests that the size of the formal financial sector in India, measured by market capitalization and volume of bank credit, is small in relation to the size and needs of the economy. Consistent with this finding, the Prowess sample indicates that Indian firms obtain only about 26% of their total financing needs from formal sources per year. Further, this proportion is far lower for smaller firms, consistent with evidence from other countries (e.g. Berger and Udell (1995, 1998) for evidence on small U.S. firms). Our survey evidence accentuates this pattern. Small firms rely mostly on alternative financing sources, such as funds from friends, families, and business partners, and trade credits, often without a formal contract, to finance their investments, operations, and growth. Ordered Probit regressions show that the proportion of alternative finance in total finance increases as the hurdle for formal finance (as measured by the requirements and contingency conditions for bank and institutional credit) rises, clearly indicating that alternative finance substitutes for formal finance when the latter is inaccessible.5 Consistent with aggregate evidence, close to a third (34%) of the survey respondents find bank finance costly and hard to get. However, we also find evidence that the reliance on alternative financing sources persists for years beyond the start-up phase, suggesting that such sources remain the 5 The pattern that smaller Indian firms in India depend more on alternative finance, and on trade credits in particular, for their financing needs, is very consistent across the entire firm-size distribution. The Prowess sample and our survey findings both reflect the same pattern. For firms at the lower end of the distribution, trade credit provides the greater part of their financing need. The finding indicates that these firms substitute, not just one form of financing for another, but inter-firm financing for the financial system altogether.

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