Capital Ideas Blog

to what extent does financial reform spur economic growth

By Kate Marshall Dole

From: Blog

Financial reform can prompt economies to allocate resources more efficiently across companies, and raise aggregate productivity, according to conventional wisdom among financial economists. But there have been few attempts to measure the exact extent of the effect.

A model by University of Chicago PhD student N. Aaron Pancost changes that, with its analysis of India’s manufacturing sector following financial reform. Pancost’s model produces evidence that reform, at least in India, spurred growth

Several factors can affect a manufacturer’s productivity. A decrease in the availability of iron ore could impact a steel company, for example. Pancost’s homed in on financial regulations and the way changes in regulations can affect how a company allocates its resources. 

Pancost equates financial reforms to fewer financial frictions in the market. In his model, those reduce borrowing costs, letting borrowers grow faster and be more productive. He says that this leads to a stronger relationship between company size and productivity, and that tracking a size-productivity link over time allows his model to isolate changes in financial frictions from other shocks that impact aggregate productivity.

He applies his model to data collected from Indian manufacturing plants between 1990 and 2011, a good testing ground, he argues, because the sample is large, accounting for 27 millio­n–46 million workers, and diverse, encompassing companies of various sizes and industries. Moreover, since manufacturing plants produce tangible goods, productivity can be measured more directly compared with other sectors such as tourism or IT services. India instituted a number of financial reforms beginning in 1991, many of which affected manufacturing.

Companies’ labor productivity grew steeply in the years following India’s financial reforms, Pancost finds. “My methodology allows me to quantify how much of this improved performance is attributable to the increased efficiency of the financial sector,” he writes. He finds that financial factors explained 71 percent of the labor productivity growth from 1990 to 1995. 

While the manufacturers improved their resource allocation and productivity until 1995, Pancost finds the reforms had no significant impact on aggregate productivity after that point. Between 1995 and 2011, the sector’s labor productivity continued to boom, but he attributes only 2–8 percent of the growth to financial reforms.

“Because Indian labor productivity has increased dramatically since 1994–95, the model suggests that factors other than financial frictions are important in explaining India productivity growth,” he notes. While the effects of financial reforms may have worn off, changes in management practices, and fewer government restrictions on the types of firms allowed to manufacture certain products, may have helped spur longer-term growth.

N. Aaron Pancost, “Do Financial Factors Drive Aggregate Productivity? Evidence from Indian Manufacturing Establishments,” Working paper, November 2015.


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