T C A Srinivasa-Raghavan: Unity in diversity

OKONOMOS

Indian firms prefer informal sources of finance and trust informal systems of governance more than the formal ones.

When mention is made of India's unity in diversity, the reference is invariably to ethnic, linguistic, geographic and other such obvious things. No one ever mentions the diversity of thought and the unity in it.

Thus, while a bunch of commission agents think Mumbai should be turned into an international financial centre "" actually, it is already that, they just want it to be bigger for more and bigger commissions "" another lot shies away from formal finance as diligently as it would from plague.

Franklin Allen, Rajesh Chakrabarti, Sankar De, Jun "QJ" Qian and Meijun Qian* from the Indian School of Business at Hyderabad have taken a good and hard look at how Indian firms prefer to finance themselves, and found that they prefer non-market sources. Main reason: corruption.

"Despite its English common law origin, strong legal protection provided by the law and a democratic government," they say, "corruption within India's legal system and government significantly weakens investor protection in practice." The result should interest the Mumbai-as-IFC-wallahs because "...the characteristics of listed firms are similar to those from countries with weak investor protection" and they "have concentrated ownership and low valuations and pay low dividends relative to firms from countries with strong legal protection."

The authors carried out a survey of small and medium-scale firms and discovered what Indians who know the Greater Indian Reality have always known, namely, that alternative financing channels provides the most important source of funds.

Not just that. They also found that all that formal institutions claptrap is of no use here. "Informal governance mechanisms, such as those based on reputation, trust and relationships, are more important than formal mechanisms (for example, courts) in resolving disputes, overcoming corruption and supporting growth." So much, then, for the Mumbai-as-IFC idea.

But the paper's main strength, in my view at least, is the cross-country comparisons that give it its real value. They say they have studied "all aspects of the financial system in the second largest developing country" and found that it simply does not match up with the others. The clincher comes in the aggregate and firm-level evidence. It would be a useful exercise to compare this data with what the RBI has. There are various reports and speeches of deputy governors on the subject.

Anita Kumari** of the Institute of Economic Growth in Delhi University has reached a very similar conclusion. She analysed the capital structure and its growth in high, medium-high, medium-low and low technology industries.

"Internal sources of funds for firms in medium-low tech industries and external sources of funds for firms in low tech industries have been found to be significant in explaining the growth rate of capital... and new firms have been investing more in med-high tech, med-low tech and low tech group of firms."

From a policy point of view, the most interesting finding is that it is largely high tech and medium-high tech industries which are actively helping the growth of capital. This necessarily means higher imports of capital goods, a fact which is borne out by import data.

While this is doubtless a good thing, the obverse is not. The technologically weaker industries are dropping off the map. This includes older firms (which probably have fourth generation managements).

The overall conclusion that these two papers lead to, I think, is that the governance problem has reached a stage where economic activity is increasingly going below the surface. As happened with the Mughal empire, when governments are cut out of the economic action, they are eventually cut out of everything else.

*Financing Firms in India, April 2006, http://www.isb.edu/WorkingPapers/FinancingFirms_inIndia.pdf
**Growth of Capital in Indian Manufacturing Industries During Post-Reform Period, IEG Discussion paper No. 108/2006, http://iegindia.org/dis_108_2006.pdf