Effect of Financial Liberalization on Investment Allocation: An Empirical Analysis

This paper by Basudeb Guha-Khasnobis and Saumitra Bhaduri of the Madras School of Economics attempts an early evaluation of the effect of the ongoing reforms in the financial sector, especially those related to the capital market. The authors address the question of whether the abolition of the Controller of Capital Issues (CCI), the gradual easing or removal of a few other restrictions on interest rates and reserve requirements and reductions of Statutory Liquidity Ratio (SLR), have led to an improvement in the allocation of investment in India during the 1990s. They test the hypothesis that a more market oriented financial sector should be able to direct investment towards industries, and firms within an industry, which are growing or profitable, so that the growth rate of the
economy is maximised. Their econometric analysis leads them to the findings that for the chemicals, automobiles, electronics and food industries, the allocation effect of investment is in the expected direction. But in other industries, e.g., cement, drugs & pharmaceuticals, iron and steel, machinery, paper and metal products, etc., this does not hold.