Published on All About Finance

How does financial development affect firm lifecycle?

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In a new paper, we address this question using detailed manufacturing census data from India. India offers an ideal laboratory for testing the role of institutions on firm lifecycle given the large persistent differences in institutions, business environment, and income across different regions. Specifically, we examine the relationship between plant size, age, and growth and ask: how does local financial development influence the size-age relationship? Are there differences in the size-age relationship across different industry characteristics and between the formal and informal manufacturing sector and does this vary with the extent of local financial development? Does the role of local financial development on firm lifecycle vary with major regulation changes in India such as financial liberalization, changes in labor regulation, and industry de-licensing?

Overall, our analyses shows that the average 40 year old firm in the formal sector in India is 2 to 4 times the size of firms less than five years of age. Our results hold true when we take sampling weights into account and look at the entire population of firms. Thus, while firms in India may not be growing at the same rate as in developed countries such as the US where the size-age ratio is eight times, there is clear evidence that older firms in the formal manufacturing sector are larger than younger firms. We do find stark differences in firm lifecycle in the formal and informal sectors however: Older firms in the unorganized manufacturing sector in India employ fewer people than firms younger than 5 years old. Hence, informal firms look very different from formal firms in terms of size, productivity, and education level of managers and there is little evidence that growth occurs by informal firms eventually becoming large formal firms.

Turning to the formal sector, despite considerable differences in financial depth across Indian states we find the role of financial development to be marginal in explaining lifecycles in the broad population of firms and in most of the sub-samples we analyze. These results are robust to a number of checks including looking at just the firms in the right tail of the size distributions, across states with flexible versus rigid labor market regulation, and using alternate indicators of financial development. We also find no differential impact of financial development on lifecycle when we look at firms born after India’s financial liberalization in 1991 or looking at periods after industry de-licensing. We also find only marginal differences in the proportion of manufacturing employment in old and new firms across different levels of financial development.

Furthermore, we find the extent of financial dependence of industries does not predict the life cycles of firms across states in India. Classifying industries into financially dependent and financially independent depending on the extent to which firms can support their capital expenditures using cash flow from operations, based on the experiences of US firms in the same industries, we find that firms in financially dependent industries are larger at all stages of their life-cycle. Thus, there is no evidence that financial dependence affects growth rates of established Indian firms relative to firms in industries that are not financially dependent.  Furthermore we do not see that firms in financially dependent industries are larger or face different lifecycle effects in financially developed states than under-developed states. Using a similar difference-in-difference set-up we also find that firms in large-firm dominated industries are larger at each stage of the life-cycle, both in the case of capital intensive and labor intensive industries.

Our findings contrast with the literature that finds significant effect of within-country institutional differences on firm performance. The explanation for the differences in findings is most likely that the state-owned and controlled financial sector in India is not significantly contributing to firm growth. In such a system, the regional differences in financial development as measured by the financial depth of the banking system may be masked by other potentially more important institutional (e.g. infrastructure constraints) and firm-specific factors (e.g. organizational form). The finance literature also shows that in a large cross-section of countries, higher government ownership of banks is associated with slower subsequent financial development and lower income per capita growth and productivity, as well as poorer financial access by small firms. Our findings are also consistent with research that shows that the depth of the financial sector does not promote growth of provinces in China, another country where the banking system is largely state owned and controlled. Hence, our findings on India provide additional evidence that state-ownership in banking hampers the impact of finance on growth. As far as policy implications, our findings underline the importance of increasing the private sector share of the banking system through further liberalization, increasing competition and reducing state control and political interference in potentially improving the efficiency of credit allocation in India.

Reference: Ayyagari, Meghana; Demirguc-Kunt, Asli and Maksimovic, Vojislav, Does local financial development matter for firm lifecycle in India? WPS 7008.


Asli Demirgüç-Kunt

Former Chief Economist, Europe and Central Asia Region

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