The study’s major aim is to explore the effects of financial constraints and the investment climate conditions on resource misallocation and productivity of Indian Small and Medium Enterprises on a larger sample of 6,932 firms using data from the World Bank Enterprises Survey, 2014. The current study employs Hsieh and Klenow model (2009) and Stochastic Frontier Analysis to measure the distortion in input misallocation and firm productivity, respectively. The study’s major findings suggest a distortion of resources in capital and labour, but the extent of misallocation is more significant in the case of capital. Financial constraint significantly affects the marginal productivity of capital and labour and firms’ total factor productivity. Investment climate conditions such as red tape and harmful competition are critical to achieving the productivity gap of capital. Further, red tape in the system adversely affects the efficiency and productivity of firms. Hence, in addition to access to finance, focus on investment climate conditions such as red tape and harmful competition should be given while framing policies to support Small and Medium Enterprises in India.
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