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«Incumbents and Protectionism: The Political Economy of Foreign Entry Liberalization *Anusha Chari **Nandini Gupta University of Michigan Indiana ...»

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Incumbents and Protectionism: The Political Economy of Foreign Entry Liberalization

*Anusha Chari **Nandini Gupta

University of Michigan Indiana University

August 2007

Abstract

This paper investigates the influence of incumbent firms on the decision to allow foreign direct

investment into an industry. Based on data from India’s economic reforms, the results suggest that firms

in concentrated industries are more successful at preventing foreign entry, that state-owned firms are more successful at stopping foreign entry than similarly placed private firms, and that profitable stateowned firms are more successful at stopping foreign entry than unprofitable state-owned firms. These findings continue to hold after controlling for industry characteristics such as the presence of natural monopolies and the size of the workforce. The pattern of foreign entry liberalization supports the private interest view of policy implementation.

Contact Information: * Anusha Chari, Department of Economics, University of Michigan, 611 Tappan Street, Ann Arbor, MI 48109. Internet: achari@umich.edu. ** Nandini Gupta, Kelley School of Business, Indiana University, 1309 East 10th Street Bloomington, IN 47405. Internet: nagupta@indiana.edu. We thank the editor, Bill Schwert, an anonymous referee, Utpal Bhattacharya, Ray Fisman, Galina Hale, Rick Harbaugh, Peter Henry, Simon Johnson, Diana Kirk, Randy Kroszner, Francisco Perez Gonzalez, Enrico Perotti, Jeff Smith, Ramana Sonti, TCA Srinivasa Raghavan, and Luigi Zingales for helpful comments. We have also benefited from the comments of participants at the NBER’s International Financial Markets Fall Meeting, 2005; the Darden/JFE/World Bank Emerging Markets Conference, Indiana and Michigan finance department workshops; the Summer Conference at the Indian School of Business, 2006; and the 6th International Conference on Financial Market Development in Emerging and Transition Economies, Moscow 2005. Chari thanks the Center for International Business Education for financial support.

1. Introduction Liberalizing international capital flows can increase economic growth (Bekaert, Harvey, and Lundblad, 2005). Yet, many countries restrict the inflow of foreign investment that can benefit their economies. Recent evidence suggests that incumbent firms that receive preferential treatment may oppose financial market reforms that threaten their favored status.1 In particular, Rajan and Zingales (2003a, b) and Stulz (2005) argue that entrenched incumbent firms have an incentive to oppose the liberalization of international capital flows if liberalization limits their ability to extract monopoly rents. This paper investigates incumbent firm influence on the decision to liberalize foreign direct investment.

Specifically, we examine the Indian government’s decision to selectively reduce barriers to foreign direct investment in a subset of industries after a balance-of-payments crisis in 1991. The Indian corporate sector is characterized by the concentrated control of assets by state- and family-owned firms, much like the rest of the world (La Porta, Lopez de Silanes, Shleifer, and Vishny, 1999). We adopt a political economy approach to ask the following questions: Did incumbent firms influence the state’s decision to liberalize foreign direct investment in some industries and not others? If so, which incumbent firms had the most to lose from foreign entry and the ability to oppose it?

To investigate these issues, we use a rich firm-level data set that provides detailed balance sheet and ownership information for more than 2,100 firms that account for over 70% of India’s industrial output. The data are classified into state-owned, group-owned, and privately owned firms. We investigate whether pre-liberalization characteristics such as industry structure and the ownership of incumbent firms can explain the government’s decision to selectively open up some industries to foreign entry.

The private interest and public interest views of policymaking suggest possible explanations for the government’s decision to liberalize some industries and not others. The private interest view characterizes the policy process as one where special interest groups lobby the government to influence The evidence suggests that (1) banking deregulation is delayed in U.S. states where incumbent banks have the most to lose from entry (Kroszner and Strahan, 1999); (2) entrenched firms lobby to restrict access to credit after a crisis, forcing poorer entrepreneurs to exit (Feijen and Perotti, 2005); and (3) post-1500, Western European countries with monarchies opposed free entry in profitable industries (Acemoglu, Johnson, and Robinson, 2005).

policy decisions in their favor, which may result in non-welfare-maximizing outcomes.2 The public interest view assumes that governments enact welfare-maximizing policy changes to achieve socially efficient outcomes and correct market failures, without regard for private interests (Joskow and Noll, 1981).

Using data on industry structure and firm characteristics, we investigate whether the government randomly liberalized industries, or whether the private or the public interest views better explain the pattern of liberalization. For instance, the private interest view holds that the probability of foreign entry liberalization will be inversely related to industry concentration. According to Olson (1965), Stigler (1971), and Peltzman (1976), incumbent firms in these industries have a greater ability to lobby the government and prevent policy changes, such as foreign entry, that could adversely affect them. Further, Stigler (1971) argues that incumbent firms in profitable, concentrated industries have a greater incentive to prevent entry in order to protect their monopoly profits. In contrast, from a public interest perspective the government would liberalize entry to reduce deadweight losses in concentrated industries that earn monopoly profits (Pigou, 1938).





The government also may be more receptive to the interests of particular incumbents, such as state-owned firms that occupy a prominent position in many economies around the world (Megginson, 2005).3 Politicians obtain private benefits from state-owned firms, such as the ability to hire surplus workers (Shleifer and Vishny, 1994). Moreover, the earnings of state-owned firms directly accrue to the government. Therefore, policy makers may have an incentive to protect industries with large or profitable state-owned firms from competition.

Our main results are as follows. First, consistent with the private interest view, the likelihood of foreign entry liberalization in an industry is inversely related to its concentration. On average, the probability of liberalization decreases by 27% for a one standard deviation increase in the Herfindahl Olson (1965), Peltzman (1976) and Becker (1983) describe the regulatory process as one of interest group competition in which compact, well-organized groups are able to use the coercive power of the state to capture rents at the expense of more dispersed groups.

According to Gupta (2005), Indian state-owned firms account for over 40% of the total capital stock in the economy.

index from its sample mean of 0.45.4 Second, consistent with the hypothesis that firms in concentrated industries have an incentive to protect their monopoly profits, the likelihood of foreign entry liberalization is significantly lower for profitable, concentrated industries. Third, regional variation in firm location reveals a negative and significant relationship between geographic concentration and the likelihood of foreign entry liberalization.

Fourth, the results show that industries with a sizable state-owned firm presence are significantly less likely to be liberalized. Whereas industries with state-owned monopolies face a 14% chance of being liberalized, industries with no state-owned firms face a 52% probability, making them nearly four times as likely to be liberalized. Also consistent with the private interest hypothesis, the evidence suggests that the government is more likely to protect profitable state-owned firms. The results are robust to industry size, concentration, and workforce.

Four methodological issues may be raised in the context of our empirical analysis. First, the pattern of liberalization may reflect underlying technologies that determine scale rather than barriers to entry created by incumbent firm influence. We examine the difference between Indian and U.S.

concentration in the same industries where U.S. concentration captures the ‘natural’ level of concentration in an industry and find that the likelihood of liberalization is negatively correlated with our measure of “excess concentration.” Consistent with Rajan and Zingales (2003a, b), this result suggests that past industrial policies in India created powerful incumbent firms that used their market power to oppose financial market reforms. Second, while industry concentration may proxy for natural monopolies or industries of strategic importance, we find that concentration continues to be significantly and negatively correlated with the probability of liberalization after controlling for industries in these two categories.

Third, industry concentration may proxy for the political connections of certain incumbents like family-owned firms. We find that industry concentration continues to be significantly and negatively related to the probability of liberalization with the inclusion of controls for the stake of privately-owned The Herfindahl index is an indicator of the degree of competition among firms in an industry. It is defined as the sum of the squares of the market shares of each firm in an industry. The value of the Herfindahl index can range from zero in perfectly competitive industries to one in single-producer monopolies.

and state-owned firms in an industry, which are proxies for the political influence of these firms. A limitation of this approach is that there may be heterogeneity in the influence of private firms arising out of family connections that are not captured by ownership categories.

Fourth, our methodology is related to the literature on the political economy of trade, where politically organized groups use campaign contributions to influence politicians as in Grossman and Helpman (1994).5 For instance, Goldberg and Maggi (1999) and Bandhyopadhyay and Gawande (2000) find that tariffs are higher in industries that are represented by organized lobbies. However, as Gawande and Krishna (2004) point out, one concern in this literature is that industry characteristics are an endogenous outcome of differences in tariff barriers across industries. Our data have the advantage that before 1991, draconian restrictions on foreign entry were uniformly applied across all industries so that foreign investment inflows were negligible.6 We also estimate an instrumental variable specification using industry concentration in the United States as an instrumental variable for the Herfindahl index in India to capture influence arising out of market power rather than past protection. Industry concentration remains inversely correlated with the probability of liberalization.

Our findings contribute to the literature that documents the relation between financial constraints and product market competition (Cetorelli and Strahan, 2006) as well as the relation between financial market development and economic growth (Rajan and Zingales, 1998; Bekaert, Harvey, and Lundblad, 2005). Given the widely documented inefficiencies of state-owned enterprises (Megginson, 2005) and the deadweight loss associated with industry concentration, selective entry liberalization to protect these incumbent firms may inhibit economic growth. Because entrenched state-owned firms are likely to hinder financial market reforms, a policy implication of our results is that it may be necessary to reduce the influence of these firms, for example, through privatization, to optimally implement reforms.

We do not observe more direct measures of influence such as parliamentary voting records or lobbying contributions because the former are not available for the liberalization measure studied here, and the latter are illegal in India. A potential concern with using data on lobbying contributions, if available, is that the contributions and the policy positions of politicians may be simultaneously determined. It is difficult to make a similar claim for the ex-ante stake of incumbent firms, which lies at the core of the identification strategy in this paper.

In the four years preceding liberalization foreign investment inflows accounted for less than 0.3% of gross capital formation on average in India (World Bank, 1991).

Section 2 discusses the economic reforms and industrial structure in India. Section 3 provides summary statistics and describes our methodology. Section 4 describes the data. Section 5 discusses the relation between industry and firm characteristics, and the likelihood of foreign direct investment liberalization. Section 6 provides additional robustness checks, and Section 7 concludes.

2. Reforms and Industrial Structure

2.1. Liberalizing Foreign Entry in India In response to a balance-of-payments crisis in 1991, India undertook sweeping economic reforms.

A key reform involved reducing restrictions on foreign direct investment in a subset of industries.

Specifically, according to the Industrial Policy Resolution of 1991, automatic approval was granted for foreign direct investment of up to 51% in 46 of 96 three-digit industrial categories (Office of the Economic Advisor, 2001). In the remaining 50 industries, the state continued to require that foreign investors obtain approval for entry. Table A1 in the Appendix provides a list of liberalized industries.

Before 1991, ownership and industry concentration patterns in India were an outcome of state-led industrialization policies rather than of market forces. A chronology of industrial policies since India’s independence shows that these policies restricted the participation of private and foreign firms in the economy (Appendix, Table A2). For example, the Industrial Policy Resolution of 1956 reserved certain industries for state-owned firms, prohibiting the entry of all private firms. Until 1991, government approval was required for foreign direct investment in all industries, severely curtailing FDI flows.



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