Promarket reforms and allocation of capital in India

The government of India initiated pro-market reforms in the 1990s, after almost five decades of socialist planning. These and subsequent policy reforms are credited as the drivers of India’s radical economic transformation. Prior to reforms, private investment was strictly regulated and restricted to limited sectors. There have since been numerous changes in sectors important for investment, such as the bank sector, which affects outcomes of firm-level strategic decision making and investment behavior. By most estimates, India’s economy will continue to grow rapidly. The purpose of this paper is to investigate changes in investment behavior from the introduction of reforms to current conditions. Reforms changed several institutional frameworks for firm operations, allowing firms to pursue more competitive strategies. Given the importance of ownership in determining firm efficiency and access to capital, we examine the effect of ownership type, and also control for industry differences in capital allocation. We compute a measure of investment efficiency derived from the accelerator principle: Elasticity of capital with respect to output.We find that the allocation of capital has been slow to respond to reforms, indicating similar pace of firm responses. The findings suggest that firms face significant costs in adjusting their capital stock, which inturn leads to inefficient capital allocation. Surprisingly, we find no significant improvement over the 1991-2006 time period.