Published on Let's Talk Development

What can we learn from land and financial allocation in India?

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Factor Allocation and Growth
A central challenge for developing countries is to promote growth by reducing the misallocation of factors of production—labor, capital and land. While there may not be such a thing as a perfectly efficient factor allocation, evidence shows that there are huge gains in growth from reducing factor misallocation. Growth requires more efficient firms to produce more output and use more factors of production. Our past work has shown that land allocation is barely better than random at best, and probably worse than random in India. Put differently, low productivity firms have better access to land and buildings than high productivity firms. Indeed, land and buildings misallocation appears to be at the root of much of the misallocation of output and it accounts for a large share of the observed differences in output per worker in the manufacturing sector.  

If land is misallocated, is capital also misallocated? There is an important reason to suspect that the two are connected. Most bank loans require some form of collateral to guarantee the loan. Land is simply the best form of collateral due to its immobility (i.e. the debtor can’t run off with land). This can be contrasted with a piece of specialized machinery, for example, where the borrower could seek to hide it from debt collectors or where its sale to other parties after repossession is weak. This difference is visible in terms of the amount of loan collateral possible against asset classes. While borrowers can often pledge 80% of land values against loans, for most other forms of fixed investment the loan-to-collateral value ratio is substantially lower (e.g. 25%). So, if land markets are highly distorted, then it is likely that the finance market is also distorted, given the misplaced collateral channel. This can in turn lead to its own economic consequences. For example, rapidly growing firms in asset-intensive sectors require external finance due to their capital growth needs. If this is reduced due to land misallocation, this would help explain why India’s firms have trouble scaling up. Similarly, start-ups are often backed by bank loans for which land is used as collateral. Poorly-functioning land markets may explain why there are so few entrepreneurs, and entrants are constrained by factor market distortions, and incumbents don’t grow in India. We examine these issues in a recent paper—D. Gilles, E. Ghani, Arti Goswami, and W. Kerr. "Effects of land misallocation on capital allocations in India," Policy Research Working Paper Series 7451, The World Bank.
Financial Misallocation
There are many interesting trends to observe.  First, a very low proportion of manufacturing establishments report accessing financial loans in India (8%). But this low average masks huge spatial, sectoral and gender differences. Second, there are huge spatial disparities in access to finance within India. It is significantly higher in leading regions compared to lagging regions. Leading states like Maharashtra show important depth of financing for firms. At the other extreme are states like Bihar where access to loan is very low. Third, firms in the organized sector have much higher access to loans compared to firms in the unorganized sector. States like Gujarat, Punjab, Haryana and Rajasthan have access to financial loans for over 95% of the organized sector plants. States like Bihar and Manipur perform poorly in providing external credit support for both the organized and unorganized sectors. Fourth, irrespective of the urban/rural location, the share of plants accessing external loans in the organized sector has increased over time. By contrast, it has declined for the unorganized sector. Fifth, there are urban-rural disparities in access to finance, with rural locations lagging behind their urban counterparts. However, the share of urban plants in the organized sector has declined, while that in the unorganized sector has increased. That organized sector is de-urbanizing and the unorganized sector is urbanizing is a key aspect of India’s spatial development. Sixth, and most importantly, there is significant disparity against women-owned enterprises. Although the gap between the access shares of female-employee-dominated plants vis-à-vis male-employee-dominated plants is closing in the organized sector, this gap is not shrinking in the unorganized sector. The same is true for female-owned plants in the unorganized sector.
Misallocation and Productivity
It is widely believed growth can be enhanced by the reallocation of the factors of production from a less-productive to a more-productive firm. Thus, the ranking of firms by factor usage should reflect their relative productivity ranking and hence be perfectly correlated under optimum allocation. Conversely, a less-than-perfect correlation between productivity and factor usage indicates a misallocation of factors across firms. The lower this correlation between productivity and factor usage, the greater is the extent of misallocation of factors of production.
We compute an index of misallocation for each Indian district for the organized and unorganized sectors separately. The indices of misallocation for output, value added, and factors of production are computed individually for factors such as labor and the extent of financial loans. These measures of misallocation are then used in various district-industry level regressions that seek to examine both the determinants and the implications of misallocation, especially how the misallocation in access to finance is linked to the misallocations in land and buildings and labor. Although our results do not provide a final answer to the causal connections, they do provide substantial confirmation in the links between land misallocation and financial misallocation.  
These emerging trends in factor misallocation are worthy of more attention.  The unorganized sector accounts for nearly 80% of employment and about half of the value of land and buildings held in the manufacturing sector in India. Yet, the value of financial loans reported in this sector is barely 2-6% of the value of total loans reported in the manufacturing sector. Much more striking is the huge disparity against women-owned enterprises, where the gap is increasing.

See Land and Poverty Conference 2016: Scaling up Responsible Land Governance happening on March 14-18, 2016


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