Macro-International-Growth Lunch: Wed Dec 6 2006: U.C. Berkeley Department of Economics: Banerjee, Duflo, and Munshi (2003) "The (Mis)allocation of Capital"

Disconnect Between the Fed and the Markets

Applied Utilitarianism and Global Climate Change

Macro-International-Growth Lunch: Wed Dec 6 2006: U.C. Berkeley Department of Economics: Banerjee, Duflo, and Munshi (2003) "The (Mis)allocation of Capital"

Macro-International-Growth Lunch: Wed Dec 6 2006: U.C. Berkeley Department of Economics

Notes on Abhijit V. Banerjee, Esther Duflo, and Kaivan Munshi (2003) "The (Mis)allocation of Capital," Journal of the European Economic Association 1(2–3), 484–494 http://www.mitpressjournals.org/doi/pdf/10.1162/154247603322391125?cookieSet=1

How economists use the neoclassical benchmark:

At Chicago: Assume that the economy is at the neoclassical benchmark, and demonstrate that whatever exists is, in some subtle sense, constrained Pareto-optimal efficient--except where ham-handed government intervention has caused messes.
At Berkeley: Investigate the deviation from the neoclassical benchmark that can be caused by one single but significant market failure, demonstrate that this deviation matches up to some important feature of the real world, and demontrate that a clever, subtle, and strategic government intervention can move us to a situation that is constrained Pareto-optimal.

Banerjee, Duflo, and Munshi set out to hunt down this neoclassical benchmark, and show that the real world is so far from it that the benchmark's utility as a base of operations--in either the Chicago or the Berkeley sense--is... severely limited.

Their claim: capital markets in India simply don't work. Firms employing less than 50 people where the marginal product of capital is on the order of 100% per year can't get additional financing to exploit these opportunities.

And now to the paper: Abhijit V. Banerjee, Esther Duflo, and Kaivan Munshi (2003) "The (Mis)allocation of Capital.: Journal of the European Economic Association 1(2–3), 484–494 http://www.mitpressjournals.org/doi/pdf/10.1162/154247603322391125?cookieSet=1

Simple implications of the theory of credit markets:

A firm is credit constrained if the marginal product of capital in the firm is higher than the rate of interest that firm is paying on its marginal rupee of borrowing.
If a firm that is not credit constrained is offered some extra credit at a rate below what it is paying on the market, then the best way to make use of the new loan must be to pay down the firm’s current market borrowing, rather than to invest more.
By contrast, a firm that is credit constrained will always expand its investment to some extent.
For unconstrained firms, growth in revenue should be slower than the growth in subsidized credit.
If we do not see a gap in these growth rates, the firm must be credit constrained.

Priority sector rules in India:

All banks in India are required to lend at least 40 percent of their net credit to the “priority sector,” which includes small scale industry (SSI), at an interest rate that is required to be no more than 4 percent above their prime lending rate.
In January, 1998, the limit on total investment in plants and machinery for a firm to be eligible for inclusion in the small scale industry category was raised from Rs. 6.5 million to Rs. 30 million. [Rs. 1 = $0.02; GDP/capita = Rs. 40,000 per year]

Data obtained from one of the better-performing Indian public sector banks:

From the loan folders maintained by the bank.
Data on profit, sales, credit lines and utilization, and interest rates.
253 firms (including 93 newly eligible firms
Including 175 firms for which we have data from 1997 to 1999.
We can allow small firms and big firms to have different rates of growth
The rate of growth to differ from year to year
We assume that there would have been no differential changes in the rate of growth of small and large firms in 1998, absent the change in the priority sector regulation.

The change had an impact:

Credit limits granted to firms below Rs. 6.5 million in plant in machinery (henceforth, small firms) grew by 11.1 percent during 1997
Credit limits granted to firms between Rs. 6.5 million and Rs. 30 million (henceforth, big firms) grew by 5.4 percent.
In 1998, after the change in rules, small firms had 7.6 percent growth while the big firms had 11.3 percent growth.
By 1999 new equilibrium.

Table 1: http://delong.typepad.com/images/20061206_misallocation_image003.png

Results

Bank credit as the outcome for the firms where there was a change in credit limit: The coefficient of the interaction BIG-POST is 0.24, with a standard error of 0.09.
Whether or not a file is brought out for a change in limit has nothing to do with the needs of the firm, but the internal dynamics of the bank.
This additional credit in turn led to an increase in sales. The coefficient of the interaction BIG-POST in the sales equation, in the sample where the limit was increased, is 0.21, with a standard error of 0.09 [column (5)].
By contrast, in the sample where there was no increase in limit, the interaction BIG-POST is close to zero (0.05) and insignificant [column (8)].
The effect on profit is even bigger than that on sales: 0.75, with a standard error of 0.38.
The IV estimate of the impact of bank credit on profit is 2.7. This is substantially greater than 1, which suggests that the technology has a strong fixed cost component. We can use this estimate to get a sense of the average increase in profit (net of interest) caused by every rupee in loan. An increase of Rs. 1,000 in the loan corresponds to a 1.04 percent increase. Using the coefficient of loans on profits, an increase of Rs. 1,000 in lending therefore causes a 2.7 percent increase in profit. At the mean profit (which is Rs. 37,000), this would correspond to an increase in profit (net of interest) of Rs. 999. Consistent with firms being credit constrained, this suggests a gap between the marginal product of capital and the interest rate of about 100 percent.
This data does not tell us anything about the efficiency of allocation of capital across firms—it remains possible that capital does have the same marginal product in all its uses.

Tirupur is a smallish town in Southern India which dominates the Indian knitted garment industry:

Through a good part of the 1990s the industry in Tirupur was growing at 50 percent or more.
The industry was traditionally dominated by a single local caste group, the Gounders.
Our basic strategy is to compare the investment behavior of Outsiders with that of the Gounders.
Gounders are a small, wealthy, agriculturist community from the area around Tirupur who have moved into the local knitted garment industry over the last three decades because there is not much scope for more investment in agriculture. They have virtually no industrial presence outside Tirupur. Going into local knitted garment business, or helping a family member or friend get set up in the business, is therefore one of the best ways to use their considerable wealth.
Outsiders have few strong ties in Tirupur, being from hundreds and even thousands of miles away. Moreover, they are from communities that have many alternative opportunities for investing their money. We would expect the Outsiders not to have the kind of capital access enjoyed by the Gounders.

Data: A survey of 147 exporters in 1995:

Gounders own about twice as much capital and maintain capital-production and capital-export ratios 1.5 to 2.5 times as high as the Outsiders
Columns (2) and (3) tell us that Gounders start with a higher capital-output ratio, and maintain that advantage at every level of experience.
Do Gounders simply simply make better use of capital? The data on exports and production clearly rejects the possibility that the Gounders are more productive in general.
Outsiders start out producing and exporting less but grow faster and overtake the Gounders by the time they have been in business about five years. Average output for Outsiders who have six years or more of experience is significantly higher than that of the Gounders.

Table 2: http://delong.typepad.com/images/20061206_misallocation_image006.png

Conclusion

Capital markets in India are very far from the neoclassical ideal.
The gap between the marginal product of capital and the market interest rate seems to be at least 70 percentage points.
The gap between the marginal product of capital and the rate paid to savers is even larger.
Investors who on average are less productive may invest as much as three times more than their more productive counterparts.
All this is not necessarily surprising given that the legal system is slow, inefficient and sometimes corrupt, and defaulters usually get off lightly.
But it does raise questions about the usefulness of the neoclassicalbenchmark.

December 06, 2006 at 11:00 in #economicgrowth, #economics | Permalink | Comments (45)

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Macro-International-Growth Lunch: Wed Dec 6 2006: U.C. Berkeley Department of Economics

How economists use the neoclassical benchmark:

At Chicago: Assume that the economy is at the neoclassical benchmark, and demonstrate that whatever exists is, in some subtle sense, constrained Pareto-optimal efficient--except where ham-handed government intervention has caused messes.
At Berkeley: Investigate the deviation from the neoclassical benchmark that can be caused by one single but significant market failure, demonstrate that this deviation matches up to some important feature of the real world, and demontrate that a clever, subtle, and strategic government intervention can move us to a situation that is constrained Pareto-optimal.

Simple implications of the theory of credit markets:

A firm is credit constrained if the marginal product of capital in the firm is higher than the rate of interest that firm is paying on its marginal rupee of borrowing.
If a firm that is not credit constrained is offered some extra credit at a rate below what it is paying on the market, then the best way to make use of the new loan must be to pay down the firm’s current market borrowing, rather than to invest more.
By contrast, a firm that is credit constrained will always expand its investment to some extent.
For unconstrained firms, growth in revenue should be slower than the growth in subsidized credit.
If we do not see a gap in these growth rates, the firm must be credit constrained.

Priority sector rules in India:

All banks in India are required to lend at least 40 percent of their net credit to the “priority sector,” which includes small scale industry (SSI), at an interest rate that is required to be no more than 4 percent above their prime lending rate.
In January, 1998, the limit on total investment in plants and machinery for a firm to be eligible for inclusion in the small scale industry category was raised from Rs. 6.5 million to Rs. 30 million. [Rs. 1 = $0.02; GDP/capita = Rs. 40,000 per year]

Data obtained from one of the better-performing Indian public sector banks:

From the loan folders maintained by the bank.
Data on profit, sales, credit lines and utilization, and interest rates.
253 firms (including 93 newly eligible firms
Including 175 firms for which we have data from 1997 to 1999.
We can allow small firms and big firms to have different rates of growth
The rate of growth to differ from year to year
We assume that there would have been no differential changes in the rate of growth of small and large firms in 1998, absent the change in the priority sector regulation.

The change had an impact:

Credit limits granted to firms below Rs. 6.5 million in plant in machinery (henceforth, small firms) grew by 11.1 percent during 1997
Credit limits granted to firms between Rs. 6.5 million and Rs. 30 million (henceforth, big firms) grew by 5.4 percent.
In 1998, after the change in rules, small firms had 7.6 percent growth while the big firms had 11.3 percent growth.
By 1999 new equilibrium.

Table 1: http://delong.typepad.com/images/20061206_misallocation_image003.png

Results

Bank credit as the outcome for the firms where there was a change in credit limit: The coefficient of the interaction BIG-POST is 0.24, with a standard error of 0.09.
Whether or not a file is brought out for a change in limit has nothing to do with the needs of the firm, but the internal dynamics of the bank.
This additional credit in turn led to an increase in sales. The coefficient of the interaction BIG-POST in the sales equation, in the sample where the limit was increased, is 0.21, with a standard error of 0.09 [column (5)].
By contrast, in the sample where there was no increase in limit, the interaction BIG-POST is close to zero (0.05) and insignificant [column (8)].
The effect on profit is even bigger than that on sales: 0.75, with a standard error of 0.38.
The IV estimate of the impact of bank credit on profit is 2.7. This is substantially greater than 1, which suggests that the technology has a strong fixed cost component. We can use this estimate to get a sense of the average increase in profit (net of interest) caused by every rupee in loan. An increase of Rs. 1,000 in the loan corresponds to a 1.04 percent increase. Using the coefficient of loans on profits, an increase of Rs. 1,000 in lending therefore causes a 2.7 percent increase in profit. At the mean profit (which is Rs. 37,000), this would correspond to an increase in profit (net of interest) of Rs. 999. Consistent with firms being credit constrained, this suggests a gap between the marginal product of capital and the interest rate of about 100 percent.
This data does not tell us anything about the efficiency of allocation of capital across firms—it remains possible that capital does have the same marginal product in all its uses.

Tirupur is a smallish town in Southern India which dominates the Indian knitted garment industry:

Through a good part of the 1990s the industry in Tirupur was growing at 50 percent or more.
The industry was traditionally dominated by a single local caste group, the Gounders.
Our basic strategy is to compare the investment behavior of Outsiders with that of the Gounders.
Gounders are a small, wealthy, agriculturist community from the area around Tirupur who have moved into the local knitted garment industry over the last three decades because there is not much scope for more investment in agriculture. They have virtually no industrial presence outside Tirupur. Going into local knitted garment business, or helping a family member or friend get set up in the business, is therefore one of the best ways to use their considerable wealth.
Outsiders have few strong ties in Tirupur, being from hundreds and even thousands of miles away. Moreover, they are from communities that have many alternative opportunities for investing their money. We would expect the Outsiders not to have the kind of capital access enjoyed by the Gounders.

Data: A survey of 147 exporters in 1995:

Gounders own about twice as much capital and maintain capital-production and capital-export ratios 1.5 to 2.5 times as high as the Outsiders
Columns (2) and (3) tell us that Gounders start with a higher capital-output ratio, and maintain that advantage at every level of experience.
Do Gounders simply simply make better use of capital? The data on exports and production clearly rejects the possibility that the Gounders are more productive in general.
Outsiders start out producing and exporting less but grow faster and overtake the Gounders by the time they have been in business about five years. Average output for Outsiders who have six years or more of experience is significantly higher than that of the Gounders.

Table 2: http://delong.typepad.com/images/20061206_misallocation_image006.png

Conclusion

Capital markets in India are very far from the neoclassical ideal.
The gap between the marginal product of capital and the market interest rate seems to be at least 70 percentage points.
The gap between the marginal product of capital and the rate paid to savers is even larger.
Investors who on average are less productive may invest as much as three times more than their more productive counterparts.
All this is not necessarily surprising given that the legal system is slow, inefficient and sometimes corrupt, and defaulters usually get off lightly.
But it does raise questions about the usefulness of the neoclassicalbenchmark.

Grasping Reality on TypePad, by Brad DeLong

The current place where I am posting material is over on the SubStack: http://braddelong.substack.com

Macro-International-Growth Lunch: Wed Dec 6 2006: U.C. Berkeley Department of Economics: Banerjee, Duflo, and Munshi (2003) "The (Mis)allocation of Capital"

Comments