Directed credit, financial development and financial structure: theory and evidence

ABSTRACT

The recent initiative of the RBI in reviving the policy of directed credit allocation in a period dominated by the neoliberal philosophy necessitates reconsideration of the role of policy-directed credit allocation process on financial development and financial structure of firms. Introducing certain policy parameters, the paper attempts to model how financial development-financial structure interlinkage is influenced by the liberalization policies of the government. The theoretical construct is empirically verified using both aggregated and disaggregated (firm-level) data comprising a panel of 932 Indian manufacturing firms. Findings reveal that following the liberalization measures in the early 1990s, there has been a structural shift in the debt–equity ratio of firms, with equity market activities assuming prominence over time. As regards financial development, it has been observed that the withdrawal of DFIs specialized in term-lending activities in the early 2000s led to a significant increase in the degree of financing constraints faced by the manufacturing firms. This contradicts the basic premise of financial liberalization. The paper argues that under certain conditions, government intervention in the form of directed credit programmes would not only act as an effective instrument in ushering financial development, but also provide important guidelines in ensuring sustainability of institutions.

KEYWORDS:

• Financial development
• financial liberalization
• financial structure
• structural break
• panel data

JEL CLASSIFICATION:

• C23
• G28

Acknowledgments

We are very grateful to the editor and the anonymous reviewer for their incisive comments and suggestions that imparted more clarity and strengthened the context of the study. The usual disclaimer applies.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ This assumption is done to dichotomize financial development from financing choice decisions. Linking the return of the intermediary to the returns of the capital-producing firms would result in an interlinkage between financial development and financing choices. Though this would have apparently made the paper more appealing, we refrained from such an analysis as this would not change the basic findings of the paper.

² The assumption of such managerial skill generation by the financial intermediary has been introduced to reflect the significant contribution of the development finance institutions in the development of skills in developing countries (de Aghion 1999).

³ In fact, the sufficient condition required in this theory will be $A_{t+1}>\left[\frac{1-h_t^{\ast }}{\left({\tau }_t^{\ast }-h_t^{\ast }\right)\left(\frac{pR}{I}\right)}\right]T$. The implication of this restriction will be revealed in the course of our analysis.

⁴ We thank the anonymous referee for this valuable input.

⁵ Some studies use capital expenditure in the numerator, while others use gross fixed assets in the denominator. Our results are not sensitive to which specification we use.