Misallocation due to Inefficient Exits: Evidence from India

An efficient market economy requires firm exits so that resources are lured or forced away from unproductive uses. Creditors’ ability to seize defaulters’ assets is an important aspect of making the process of exit of firms efficient. I examine the implications of suppressing the normal competitive process of destruction whereby low-quality borrowers would be forced to lose workers and cut investment. I exploit a 2002 law in India that made it easier for secured creditors to seize defaulters’ assets. Prior to the policy change, low-quality and unprofitable borrowers increased debt partly due to evergreening of loans by banks. Also, the congestion created by low-quality firms during this period allocated debt away from healthier firms. Post the passage of the law, banks increased credit to high-quality firms and cut credit to low quality firms. The resulting decongestion increased employment and investment of high-quality borrowers that operate in the same industry. Productivity and profitability of low quality firms also increased, overall profitability and productivity increased more so in industries that witnessed greater decongestion.