Financing Firms in India

We examine legal and business environments, financing channels, and governance mechanisms of various types of firms in India. Despite its English common-law origin, strong legal protection provided by the law and a democratic government, corruption and inefficiencies within India’s legal system and government significantly weaken investor protection in practice. Accordingly, firm financing has been dominated by internal sources and non-market, relationship-based channels such as trade credits, while firm characteristics, especially those of the small and medium enterprises (SMEs), resemble those from countries with weak investor protection. Our evidence, including results based on surveys of private firms in the SME sector, also shows that informal governance mechanisms, such as those based on reputation, trust, and relationships, are more important than formal mechanisms in resolving disputes, enforcing contracts, and overcoming corruption. Finally, the SME sector, relying on informal financing and governance mechanisms, has grown faster than large scale firms, which operate in environments with stronger legal protection and have better access to formal financing.