Debt Contract Enforcement and Product Innovation

Developing countries are associated with the weak enforcement of debt contracts often attributed to long delays in the liquidation proceedings and limited expertise in solving debt recovery cases by courts. Weak enforcement of debt contracts can have unwanted consequences for financial development in the economy as banks reduce lending due to the difficulties in recovering claims from distressed firms. Recent research finds a positive link between debt contract enforcement and access to credit (Ponticelli and Alencar, 2016). However, despite the importance of product innovation for economic growth, we have surprisingly little evidence on the causal link between debt contract enforcement and product growth in the economy. In our recent working paper ‘Debt Contract Enforcement and Product Innovation: Evidence from a Legal Reform in India’, we study the effect of a legal reform targeting the efficiency of debt contract enforcement on product growth in the manufacturing sector in India.

Debt Contract Enforcement and Product Innovation

Introducing new product lines entails considerable upfront investments and financial constraints may force firms to operate in a sub-optimal number of product lines. Thus, the relationship between debt enforcement and firms' product growth depends on its effect on firm borrowing. On the one hand, efficient debt enforcement increases the liquidation value of the collateral that creditors can recover from defaulting firms and can also mitigate moral hazard problems in credit markets. Thus, efficient contract enforcement can increase access to credit for firms. On the other hand, an increase in the efficiency of debt enforcement can also discourage firms from investing in product innovation by increasing the cost of failure due to the threat of premature and inefficient liquidation by creditors. As such, whether efficient debt enforcement leads to increased borrowing and, in turn, product growth is an empirical question and depends on which channel dominates.

Why Product Growth?

We focus on product innovation as it is key to firm survival and growth, and firms must continually update their existing products and develop new product lines to preserve and expand their customer base. Further, other measures of innovation such as patents fail to fully capture innovation activity in the product market. Even for developed economies like the US, only a small fraction of manufacturing firms (6.3%) use the patent system (Graham and others, 2018), and this share is likely to be even lower in developing countries that have weak protection of intellectual property rights. Finally, introducing new products is a complex process, and the knowledge generated through research needs to be supplemented with substantial upfront investments in product development, plant and machinery, advertisement, and distribution activities. Thus, firms' product scope may be more responsive to the relaxation of financial constraints as compared to investment in research activities. The introduction of new products by firms directly measures the outcome of innovation activity for all firms and helps us better capture the aggregate impact of debt enforcement on innovation through product creation in the economy.

Detailed data on product lines manufactured by firms is rarely available. However, in India, under the Companies Act 1956, companies are required to report information on sales and quantity for all product lines. For our study, we use the CMIE Prowess database which reports product level information for all product lines manufactured by each firm over time. We compile data on product lines with other firm level indicators to examine the effect of debt enforcement on product growth.

Debt Recovery Tribunals (DRTs) under the RDDBFI Act 1993

The Recovery of Debts Due to Banks and Financial Institutions Act 1993 (RDDBFI Act) was enacted to improve debt recovery for banks by introducing specialized courts for debt recovery. Debt Recovery Tribunals (DRTs) were supposed to be established across the country in 1993, however, only 5 tribunals were introduced in 1993 as the law was challenged in court, which halted the process for 2 years. The process of DRT establishment restarted after the interim ruling of the Supreme Court in favor of DRTs. The staggered implementation of DRTs across the states provides us the ideal setting to study the effect of debt enforcement on product growth.

Before introducing the RDDBFI Act, all loan recovery cases were processed in civil courts in India. Civil courts in India are prone to procedural delays. According to a 1988 Government of India report, more than 40% of liquidation cases were pending for more than 8 years in Indian civil courts. Consequently, a large proportion of bank funds was blocked in non-performing assets. To remove these legal bottlenecks in the recovery of bank dues, the Government of India passed the RDDBFI Act in 1993 to establish new specialized debt recovery courts. These Debt Recovery Tribunals have significantly improved the efficiency of the debt recovery process as documented in Visaria, 2009.

DRTs and Product Growth

Figure 1 below shows the yearly differential effect on firms’ product scope in DRT versus non-DRT states. We find that following the implementation of DRTs, firms increase their product scope on average by 2.4%, accounting for 15% of the observed change in product scope during our study period. Further, due to inelastic credit supply in the short run, only the firms with high tangible assets experience an increase in credit. This increased credit supply led to an increase in the product scope of firms with high tangible assets. We find that DRTs account for a 51% increase in the product scope of high tangible asset firms during our study period. We also find that firms introduced new product lines in industries outside of their current scope of operation suggesting bolder innovation moves in response to DRTs.

Mechanism: Financial Constraints

We find that the underlying mechanism that drives the effect of DRTs on product innovation is access to credit. Our findings suggest that high tangible asset firms experience an increase in leverage and total borrowings. Further, we find that the increase in the product scope is predominantly driven by firms in industries with higher external financial dependence and by younger firms, which are likely to be more financially constrained.

DRTs and Firm Performance

We find that high tangible asset firms experience a significant increase in profitability, as measured by return on assets and operating margins, after the establishment of DRTs. Finally, we estimate the effect of DRTs on Total Factor Productivity (TFP) of firms and the allocation of physical capital and labor across firms with differing TFP levels. We find evidence of an increase in firm level TFP after the implementation of DRTs. We also find that DRTs led to the reallocation of capital and labor towards the high TFP firms. Taken together, these results imply that DRTs have had a positive impact on both product growth and productivity of firms.

Conclusion

Legal institutions, by protecting property rights and assisting in the enforcement of contracts, play an important role in financial development and economic growth. However, the mechanisms underlying this relationship are not clear. Do firms grow by accumulating physical capital with the same technological knowhow? Or do they grow by undertaking innovation activities that enable them to introduce new product lines and improve efficiency?­ Our study takes a step in addressing this gap and provides the first causal evidence that an increase in the efficiency of debt contract enforcement leads to a significant increase in product scope and productivity of manufacturing firms in India. Thus, at least in India, legal institutions play an important role in funding firms’ innovation activities.

Tanya Jain is a Doctoral Student in Economics & Social Sciences at the Indian Institute of Management (IIM) Bangalore.

Rahul Singh is an Assistant Professor in Economics and Public Policy at Ahmedabad University.

Chetan Subramanian is Professor of Economics and Social Sciences at the Indian Institute of Management (IIM) Bangalore.

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[1] Product scope is defined as the total number of products produced by a firm in a year.

[2] High tangible assets is a dummy variable which is equal to 1 if a firm belongs to the top quartile of tangible assets distribution and 0 if otherwise. The measure of tangible assets is Net plant, property, and equipment deflated by capital deflator.