Structural Change and Economic Dynamics

17 (2006) 4669

Financial liberalisation, corporate governance and

the efficiency of firms in Indian manufacturing
Uma S. Kambhampati
Centre for Institutional Performance, Department of Economics, University of Reading,
Whiteknights, Reading RG6 2AA, UK
Received June 2003; received in revised form June 2004; accepted February 2005
Available online 5 April 2005

Abstract
In this paper, we argue that the way in which a firm is financed will affect its efficiency. Firms
obtaining finance from the government are likely to be less efficient than firms obtaining finance from
banks or foreign financial institutions (FFIs). We analyse these issues by estimating a stochastic frontier
for firms in seven manufacturing industries in India where these differences have been reinforced
by financial de-regulation. Our results indicate that the government is generally less effective in
monitoring the firms that it lends to than either banks or Indian Financial Institutions (IFIs), but neither
of these institutions is particularly efficient either. Though the impact of FFIs on firm efficiency is
insignificant, foreign ownership has a positive impact in a majority of the industries. Finally, likelihood
ratio tests confirm that while the government and IFIs have a similar impact on firm efficiency, banks
are quite distinct in a majority of industries.
2005 Elsevier B.V. All rights reserved.
JEL classication: F14; D24
Keywords: Liberalisation; Corporate governance; Efficiency; India

Since the reforms of 1991, the sources of firm-level financing in India have become more
diversified: banks are beginning to be privatised, financial institutions are freer to follow
the dictates of the market (though still not entirely so), foreign financing has increased, as
has financing by the stock market. In this paper, we analyse the impact that these changes in
financing patterns may have on a firms efficiency. The paper focuses on the role that creditors
E-mail address: les98usk@rdg.ac.uk.
0954-349X/$ see front matter 2005 Elsevier B.V. All rights reserved.
doi:10.1016/j.strueco.2005.02.001

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

47

may play in monitoring a firm, and therefore, in improving the efficiency of that firm. In
general, it is hypothesised that in India, banks are likely to impose stronger restrictions
on firm performance than the government and that lenders from the foreign private sector
are likely to be more stringent than either. We also consider how the monitoring of firm
performance by these institutions, which provide debt finance, compares to that of equity
holders in India. To do this, we estimate firm-level frontier production functions for seven
sectors within Indian manufacturing and analyse the impact of financial sector reforms on
the efficiency of firms (or their distance from the frontier).
This paper contributes to the literatures on firm-level efficiency as well as on financial
deregulation. Few papers on the financing of firms have empirically considered the corporate
governance role of financial institutions in influencing firm efficiency. Similarly, though
financial deregulation has been widely written about, there are few papers on the impact
that such deregulation may have on firm efficiency.
It is clear that while firm financing may influence its efficiency (via the monitoring
function of the lending institutions), it is equally possible that a firms efficiency levels
will influence the funding, it is able to attract from financial institutions. We recognise this
endogeneity in this paper and deal with it by a suitable lagging of the variables (see Section
5.1).

1. India: the nancial sector and reforms

Much of the financial literature on developing countries has found that firms rely on
internal sources to finance growth.1 Singh (1998), however, finds that Indian firms rely
more on external sources of funds than even their Western counterparts seem to do. The
average Indian firm, Singh finds, financed 60% of its net assets from external sources, of
which one-third was from equity and two-thirds from long term debt in the 1980s. This grew
considerably in the 1990s. Samuel (1996) and Shirai (2002, p. 21) confirm this: external
sources of funds constantly exceeded internal sources during 19902001. In his study
comparing US and Indian firms, Samuel (1996, p. 18) finds that on an average, internal
finance contributed about 42% of total funds and external finance the remaining 58%. In
this context, the role played by the funding institutions in influencing the behaviour and
efficiency of the firms that they lend to is very significant.
This paper concentrates on the role played by four broad types of credit institutions in
IndiaBanks, Indian Financial Institutions (IFIs), Foreign Financial Institutions (FFIs) and
the Government. Though one would not expect the government to play a significant role
in lending to large and medium public limited companies, our figures (Table 1) indicate
that during this period, government sources provided between 1 and 5% (on average across
industries) of total firm borrowing. Since this is not negligible and is likely to be larger for
certain firms than others, it was included in our analysis.
Before we go any further, it is worth defining each of these sectors more precisely. In
the context of our data, bank lending involves lending only from Indian banks. In the pre1

Myers and Majluf (1984) showed that in the presence of asymmetric information, even profit maximising
managers would prefer to rely on internal sources in the first instance.

48

Industry
number

Industry name

Bank borrowing/total
borrowing

IFI borrowing/total
borrowing

FFI borrowing/total
borrowing

19861991

19921999

19861991

19921999

19861991

19921999

19861991

19921999

19861991

19921999

442
448
454
457
465
466
468

Automobile components
Electrical machinery
Steel forgings
Metals
Basic industrial chemicals
Pharmaceuticals
Other Chemical products

0.525
0.595
0.521
0.511
0.388
0.601
0.566

0.634
0.644
0.543
0.601
0.461
0.680
0.608

0.259
0.205
0.286
0.265
0.372
0.145
0.206

0.247
0.213
0.329
0.254
0.375
0.191
0.242

0
0
0.003
0
0
0
0.00002

0
0.002
0.021
0.006
0.005
0.001
0

0.011
0.01
0.014
0.013
0.021
0.0141
0.01

0.022
0.019
0.015
0.020
0.051
0.025
0.051

0.635
0.639
0.711
0.660
0.637
0.615
0.627

0.739
0.686
0.731
0.708
0.695
0.694
0.691

These figures are averages over the years in this period and over all the firms in this sector.

Government borrowing/total
borrowing

Debt/(debt + equity)

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

Table 1
Financing patterns of firms in the sample: 19861991 and 19921998

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

49

reform period, most of these banks were public sector banks. In the post-reform period,
this has been changing, as we will see. IFIs are defined as private and public non-bank
financial institutions and they include development finance institutions (like the Industrial
Development Bank of India) and insurance companies. All foreign financial institutions are
included within FFIs and borrowing from central and state governments, semi-government
bodies (like municipal corporations and port trusts) is included within government lending.2
In a purely market-oriented economy, one would expect the loans provided by these
institutions to be driven by market factors. Thus, loans which are not expected to perform
well, will not be funded. Equally, once funded, one would expect the lending institutions to
maintain vigilance regarding the performance of these loans, making the corporate governance role of these institutions very important. In the Indian case, however, neither banks
nor Indian Financial Institutions were particularly market sensitive at least until the early
1990s. The IFIs were, in fact, first set up with a view to financing Indias development plans.
Most of these financial institutions faced quantitative loan targets, interest rate regulations,
entry restrictions and reserve and liquidity requirements. Credit was allocated not on the
basis of market forces but in relation to quotas on the funds that needed to be disbursed. In
addition to these constraints, the corporate governance or monitoring function of these institutions was rendered ineffective because government objectives saw firm-level efficiency
as secondary to the continued survival and growth of firms, as well as to the governments
other objectives with respect to employment and investment. Such political expediency
implied that financial institutions in India rarely ever called back loans, however, badly
they performed. Profits were not a major motivation for most of these institutions, since in
the final analysis, it would be the taxpayer who would pick up the bill. All these factors
undermined the disciplining role of financial institutions and encouraged borrowing firms
to rely on soft budget constraints. Banks, which were also nationalised in the 1970s, were
seen as part of the same process.3
By the late 1980s, however, it was increasingly becoming clear that this situation could
not continue and in 1991, when the government began its liberalisation programme, it also
undertook significant reform of the financial sector. As part of these reforms, interest rates
were decontrolled, reserve and liquidity requirements were cut, and priority-sector lending
was overhauled in 1992. The Reserve Bank of India (RBI) provided recapitalisation support
to nationalised banks. The share of the government in the capital of public sector banks was
also diluted with several banks making public offering of their equity shares. New private
banks as well as foreign banks4 were permitted to enter. Nine new banks were set up in the
private sector and the number of foreign banks increased to 44 by March 1999 leading to a
decrease in the share of the top five banks in total assets from approximately 52% in 1991
to 44% in 2001. This increase in competition led to an increase in the number of public
sector banks that made profits so that by 20012002, there were no loss making public
2 The borrowing of each firm is divided into these sources. If, after the liberalisation, one of these sources
changes status, i.e. from development finance institution to bank, for instance, then in the years after the change,
the borrowing would show up as coming from banks rather than IFIs.
3 Before 1991, 90% of total deposits in India were in public sector banks.
4 This followed the Narasimham Committees recommendation (1998) for the dilution of public equity in banks
to 33%. In addition, the growing presence of commercial banks in the capital market is reflected in the increase in
the number of banks listed on the stock exchange from 6 in 1994/1995 to 29 in 1999/2000 (RBI, 2000).

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U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

sector banks. The increase in competitiveness was also reflected in a decrease in the gap
between the lending and deposit rate in real terms in the second half of the 1990s. After
the deregulation, Indias real domestic interest rates (deflated for movements in exchange
rates) also became better aligned with international benchmark rates (RBI, 2003). While
these changes are significant, there is still a long way to go before the financial sector can
be said to be fully liberalised. The changes have been very gradual (Arun and Turner, 2002)
and may only influence firm performance in the medium to long term, as we will see.
Another financial institution that has long played a role (though limited) in India is the
stock market, which has provided funds to firms since 1875. By the early 1980s, the Reserve
Bank of India had advised that household savings be mobilised through capital market
expansion because the development finance institutions in India could not meet governmentimposed requirements to finance the corporate sector. However, until the early 1990s, Indias
stock market played a very limited role both in financing firms and in disciplining them.
During the 1990s, the pace of liberalisation in private capital markets increased, with the
repeal of the Capital Issues Control Act and the Securities and Exchange Board of India
(SEBI) Act of January 1992, which established the SEBI as the main authority governing the
stock market and many other financial activities. The Reserve Bank of India also liberalised
its credit control regime between 1992 and 1995, with ceilings on debenture coupon rates
and other interest rates being abolished.
Since its deregulation in the early 1990s, the financing role of the stock market in India has
increased and there have been two stock market booms, in 1995 and in 19992000 (Shirai,
2002). The BSE Sensex (a value weighted index of 30 companies with 1979 = 100) grew
by more than four times between January 1990 and 1997. Primary market capitalisation
increased from an index of 100 in 1991 to 138.8 in 1997 (Paul and Ramanathan, nd). The
number of issuing firms increased from 57 in 1971 to 121 in 1981 and to 426 in 1993, while
the amount issued has gone up from Rs. 423 million (mn) in 1971 to Rs. 984 mn in 1981
to Rs. 42 billion (bn) in 1993 (Samuel, 1996, p. 25). The stock markets role in corporate
governance works through the purchase and sale of existing shares, the pricing of new stock
and the threat of takeovers. These, it is expected, keep firms that are quoted on the stock
market efficient.
The reforms in the early 1990s also made it easier for foreign financial institutions to
enter the country and eased rules regarding the ownership of firms. While the earlier FERA
regulations only allowed 49% foreign ownership (and this also only in limited sectors), the
new regulations allowed 51% foreign ownership and even completely foreign-owned firms.
As has been discussed in a number of papers, the 1991 reforms in India extended beyond
the financial sector. They encompassed the first sustained attempts to increase the autonomy
of the private sector (Ahluwalia, 1999). The programme attempted to deregulate foreign
trade and the labour market. As part of this programme, the government abolished or
eased licensing requirements in a large number of industries, removed most licensing and
other non-tariff barriers on imports of capital and intermediate goods, relaxed anti-trust
rules and devalued the Rupee5 (see, Ahluwalia et al., 1996). Though the exit of firms

The government devalued the Rupee in July 1991 by 24% in two phases. In March 1993, it moved to a unified
floating exchange rate which settled at Rs. 31 = US$ 1.

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

51

continues to be difficult,6 the government has begun to decrease its support of inefficient
firms.
In this paper, we consider the impact of these reforms on the efficiency of firms within the
manufacturing sector in India. We concentrate on the impact of the reform of the financial
sector. The reforms changed the volumes of financing provided by each set of institutions (increasing borrowing from banks and foreign financial institutions, for example (see
Table 1)) as well as the behaviour of these institutions (easing the restrictions on banks, for
example). In some cases, it also led to changes in the status of the institutions. All of these
changes can have an impact on the firms that borrow from them.
Our expectation in this paper is that, in general, banks are likely to be stricter in monitoring
their debtors than the government and that foreign lenders are likely to be strictest. Second,
we also expect that since the reforms, all lenders will have become more sensitive to the
dictates of the market causing them to monitor their debtors more carefully than they did in
the past. We test both expectations in this paper. In addition, we also consider the impact of
trade and other reforms on firm-level efficiency. In Section 2, we will review the literature
relating to firm-level efficiency and the financing of firms.

2. The nancing of rms and rm efciency: literature and hypotheses

As indicated above, in this study, we are concerned with the impact that different sources
of financing may have on a firms performance. We expect the source of finance to influence
a firms performance because different financial institutions follow different corporate governance regimes. This is increasingly being recognised in the transitional economies where
the corporate governance role of banks relative to stock markets is debated in the context of
privatisation (Corbett and Mayer, 1991; Miurin and Sommariva, 1993). In India, while the
development financial institutions and government are unlikely (for the reasons discussed
above) to impose strict budget constraints on the firms that borrow from them, banks and
FFIs are likely to be stricter because they do not want large amounts of non-performing
loans on their books.7 As private sector involvement in the banking sector increased in the
1990s, we would expect the impact of this variable to increase in the post-1991 period.
It is also clear from the above that in the face of the reforms in the early 1990s, each of
these institutions is likely to have become more sensitive to market forces. This might arise
both because the amount of business carried out by the private banks (as opposed to the
public financial institutions) may have increased after the reforms but also because the deregulation of all lending institutions may have changed the way they operate. In this paper,
we will test three hypotheses relating to the way in which firms are financed in India and
the impact that this has on the firms efficiency.

6 A firm that wishes to exit has to be declared bankrupt by the Board for Industrial and Financial Restructuring.
The process can take up to 23 years and sometimes as long as 10 years (Goswami, 1996).
7 Note that though banks were nationalised in the pre-1991 period, one would still expect them to be stricter
than IFIs because their remit was profit making (at least in principle) whereas for IFIs, the remit was facilitating
development rather than making profits. Our results, in Section 6.1, confirm this argument.

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U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

H1 (S). tock markets in India play a more effective role in corporate governance than banks
and other financial institutions.
There has long been a distinction between the market-based monitoring of firms, which is
common in the UK and the USA and bank-based monitoring (i.e. the supervision of lenders)
which is common in Germany and Japan. In the early 1970s and 1980s, it was argued that the
close relationship between banks and the firms to which they lent, in countries like Germany
and Japan was chiefly responsible for the positive performance of these economies. During
this time, it was also argued that the dictates of the stock market led to an emphasis on short
term financing, which in turn, had a negative impact on the performance of firms within
the UK and the US economies. The post-war growth of Germany and Japan was seen as
evidence in favour of a bank-based system. However, the 1997 East Asian crisis has opened
the debate up again.
In this context, some writers argue that borrowing on equity markets imposes wide
and very public scrutiny on firms, which together with the existence of an active secondary
market in shares and the threat of takeovers, keeps firms efficient. Others argue that equity is
owned so widely and the owners are often so dispersed that stock markets are rarely effective
in governing firms.8 Allen and Gale (1999) maintain that the efficiency of the stock market
relative to the debt market in financing firms depends upon the sector being considered.
Thus, stock markets are better at financing new technologies (which are viewed with widely
differing levels of risk) because they allow investors to hold diverse views about investments.
On the other hand, banks are better placed in sectors with a high degree of consensus and are,
therefore, better at financing mature technologies. Alba et al. (1998), studying the financing
of firms in Thailand in the wake of the 1997 crisis, argue that as free cash flow builds
up within firms, banks lose their disciplining influence. Under these circumstances, the
stock market (and more specifically equity holders) play a better disciplining role because
stock market discipline can be imposed through the pricing and trading of existing stock.
This is, of course, not surprising since banks can do no better than receiving their interest
payments and principal repayments but the upside for shareholders is unlimited, giving
them an added incentive to carefully monitor the firms they invest in. This would be true
whether the equity was stock market equity or non-stock market equity because in either
case, profit-sharing occurs and this increases the incentive to monitor the firm carefully.
Green et al. (2002) find that there is a small but perceptible rise in the equity share of
the balance sheet over time in India and a corresponding fall in debt (p. 18). In spite of this,
however, they find that the debt ratio of Indian companies is relatively high compared with
other developing countries though it is broadly in line with the OECD countries (p. 17). In
this context, we consider whether the equity market in India is efficient in monitoring the
firms that borrow from it. To analyse this issue, we will consider whether the proportion
of debt in a firms total borrowings (debt + equity) influences the firms efficiency levels. If
equity holders are more efficient than lending institutions, then we would expect that the
proportion of debt will have a negative impact on the efficiency of the firm. Our data does
not allow us to distinguish between internal and external sources of equity, i.e. to consider
8

In the Indian case, this is compounded by the fact that a large proportion of the stock of most Indian firms is
still owned by the family.

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

53

non-stock market listed equity financing. In testing the hypothesis in this way, therefore,
we are making the assumption that the level of non-stock market listed equity is small or
that the disciplinary influence of stock market equity is not very different from non-stock
market equity.
H2. Amongst the various sources of debt finance, foreign financial institutions are likely
to be most stringent when governing firms, while the government will be least strict. In
between come the banks and IFIs, in that order.
H2 relates to the various sources of debt and their impact on firm efficiency. Green et al.
(2002) conclude that in India, the proportion of bank debt incurred by quoted companies
fell following equity market liberalisation in the early 1990s but increased as credit controls
were relaxed by the RBI. They conclude that capital market reforms did have an impact on
the financial structure of Indian companies, (Green et al., 2002, p. 19). What impact might
such changes have on the efficiency of firms?
Rajan and Zingales (1998) and Khanna and Palepu (1999) argue that though public
finance institutions in developing countries are set up to correct for market failures and
to channel funds for industrialisation, they are often captured by political interest groups.
Berglof and von Thadden (1999) agree, claiming that in developing countries, large family
owners may use their close ties with the government to obtain finance on favourable terms.
In addition, government institutions have little incentive to monitor and discipline firms
because, should they fail, the funds have to come from the taxpayer. Finally, political expediency implies that most governments would be unwilling to call back loans and cause a firm
to go bust, and thus, cause unemployment. These factors result in soft budget constraints,
which imply that firms relying heavily on the government and IFIs for funds are likely to
be less efficient than other firms.
On the other hand, it is often argued that FFIs are privately owned and managed, and
therefore, have greater incentives to monitor corporate performance. Since they also possess
better tools for such monitoring (Khanna and Palepu, 1999) and may provide managerial
and other inputs to debtors, borrowing from such FFIs may increase the efficiency of firms.
To test this hypothesis, we include four variables denoting the proportion of funds borrowed by a firm from banks, IFIs, FFIs and the government into our model. We expect that a
high proportion of borrowing from the government would decrease efficiency levels, while
a high proportion of borrowing from an FFI would increase efficiency levels.9
In this context, we also test a hypothesis relating to ownership. Just as funds from a foreign
financial institution may be expected to improve efficiency, so also foreign ownership of a
firm may be expected to lead to increased efficiency. This may be because foreign-owned
firms have access to better technology and more up-to-date management practices as well
as because they have a greater ability to take risks, backed as they are by funds from abroad.
We test this by including a variable relating to the country of ownership of a firm.
H3. The impact of each of these sources of funds has changed since the liberalisation.
9 Given the public ownership of banks and most IFIs before the reforms and the strict controls exerted on them
by the state, we also test for the possibility that there is really no difference between banks, IFIs and government
lending in India. This is done in Section 6.1.

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U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

In addition to arguing that each source of funds has a different impact on firm performance, we also hypothesise that this impact will change after the financial sector reforms in
1991. The 1990s saw a shift from a relatively centralised banking system in India to a more
decentralised system in which nationalised banks were privatised, new banks were set up
and others entered through FFIs. Carlin and Mayer (2002) suggest that such a change towards a decentralised financial system with many banks is likely to lead to stricter financial
discipline on firms than a centralised system.
In addition, both foreign ownership and foreign lending have increased since the liberalisation. During the 1990s, foreign portfolio capital inflows into India increased (to US$
4.9 bn in 1994/1995), and a number of FFIs entered the country to invest in both primary
and secondary markets. Thus, FFIs have become increasingly important in financing Indian
firms over the last two decades. At the same time, banks and IFIs have become freer to
follow market imperatives, so that the impact they have on firm efficiency will change after
the reforms.
To test for these changes across time, we estimate the model for each sector separately
for the pre-reform period (19871991) and for the post-reform period (19921998). We
would expect that if the reforms significantly changed the impact of a firms financing on
its performance, then the estimates of our coefficients for bank loans, IFI loans, FFI loans
and the debtequity ratio will be different in the pre- and post-reform periods.
In Section 3, we will consider the estimation methodology in more detail before we turn
to consider our results.

3. Estimation methodology
To test the above three hypotheses, we estimate firm-level frontier production functions
for seven manufacturing sectors in India. The distance between a firms individual position
and the frontier is then modelled as the inefficiency of the firm. The literature on firm-level
efficiency in developing countries has been reviewed elsewhere (Tybout, 1999) and we will
not go into it in detail here. Suffice to say that none of the papers reviewed there is concerned
with the impact of a firms nancing on its efficiency levels.
The production function frontier, pioneered by Farrell (1957), defines the maximum
possible output that a firm can produce, given input bundles x. This is the efficiency or
best-practice frontier. While average production functions attribute differences between
firms to random factors, stochastic frontier functions isolate differences in inefficiency and
random differences amongst firms by dividing the error term into a deterministic component
and a random one. In this methodology, realised output is seen as bounded from above by
the stochastic frontier (Schmidt and Sickles, 1984) and technical inefficiency is seen as the
amount by which a firms actual output falls short of the efficiency frontier.
The stochastic frontier production function was first proposed by Aigner et al. (1977)
and Meeusen and van den Broeck (1977). This was specified for cross-sectional data and
consists of a production function of the usual type:
Qit = (Xit )eit

(1)

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

55

where Qit is the value of output, Xit the vector of inputs, the vector of parameters estimated
and is the random disturbance term composed of two parts:
it = vit uit

(2)

where vit is a normally distributed error term that represents statistical noise, while uit is a
truncated (non-negative) error term that represents technical inefficiency.
In 1995, Battese and Coelli (1995) proposed a model where they assumed that the uit are
i.i.d. [N(it , u2 )] where it = (Zit ) and Zit is a vector of variables that will affect inefficiency.
This model allows the simultaneous estimation of the production function as well as the
determinants of the inefficiency, making our estimates more efficient. This is the model that
we estimate in this paper.
Various estimation techniques have been developed and their strengths and weaknesses
are summarized in Forsund et al. (1980). Estimation using panel data helps us to avoid
some strong assumptions. If the fixed-effects approach is used, then one does not need to
assume a probability distribution for the inefficiency index. In addition, the fixed effects
approach has the advantage of dispensing with the assumption that firm-level inefficiencies
are uncorrelated with input levels. The random-effects approach, on the other hand, requires
us to assume that firm-level inefficiencies and input levels are independent but unlike the
fixed effects approach, it can accommodate time-invariate variables such as industry or
location dummies.

4. Data
The data used in this paper is the Reserve Bank of India compilation of firm-level
profit and loss accounts and balance sheets of the large and medium, non-government,
non-financial, public limited companies registered in India. The data relate to individual
companies, which may be parts of much larger industrial houses, but are legally separate
entities, independent in their day-to-day operations. These companies are assigned to 83
three-digit industries on the basis of majority of (>50%) output.10 We use data for the period
19861998.
The RBI data comes from a purposive sample designed to adequately represent companies belonging to different industry groups and size classes. The sample size is relatively large both in terms of numbers (and in terms of paid-up capitalaccounting
for nearly 65% of the total paid-up capital of the entire population of public limited
companies). The size of the sample in terms of number of companies has been in10 The data set provides no information on the variety of products produced by a firm or on coverage ratios.
However, studies (Shanker, 1988; Siddharthan, 1981) have indicated that firms in India tend to diversify narrowly
(within the same three-digit industry category) though industry houses span wider industries. Palepu et al. (2002)
find that 80% of a firms output in India is from a single industry and the other 20% is from a second product.
There is very little broad diversification amongst firms, even though industrial houses are very broadly diversified.
Government licensing has also played a role in maintaining such a narrow range of diversification. Given this, it
looks likely that though firms may produce a number of different products, these products are likely to fall within
the same industry group.

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U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

creasing over the years, and over 75% of companies are retained from one year to the
next.11
We identify seven industries within our sampleAutomobile components (442), Electrical machinery (448), Steel forgings (454), Ferrous and non-ferrous metals (457), Basic
industrial chemicals (465), Pharmaceuticals (466) and Chemical products excluding industrial chemicals, pharmaceuticals, etc. (468), which had sufficiently large sample size in both
time periods to enable estimation of our proposed model.
The RBI data provides considerable detail regarding the firms financing. Table 1
above provides averages of the proportion of a firms total borrowing contributed by
banks, IFIs, FFIs and the government. It also provides averages of the debt/equity and
the debt/debt + equity ratios. The averages are calculated across all firms in the sector and
across the years in each sub-period (19861991 and 19921998). The figures indicate that
in every sector, except transport, the proportion of funds obtained from FFIs increased in the
second period. In fact, the proportions were close to zero (at the aggregate industry level) in
all seven sectors that we considered in the 19861991 sub-period. The proportion of firms
total borrowing contributed by government loans on average ranged between 1 and 3% in
the pre-1991 period and increased to between 2 and 5% after the reforms. The proportion
contributed by bank loans also increased significantly in all the sectors after the reforms.
Finally, the table indicates that debt as a proportion of total borrowing (DebtK) increased
in all our industries, implying that equity decreased in all industries after the reforms. This
finding is surprising in the light of the increasing capitalisation of the stock market in India.
It is, however, confirmed by other studies (Shirai, 2002), which show a decrease in equity
as a new source of funds from a high of approximately 35% in 1994 to below 10% by 1997.
It probably relates to the fact that while more firms are taking on equity, the average level
of equity in each firm remains limited.
Since our concern is to consider whether the difference in financing patterns before and
after the reforms is reflected in firm efficiency in these two periods, we begin by estimating
separate frontiers for each industry in each of the two periods. We then test the restriction
that a single frontier across all years would describe the data equally well. We find that this
restriction is rejected in all seven industries, confirming that in these industries, estimation
should be separated across the two periods.

5. Empirical estimation
We began the analysis by estimating both a translog and a CobbDouglas production
function. In all seven sectors, we found the translog specification was more appropriate than
the CobbDouglas specification. After transforming the data into logs we, therefore, have
the following specification:

11

For example, the combined balance sheet analysis based on the data published by the RBI in 1993 (Bulletin,
December) reported results for 19881989, 19891990 and 19901991 based on a sample of 2131 companies.
A similar analysis in 1992 (Bulletin, November) reported results for 1908 companies for 19871988, 19881989
and 19891990. The two samples had 1647 companies in common.

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

57

Qit = 0 + 1 Kit + 2 Lit + 3 Mit + 4 Kit2 + 5 L2it + 6 Mit2 + 7 (Kit Lit )

+ 8 (Kit Mit ) + 9 (Mit Lit ) + it
where Qit is the value of output, Lit labour, Kit capital, Mit raw materials, i a subscript
denoting the firm and t denotes the year (see Table A.1 in the Appendix A for variable
definitions). The output and raw material series were deflated using sectoral deflators from
the Index of Wholesale Prices. Since our dataset did not include information on the number
of employees or the number of hours that they worked, this had to be approximated from
the wage bill. To do this, we estimated an average wage rate for each industry (total wages
divided by the number of employees in each industry) from the data provided at two-digit
industry level by the Annual Survey of Industries. We then used this industry-average wage
to deflate the wage bill of each firm. This gives us an approximate figure for the numbers
employed in each industry (Srivastava, 1996; Driffield and Kambhampati, 2003). Finally,
the capital deflator was obtained from the National Accounts Statistics.
The inefficiency component is then modelled as follows:
it = 0 + 1 Ageit + 2 Foreignit + 3 Bankit1 + 4 IFIit1 + 4 FFIit1
+ 6 Govtit1 + 7 (DebtK)it1 + 8 R&Dit1 + 9 Mit1 + 10 Xit
+ 11 (KO)it + 12 Market Shareit1 + 13 trend + 14 dum
+ 15 dum trend + it
where:
Age
Foreign
Bank
IFI
FFI
Govt
DebtK
R&D
M
X
KO
Market share
Trend
dum

age from year of incorporation

=1, if firm is owned by a foreign entity and =0 if Indian
borrowing of each firm from Indian banks as % of total borrowing
borrowing of each firm from Indian Financial Institutions as % of total borrowing
borrowing of each firm from Foreign Financial Institutions as % of total borrowing
borrowing of each firm from Government Financial Institutions as % of total borrowing
total borrowing from financial institutions (debt)/debt + equity
research and development expenditure/Q
import expenditure/Q
export earnings/Q
capitaloutput ratio
sales of each firm/industry sales
time trend (1987 = 1, . . ., 1998 = 12)
=1, if year >1991; else =0

5.1. A methodological issue

Before we consider the hypotheses underlying this choice of variables, we need to consider an issue that affects the entire model. The endogeneity of the independent variables is
a potential problem in most models involving firm behaviour and performance. In the above
model too, there is potential simultaneity in the relationship between firm efficiency and
the way in which the firm is financed. Thus, while the way in which a firm is financed will
affect the governance and monitoring structures that a firm operates under, and therefore,
will affect its efficiency, it is equally possible that the firms efficiency levels will influence

58

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

the kind of financing that it is able to access. This would imply that only already efficient
firms are likely to obtain funds from FFIs (see also Alba et al., 1998) and other private
sector sources, while the government may have to continue to lend to inefficient firms. It
is also possible that while the way in which a firm is financed will influence the firms
efciency, the reverse causality may be not between efficiency and financing but between
profitability and financing, i.e. that the type of financing a firm is able to attract may depend
upon its profitability rather than its efficiency. If this is the case then the simultaneity is less
problematic.12
Such endogeneity is true of a number of other variables: more efficient firms can export,
while exporting may in its turn improve efficiency. Similarly, large market shares may allow
a firm to benefit from learning by doing and economies of scale, and therefore, to become
more efficient. However, it is also possible that more efficient firms will be able to expand
their market shares more easily.
These two-way relationships can be separated if our model is estimated with lags. Thus,
a firms current borrowing (say from banks) can be hypothesised to affect its efficiency next
year (because it takes time for banks to discipline the firms they lend to). On the other hand,
the reverse causality will be from current efficiency to next years borrowing. To allow
for this, we lag all the financial variables by one period. By doing this, we can separate
the impact of FFI finance, for instance, on a firm as opposed to the impact of efficiency
on the possibility of obtaining FFI finance. We also lag R&D, market shares and imports.
The choice of lag structure is the shortest possible that will correct for simultaneity, while
providing for as long a trend a possible (especially pre-1991). For some variables (like
market shares and imports), this is also sufficient to capture the major impact of the variable
on efficiency. For others, like R&D, a longer lag may be more appropriate because R&D
expenditure may take longer than 1 year to have an impact on firm efficiency.
5.2. Variables included
We now turn to consider the determinants of efficiency. Firms that spend more on R&D
(R&D) may be expected to increase efficiency. Sutton (2000), for instance, argues that the
main impact of trade liberalisation derives from two basic mechanismsan intensification
of price competition and a consequent narrowing of the capability window in which firms
operate, as the minimum level consistent with viability increases. A firms optimal response
to these pressures, according to Sutton (2000), will involve injecting resources to increase
capabilities, for instance, through R&D expenditure. Hence, the importance of R&D may
be expected to increase post-liberalisation. Of course, it is also possible that in the context
of liberalisation especially in developing countries, firms scrap and scale down their R&D
(product-development) programmes and focus on increasing efficiency through investment
in modern (imported) equipment, adoption of organisation practices, etc.13
A higher capitaloutput (KO) ratio is seen to increase efficiency because capital is less
variable than labour, creates fewer management problems and produces a more standardised
product. Old firms (AGE) might be expected to be less efficient because they are often
12
13

I am grateful to one of the referees of this paper for this interpretation.

I am grateful to one of the referees of this paper for this interpretation of the results.

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

59

operating with relatively old plant and technology. Even when the plant is updated, it
cannot be the same as a completely new plant. In addition, of course, old firms may lose
their dynamism and become less flexible. As seen earlier, we also argue that foreign-owned
firms (Foreign) are likely, in the Indian case, to be more efficient than Indian firms because
they bring with them more up to date technologies, management techniques as well as
deeper pockets, which enable them to undertake greater risks.
Many studies have hypothesised that large firms (relative to the size of the total market)
are able to operate, not only at a lower point on their cost functions than small firms, but
also on lower cost functions (Clarke et al., 1984; Gale and Branch, 1982). It is well known
that there is likely to be a two-way relationship between market share14 and efficiency, a
simultaneity that has been commented on in many earlier studies. To take this into account,
we lag the market share (Market Share) variable by one year. This would imply that a large
market share in the previous period could increase efficiency in the current period but the
impact that efficiency will have on market share is in future periods.
5.2.1. The nancial variables
As discussed above, we might expect the way a firm is financed to influence the efficiency
of this firm because it determines the type of corporate governance experienced by the firm
as well as the relative efficacy of such governance. To test the hypotheses (H13) put
forward in Section 2, we included a number of variables into our model. First, we include
the proportion of a firms borrowing financed from debt (as opposed to equity) and the
impact that this has on the firms efficiency. To do this, we use the variable DebtK, which is
the debt of the firm divided by total funds (debt + equity). If stock markets are more efficient
at monitoring firms, then we would expect that the higher is debt as a proportion of a firms
total funds (DebtK), the lower will be the firms efficiency level (H1).
It was also hypothesised (H2) that the source of debt will matter. Thus, we argued earlier
that the government is likely to be less effective when it comes to monitoring the performance
of a firm for a number of reasons. We would, therefore, expect government loans to have
the worst impact on efficiency. Loans from IFIs and banks would come next. Prior to 1991,
the banking sector was mostly nationalised and is likely to have behaved much like the IFIs,
though with fewer constraints. Since 1992, however, banks are increasingly being privatised
and it is expected that their impact will have changed in this period. The impact of FFIs on
efficiency may be expected to be largest because FFIs have greater incentive to, and tools
for, monitoring. They are also less restricted by government regulation. Finally, we expect
that the impact of Banks, IFIs and FFIs would all increase in the second period (19921998)
when government restrictions on their activities were decreased.
5.2.2. The trade variables (trade liberalisation)
We include import intensity (Import), which is expected to influence efficiency because
in the newly liberalised economy firms are able to import capital goods and the latest tech14

The use of market share rather than absolute size of the firm is common in the industrial organisation literature
where it is the size of the firm relative to other firms in the same industry that determines its market power and
ability to take advantage of economies of scale. It is also the result of normalising firm size by industry size to
allow for the possibility of different efficient size in different markets.

60

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

nology. High export intensity (Export) is expected to increase efficiency because exporting
firms have to compete against very efficient and competitive firms in world markets, and
therefore, might be expected to decrease X-inefficiency.
5.2.3. Testing the impact of liberalisation
We include a liberalisation dummy (dum) to capture the effect of reforms not captured
by any of the financial or trade variables discussed above. This variable will capture the
effects of de-regulation of entry, expansion and exit. We expect efficiency to increase as in
the new open and de-regulated environment, inefficiencies are less likely to be tolerated.
We, therefore, also expect that the dispersion around the frontier will decrease and more
firms will shift to the frontier or go bust. In addition to the liberalisation dummy, we include
a trend term that will capture the change in efficiency over time (Trend) and an interaction
term (dum trend) to map the post-liberalisation trend in efficiency levels in each sector.
These variables, dum and dum trend, only allow the intercept (0 ) and the trend coefficient (13 ) to vary across the two sub-periods. In reality, as we have already argued,
the coefficient of each determinant of efficiency (like our financing variables as well as
variables like R&D and imports) may vary across the two periods. To allow for this, we
estimate separate frontiers for each of our two periods, 19871991 and 19921998. These
results are presented in Tables 24.

6. Results
We estimate the model in seven different industries442, 448, 454, 457, 465, 466
and 468. In each of these sectors, we estimate three different frontierspre-liberalisation
(19871991), post-liberalisation (19921998) and the entire sample period (19871998).
We test the appropriateness of estimating separate frontiers for each period instead of a
single frontier across both time periods, using a likelihood ratio test. The likelihood ratio
test rejects pooling in all seven industries, leading us to conclude that separate frontiers
for each period are more appropriate in these sectors. In what follows, therefore, we will
consider the results for the separate estimations (19871991 and 19921998).
Our results indicate that in all cases (except three), Age decreases efficiency, implying
that the disadvantages of age outweigh the benefits of experience and learning by doing
that also come with age. In industries 442, 448 and 454 in the second period, however, Age
increases efficiency indicating that in these industries, older firms were able to improve
their performance in the post-liberalisation period.
The results show that R&D significantly increases efficiency in industries 448, 457 and
466 in the post-liberalisation period. Thus, in three out of seven industries, R&D showed
a positive impact on efficiency after the reforms. In the other four industries, it has no
significant impact. These may be the industries in which liberalisation caused firms to scale
down their R&D and to rely on capital and technology imports instead. A high capitaloutput
ratio leads to lower efficiency levels in all periods and all seven industries in India. This is
very surprising since one would normally expect the opposite to be true. However, it turns out
to be a very robust result in this study as well as in other studies on India (Athreye and Kapur,
2003; Kambhampati and Parikh, 2003). It seems to arise from the fact that despite being a

Table 2
Frontier and efficiency estimatesa industry 442 and 448 (19861998)
Automobile components

0
1
2
3
4
5
6
7
8
9
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Sigma-s
Gamma
a

Constant
Labour
Capital
Materials
L2
K2
M2
LK
LM
KM
Constant
Age
Country
Bank loans
IFI loans
FFI loans
Govt loans
Debt capital
R&D
Impsal
Expsal
KO
Market share
Trend
Dum
Dumtrend

442 (19921998)

442 (19871998)

448 (19871991)

448 (19921998)

448 (19871998)

Coefficient

t-Ratio

Coefficient

t-Ratio

Coefficient

t-Ratio

Coefficient

t-Ratio

Coefficient

t-Ratio

Coefficient

t-Ratio

0.088
0.142
0.295
0.506
0.011
0.046
0.114
0.123
0.030
0.172
0.013
0.001
0.000
0.011
0.006
0.000
0.001
0.008
0.000
0.004
0.005
0.001
0.016
0.005

0.105
0.227
0.397
0.754
0.055
0.660
1.304
0.378
0.170
0.699
0.027
0.225
0.000
0.030
0.022
0.000
0.001
0.063
0.000
0.012
0.006
1.997
2.844
0.166

0.356
0.277
1.258
0.137
0.107
0.357
0.232
0.297
0.521
0.096
0.011
0.001
0.000
0.045
0.054
0.000
0.107
0.012
0.006
0.023
0.023
0.227
0.008
0.011

2.138
1.713
9.679
1.124
2.374
11.445
7.982
5.262
12.628
1.486
0.421
2.627
0.020
2.106
2.400
0.000
1.866
0.736
0.016
0.625
0.530
16.445
12.085
6.007

1.486
0.669
1.213
10.734
2.229
1.662
0.639
1.207
3.271
1.936
0.568
1.587
0.000
1.975
0.337
0.000
0.788
1.221
0.293
1.856
1.338
3.296
1.234
0.930

0.255
0.042
0.035
1.249
0.150
0.029
0.249
0.037
0.091
0.396
0.395
0.006
0.241
0.230
0.236
0.927
0.175
0.221
2.720
0.604
0.892
0.001
0.068
0.022

1.519
0.370
0.381
14.611
6.922
1.590
20.745
1.136
3.929
14.930
2.617
3.223
4.361
2.334
2.300
4.027
0.599
2.712
2.219
3.140
3.102
19.381
8.930
2.105

7.642
1.480

0.002
0.050

13.859
0.660

0.852
1.653
3.609
11.540
4.320
4.969
6.760
2.939
2.881
4.439
3.775
3.123
0.773
1.156
0.513
0.000
1.444
1.168
3.033
2.752
1.778
11.989
5.325
1.012
0.288
0.942
5.418
7.175

0.256
0.082
0.097
1.010
0.067
0.043
0.019
0.041
0.120
0.093
0.020
0.001
0.000
0.061
0.012
0.000
0.076
0.025
0.193
0.051
0.118
0.001
0.018
0.007

0.006
0.300

0.124
0.228
0.334
1.021
0.168
0.123
0.161
0.139
0.089
0.235
0.266
0.003
0.037
0.070
0.026
0.000
0.235
0.057
6.590
0.298
0.180
0.007
0.014
0.007
0.018
0.009
0.007
0.642

0.005
0.133

10.361
0.412

0.048
0.911

7.663
59.149

0.015
0.132
0.136
1.139
0.159
0.002
0.226
0.015
0.031
0.380
1.083
0.002
0.176
0.094
0.523
0.525
1.380
0.188
14.584
0.355
1.286
0.001
0.082
0.034
0.257
0.056
0.093
0.963

0.148
1.734
2.559
21.643
10.453
0.139
26.668
0.695
1.910
21.036
10.464
2.232
2.909
1.517
6.736
1.977
9.226
4.008
34.572
10.009
23.823
19.422
21.884
2.723
3.037
4.134
12.755
226.123

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

442 (19871991)

Electrical machinery

The coefficients (0 15 ) are determinants of inefficiency: a positive coefficient implies that the variable increases inefficiency or decreases efficiency.
61

62

Table 3
Frontier and efficiency estimatesa industry 454 and 457 (19861998)
Steel forgings

Ferrous and non-ferrous metals

0
1
2
3
4
5
6
7
8
9
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Sigma-s
Gamma
a

Constant
Labour
Capital
Materials
L2
K2
M2
LK
LM
KM
Constant
Age
Country
Bank loans
IFI loans
FFI loans
Govt loans
Debt capital
R&D
Impsal
Expsal
KO
Market share
Trend
Dum
Dumtrend

454 (19921998)

454 (19871998)

457 (19871991)

457 (19921998)

457 (19871998)

Coefficient

t-Ratio

Coefficient

t-Ratio

Coefficient

t-Ratio

Coefficient

t-Ratio

Coefficient

t-Ratio

Coefficient

t-Ratio

0.778
0.229
0.664
0.341
0.093
0.180
0.230
0.130
0.300
0.050
0.447
0.000
0.000
0.124
0.148
0.392
0.189
0.102
0.985
0.110
0.861
0.112
0.004
0.051

3.123
1.882
4.903
2.433
4.177
5.765
7.074
3.545
5.611
0.932
2.374
0.077
0.000
1.715
2.428
0.806
0.993
1.238
0.624
1.270
2.171
7.205
0.895
2.290

0.902
0.378
0.261
1.312
0.062
0.094
0.100
0.110
0.128
0.347
0.063
0.001
0.063
0.030
0.056
0.108
0.137
0.158
0.026
0.022
0.132
0.008
0.002
0.019

1.111
0.820
1.613
11.062
0.943
5.383
2.649
1.626
2.036
7.205
0.961
1.973
0.085
0.852
0.515
0.155
0.196
2.197
0.027
0.395
2.190
2.138
0.653
2.638

0.476
0.375
1.743
9.835
1.440
1.759
5.422
0.508
3.606
2.315
3.600
3.040
0.000
0.522
1.134
0.000
0.876
4.256
1.263
2.168
0.939
12.304
1.440
4.203

0.318
0.236
0.757
0.692
0.086
0.199
0.226
0.079
0.438
0.059
0.153
0.001
0.018
0.040
0.006
0.410
0.021
0.001
4.647
0.017
0.075
0.137
0.049
0.006

1.955
2.223
7.559
7.168
3.763
5.128
7.672
1.720
8.017
1.418
3.957
3.357
0.522
1.532
0.203
2.514
0.357
0.062
4.426
0.424
2.050
16.326
15.697
1.919

4.150
6.094

0.003
0.098

5.977
5.270

1.534
2.005
0.687
10.450
1.678
0.884
4.356
1.857
0.043
5.350
0.034
1.397
0.204
0.090
0.738
0.213
1.417
0.385
0.001
0.279
2.566
6.767
1.693
0.720
0.361
0.037
3.319
3.898

0.065
0.037
0.152
0.824
0.031
0.055
0.117
0.020
0.144
0.084
0.173
0.003
0.000
0.022
0.063
0.000
0.574
0.297
3.710
0.180
0.079
0.032
0.020
0.050

0.002
0.700

0.304
0.264
0.082
0.939
0.047
0.020
0.131
0.057
0.002
0.219
0.005
0.003
0.322
0.007
0.109
0.055
0.294
0.020
0.001
0.046
0.220
0.016
0.007
0.010
0.029
0.001
0.005
0.360

0.004
0.460

6.546
4.406

0.003
0.779

9.866
16.387

0.129
0.065
0.210
0.882
0.069
0.081
0.159
0.002
0.189
0.129
0.075
0.002
0.028
0.008
0.018
0.393
0.048
0.001
4.666
0.039
0.035
0.037
0.004
0.006
0.022
0.004
0.004
0.086

1.067
0.750
2.752
11.084
3.642
3.039
7.855
0.057
5.396
3.857
2.374
5.090
1.016
0.410
0.803
1.511
0.836
0.040
1.969
1.185
0.892
13.055
1.178
0.906
0.685
0.563
13.179
0.452

The coefficients (0 15 ) are determinants of inefficiency: a positive coefficient implies that the variable increases inefficiency or decreases efficiency.

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

454 (19871991)

Basic industrial chemicals

465 (19871991)
0
1
2
3
4
5
6
7
8
9
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Sigma-s
Gamma

Constant
Labour
Capital
Materials
L2
K2
M2
LK
LM
KM
Constant
Age
Country
Bank loans
IFI loans
FFI loans
Govt loans
Debt capital
R&D
Impsal
Expsal
KO
Market share
Trend
dum
dumtrend

Pharmaceuticals

465 (19921998)

Coefficient

t-Ratio

Coefficient

t-Ratio

0.069
0.000
0.189
0.881
0.018
0.097
0.032
0.060
0.120
0.023
0.027
0.002
0.000
0.289
0.019
0.000
0.107
0.085
1.463
0.170
0.009
0.009
0.065
0.001

0.438
0.002
1.966
12.178
0.812
4.827
1.859
1.449
4.017
0.860
0.379
2.813
0.000
3.929
0.367
0.000
1.368
1.683
1.299
2.621
0.098
12.275
13.245
0.127

0.105
0.098
0.532
0.659
0.061
0.169
0.238
0.035
0.393
0.061
0.003
0.001
0.017
0.006
0.028
0.146
0.031
0.062
2.078
0.015
0.194
0.045
0.027
0.003

0.604
0.821
4.697
6.410
2.172
7.891
11.134
0.858
9.860
1.624
0.079
1.943
0.624
0.154
0.894
1.418
0.761
1.794
2.215
0.312
2.151
14.266
8.230
1.368

0.017
0.889

5.589
33.307

0.006
0.324

465 (19871998)
Coefficient

0.081
0.240
0.185
0.554
0.008
0.076
0.178
0.019
0.188
0.083
0.038
0.003
0.206
0.079
0.021
0.018
0.046
0.099
2.861
0.073
0.095
0.014
0.063
0.005
0.062
0.004
10.162
0.022
3.357
0.822

466 (19871991)

Chemical products
466 (19921998)

t-Ratio

Coefficient

t-Ratio

Coefficient

t-Ratio

0.751
2.937
2.389
7.005
0.386
4.818
10.751
0.568
6.551
2.762
0.702
4.771
2.386
1.818
0.518
0.059
0.767
2.200
2.547
1.401
1.812
14.760
12.241
0.451
1.031
0.320
6.339
20.069

0.062
0.089
0.299
0.638
0.042
0.101
0.174
0.001
0.239
0.088
0.053
0.002
0.000
0.039
0.360
0.000
0.408
0.024
0.798
0.294
0.121
0.123
0.040
0.030

0.488
0.997
4.143
7.642
2.007
5.102
6.222
0.033
7.022
2.298
1.147
4.008
0.000
1.059
5.145
0.000
2.773
0.525
0.497
2.376
2.023
10.837
7.055
3.616

0.380
0.178
0.444
0.956
0.133
0.166
0.160
0.111
0.234
0.166
0.268
0.000
0.036
0.017
0.026
0.087
0.029
0.049
1.009
0.019
0.041
0.094
0.054
0.003

1.848
1.248
4.185
8.890
4.414
7.429
6.309
2.542
7.231
3.617
5.321
0.812
1.967
0.571
0.756
0.316
0.474
1.988
1.691
0.337
1.016
11.733
12.19
1.113

0.004
0.484

7.161
5.974

0.005
0.817

466 (19871998)
Coefficient

0.483
0.167
0.448
0.684
0.103
0.140
0.171
0.081
0.228
0.111
0.169
0.001
0.136
0.014
0.082
1.480
0.093
0.063
3.172
0.053
0.008
0.100
0.03
0.018
0.09
0.020
12.983
0.006
8.740
0.513

468 (19871991)

468 (19921998)

t-Ratio

Coefficient

t-Ratio

3.828
1.879
6.118
9.273
5.076
7.870
8.481
2.451
9.135
3.284
4.627
2.485
2.513
0.539
2.357
1.411
1.723
2.166
3.384
1.079
0.231
15.406
9.010
2.16
2.27
2.201
8.964
9.225

0.117
0.115
0.072
0.922
0.022
0.055
0.193
0.088
0.230
0.141
0.079
0.001
0.204

0.801
0.096
1.056
0.319
0.845
0.138
10.140
0.564
0.830
0.029
2.945
0.057
9.806
0.269
2.585
0.085
7.623 0.238
3.326 0.206
1.054
0.122
0.802
0.001
3.052 0.065
0.029
2.621 0.054
0.156
0.000
0.823
0.041
0.515
0.017
0.276 1.465
0.691
0.088
0.482 0.029
10.701
0.067
1.468 0.038
3.869 0.002

0.191
0.169
0.607
0.029
0.293
0.026
0.033
0.021
0.021
0.048

0.011
0.857

6.520
20.715

Coefficient

0.004
0.636

t-Ratio

468 (19871998)
Coefficient

0.147
0.278
0.012
0.815
0.039
0.004
0.224
0.105
0.137
0.239
0.003
0.001
0.278
0.094
0.062
5.431
0.203
0.067
9.396
0.065
0.109
0.026
0.023
0.041
0.124
0.038
8.641
0.012
13.671
0.762

0.411
2.565
1.137
4.974
1.204
3.308
11.735
2.112
6.906
5.345
2.674
2.546
3.088
0.879
1.552
0.000
0.887
0.613
1.494
1.809
0.819
11.808
4.874
0.551

The coefficients (0 15 ) are determinants of inefficiency: a positive coefficient implies that the variable increases inefficiency or decreases efficiency.

t-Ratio
1.280
3.665
0.181
12.191
2.245
0.326
13.806
4.225
5.595
7.924
0.051
1.895
2.323
2.198
1.326
0.992
2.725
2.002
3.203
1.934
1.980
12.368
14.084
5.866
2.761
4.418
7.304
15.369

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

Table 4
Frontier and efficiency estimatesa industry 465, 466 and 468 (19861998)

63

64

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

capital-scarce economy, capital is very inefficiently utilised in India. Market shares (Market
Share), on the other hand, lead to increased efficiency in 9 out of 14 industry estimations.
This implies that firms with larger market shares can better benefit from learning by doing
than smaller firms. These two results are remarkably robust.
Our results also indicate that in all cases where there is a significant trend in efficiency,
the trend is positive, i.e. shows an increase except in industries 448 and 454. The impact
of Imports, however, is less clear. They decrease efficiency in industries 465, 466, 448 and
457 before the reforms. They improve efficiency only in industry 448 after the reforms.
Exports, on the other hand, increase efficiency in 6 out of our 14 estimations.
6.1. Financial variables and corporate governance
Turning to consider the impact of financing on firm efficiency, we find that firms with a
higher proportion of debt in total funds are less efficient than firms with a higher proportion
of equity in industries 454 and 465. The opposite is true in industries 448, 457 and 466.
There is no obvious difference in the results in the first and second periods, though it seems
clear that whether it increases or decreases efficiency the effect is more significant after the
reforms. This leads us to conclude that H1, the stock market has some advantage over the
credit market institutions in its monitoring function, cannot be accepted as a generalisation.
Its impact varies over sectors or across time.
Our second hypothesis (H2) argued that FFIs were likely to be best at monitoring firms,
while the government was likely to be least effective, with banks and IFIs coming in between.
Loans from FFIs had a significant impact on efficiency only in one industry448. This is,
however, partly offset by the positive effect that foreign ownership has on firm efficiency.
We know that there was very little foreign ownership of firms prior to 1991. This variable,
therefore, drops out of most of the 19871991 estimations. In the second period, however,
foreign ownership significantly increases efficiency in industries 448, 466 and 468 (though
here the effect is marginal).
Our results also indicate that while bank loans are associated with a decrease in efficiency
in three industries (442, 448 and 454), they only improve efficiency in one sector (465).
Similarly, IFI loans worsen efficiency in industries 442, 448, 454 and 468 and improve
efficiency only in industry 466. Thus, neither banks nor IFIs seem to be particularly efficient
at monitoring the firms they lend to. More importantly, this result does not change after the
liberalisation implying that at least in the medium term, the increased freedom of banks and
IFIs did not improve their monitoring of firms.
The result that stands out quite significantly is that government loans decreased efficiency
in all the sectors and periods in which they were significant. They decreased efficiency
significantly in industry 442, 448, 466 and 468. The coefficient of this variable was always
positive (i.e. it increased inefficiency) whether or not it was significant. This could be
because the government sector finds itself continuing to underwrite the losses of inefficient
firms.
Thus, we can partially accept H2, the government is inefficient at monitoring firms, but
cannot fully accept it as we find that none of our other sources seems to be particularly
efficient. Intuitively, this seems acceptable in the pre-liberalisation period, when the IFIs
and banks were mostly public sector institutions, which were strongly influenced by gov-

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

65

ernment policies and developmental objectives. It is a little surprising, however, that the
effect is not differentiated in the post-liberalisation period when the reforms were expected
to increase the independence of financial institutions making their loans more sensitive to
market performance, and therefore, improving their corporate governance capabilities. At
first glance, our results do not reflect this but we will consider it more carefully in Sections
6.2 and 6.3.
6.2. Are banks, IFIs and the government identical in terms of corporate governance in
India?
These results lead us to ask a further question. Given the developmental objectives of the
state and the high degree of regulation and government intervention in the financial sector,
can it be argued that banks, IFIs and the government behave identically in monitoring the
firms they lend to? If this is so, can we aggregate the loans obtained from banks, IFIs and the
government? We test this by estimating two restricted models and testing our restrictions.
In the first model, we hypothesise that the monitoring role of banks and IFIs is similar.
We, therefore, restrict the coefficient of bank loans and IFI loans to be the same.
In the second, we hypothesise that the monitoring role of the government and IFIs is
similar. We, therefore, restrict the coefficient of government and IFIs to be the same in
this model.
We then compare the log likelihood of these restricted models with the log likelihood of
our original model (which is unrestricted) to see if it is significantly different. Our results
are presented in Table 5.
Our results (see Table 5) indicate that though banks seem to behave like IFIs in three
industries (442, 454 and 468), their coefficient cannot be restricted to be the same as that
of IFIs in four other industries, either before or after the reforms. Thus, we can reject the
first restriction that banks and IFIs behave similarly in India. The LR tests also indicate that
restricting the coefficient of government loans and loans from IFIs to be the same, can only
Table 5
Likelihood ratio tests
Industry

442
448
454
457
465
466
468

19861991

19921997

Bank + IFIa

Government + IFIb

Bank + IFI

Government + IFI

106.46
10.28c
0.64
792.7c
11.06c
5.2c
3.46

107.68
201.52c
2.7
0.62
1.52
15.62c
2.86

1.28
31.14c
2.82
1048.52c
0
4.46c
219.62c

2.64
3.06
3.98
0.38
0.54
1.5
11.66c

Critical chi-square value = 3.95 with 1 d.f.

a Implies that the coefficient on bank loans and IFI loans is restricted to be the same.
b Implies that the coefficient on government loans and IFI loans is restricted to be the same.
c Implies that they fail the LR test. In these cases, the pooling of IFI loans with either bank loans or government
loans is inappropriate.

66

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

be rejected in two out of seven industries. Thus, in five industries, the government and IFIs
seem to perform very similarly with respect to corporate governance. Our results, therefore,
confirm that the developmental remit of IFIs makes their behaviour very similar to that of the
state (encouraging soft budget constraints) but very different from that of banks. The table
also indicates that there is no signicant difference between the pre- and post-liberalisation
periods, though there is some indication that the differences are increasing (the size of the
LR statistics is larger in the post-liberalisation period).
6.3. The impact of reforms on rm efciency
Our results so far (see Table 5) lead us to reject H3 that the impact of each source of funds
changed after the liberalisation. We also found that there is no real pattern in the impact that
banks, IFIs, FFIs and the government have on firm efficiency before and after the reforms.
This is a little surprising given the literature that argues that substantial reforms are taking
place in the financial sector in India (RBI, 2003; Arun and Turner, 2002).
Two explanations may be given for these results. First, it is possible that since the reforms
are still on going and many began to take effect only in the mid to late 1990s (towards the end
of our sample period) the long term impact of the reforms may take time to be revealed. A
study by the Reserve Bank of India seems to confirm this: since the process of de-regulation
commenced in 1992, the impact of competitive pressures was felt much later. (RBI, 2003,
p. 15). This study, however, also argued that differences in profitability and cost efficiency
between foreign and private banks and their state-owned counterparts have diminished as
the latter have improved their profitability since 19971998 (RBI, 2003, p. 15 and Shirai,
2002). A second explanation may be that though there have been some reforms in the
financial sector in India, these are not yet very significant. The pace of the reforms may be
so slow that it would take a very long time before they would impact upon the corporate
governance role of these institutions. We currently do not have sufficient post-reform data
to choose between these alternative explanations. Further analysis over the next 510 years
would be required to decide the issue.

7. Conclusions
In this paper, we began with the expectation that the way in which a firm is financed will
affect the firms efficiency performance. More specifically, we argued that firms obtaining
finance from the government are likely to be less efficient than other firms. This is because
the governments effectiveness in corporate governance is very limited. We also argued that
since the liberalisation in India is likely to have increased the sensitivity of the financial
sector to market imperatives, therefore, the impact of financial institutions on firm efficiency
after the liberalisation is likely to have increased.
Our results also indicate that the impact of the source of funds (debt versus equity)
varies from industry to industry. In some industries, lending institutions are more effective at monitoring firms, while in others, equity holders are more effective. We also
find that though the government is generally less effective in monitoring the firms that
it lends to, none of the other lending institutions (banks, IFIs or FFIs) is particularly ef-

U.S. Kambhampati / Structural Change and Economic Dynamics 17 (2006) 4669

67

ficient either. Our tests also confirm that while the government and IFIs have a similar
impact on firm efficiency, banks are quite distinct. They also indicate that the impact of
these sources of funds on firm efficiency is not significantly different before and after the
reforms.

Acknowledgements
I would like to thank the Reserve Bank of India (particularly Mr. Santhanam and Mr.
K.S. Ramachandra Rao) for making this data freely available to me. I am also grateful to Prof. C. Brooks and to Dr. A. Ferrari for their comments and help with this
paper.

Appendix A
See Table A.1
Table A.1
Industry classification number Description
442
448
454
457
465
466
468

Automobile components, etc.

Electrical machinery
Steel forgings
Ferrous/non-ferrous metal
Basic industrial chemicals
Medicines & Pharma. Preps.
Chemical products, excluding basic industrial checmicals, pharmaceuticals, etc.

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