There is a widespread perception that finance and India’s “twin balance sheet” problem have constrained India’s economic growth. A key reason why so many developing countries have failed to accelerate growth is the lack of financial development required to cope with twin balance sheet problems and misallocation of resources. So, increased fiscal policy emphasis on dealing with the twin balance sheet problem and recapitalisation of banks is often encouraged. But India also has other issues to deal with, including scaling up its physical infrastructure. While an improved financial sector is important for India’s growth, can the country still accelerate growth through other means, such as infrastructure spending? Is it infrastructure or finance that is a key contributor to India’s growth?
This question is important for several reasons. First, given the fiscal constraints, policymakers need to decide whether increased fiscal resources will be allocated to recapitalising banks or scaling up poor physical infrastructure. Infrastructure spending is increasingly being seen as an important fiscal tool for accelerating growth in most developing countries, given the fast pace of urbanisation, the urgency of creating more jobs and reducing the carbon footprint.
Second, if infrastructure investments can also overcome the limitations of weak financial development, this is an important insight for policymakers and nation-builders, as they can proceed with infrastructure projects in confidence that financial markets will work themselves out.
Infrastructure investment is a necessary condition for growth. On the other hand, if addressing the twin balance sheet problem and recapitalisation of banks is necessary for growth, then the effects of infrastructure investments will be uneven. We examined the importance of infrastructure and finance for growth in India, using data on Golden Quadrilateral (GQ) highway projects, and development of banks at the district level, before and after the highway was built (see Abhiman Das, Ejaz Ghani, Arti Grover, William R Kerr, and Ramana Nanda, Infrastructure and Finance: Evidence from India’s GQ Highway Network).
India’s transport infrastructure, especially the GQ Highway, connects the four major cities of Delhi, Mumbai, Chennai, and Kolkata, and it is the fifth-longest highway in the world. Transport infrastructure is an essential ingredient for economic development and growth, as it facilitates cheaper and more efficient movement of goods, people and ideas across places. It impacts the distribution of economic activity and development across regions to the extent that agglomeration economies and efficient sorting can be realised, competition among industries and concomitant reallocation of inputs towards more productive enterprises are achieved, and much more.
India’s investment in transport has facilitated a more natural sorting of land-and building-intensive industries from the nodal districts into peripheral locations. This general urban-rural or core-periphery pattern is evident in many countries and is associated with efficient sorting of industry placement. Infrastructure investments have made intermediate cities more attractive to manufacturing entrants. For instance, moderate-density districts — like Surat in Gujarat or Srikakulam in Andhra Pradesh — that border the GQ highway registered a more than 100 per cent increase in new output and new enterprise establishment after the GQ upgrades.
The GQ setting is a very powerful laboratory, as the massive highway upgrades came after India began collecting high-quality data on loan activity, enabling us to quantify relationships in ways that are impossible for advanced economies like the United States, where infrastructure work began long ago.
On financial development, we used detailed data on bank lending across India over an extended period, drawn from the Reserve Bank of India. While the micro-data can only be accessed at the RBI by their staff, we were allowed to use bank data at the district level. Districts are administrative subdivisions that provide more granular distances from the various highway networks. The core sample contained 311 districts that account for over 90 per cent of manufacturing activity in India. This database gave us detailed information on each outstanding loan above a small threshold, reported annually by every branch of scheduled commercials bank in India.
The context of the GQ infrastructure project enabled us to generate strong causal results of the relationship between infrastructure investment and local financial development. To understand the interaction between infrastructure and finance, we examined how the results varied, based on the pre-existing financial development of districts adjacent to the highway. This helped to answer the question of whether it was finance or infrastructure that was necessary for the real effects to be manifested.
Empirical results suggest a strong response in lending activity in districts adjacent to the GQ highway network, manifested in terms of both loan counts and larger loan sizes. They were strongest in districts where there was new construction (as opposed to upgrades), and point to bank lending responding to the increase in real activity, which arose from improved transportation infrastructure. These results provide new insights into how micro-level financial development interacted with infrastructure development in India.
This is not possible for the US, where most research has traditionally focused, owing to the older nature of the Eisenhower highway system. The later timing of the Indian investment, and better collection of financial data over recent decades, provides unprecedented policy insights and platforms for further exploration.
Yet, there is a word of caution against developing an expansive perspective of “build it and they will come”. There was a disproportionate increase in loan count and average loan size in districts along the GQ highway network. However, they were concentrated in districts with stronger initial financial development, suggesting that although financing responds to large infrastructure investments, and helps spur real economic outcomes, initial financial sector development may also play a role in determining where real activity will grow.
The writer taught economics at Delhi University and Oxford University, and has worked for the World Bank