Politics and Real Firm Activity: Evidence from Distortions in Bank Lending in India

This paper provides novel evidence on a particular real cost of political interference on banks—preferential lending to politically important sectors crowds out lending to other sectors in the economy. Analyzing staggered state elections in India, I show that politicians influence banks to increase lending to farmers before elections, which crowds out lending to manufacturing firms. These lending distortions are larger in locations where farmers have more political weight. Comparing firms in states that have an election in a given year against comparable firms in states that do not, I find that the reduced availability of bank credit forces firms to use up their cash reserves, reduce production, lay off workers, and operate at lower utilization rates. Overall, my results suggest that interference from the political environment can lead to costly crowding-out of real firm activity.  [email protected]. I thank my advisors Raghuram Rajan, Amit Seru, Amir Sufi and Gregor Matvos for numerous discussions and guidance. I would also like to thank Efraim Benmelech, Sudheer Chava, Maitreesh Ghatak, Christopher James, Andy Naranjo, Nagpurnanand Prabhala and Chad Syverson for helpful comments. I thank the Reserve Bank of India for providing data on bank lending. I am grateful to Abhiman Das and V. C. Augustine at the Reserve Bank of India for providing extensive support in accessing and understanding the data. This paper also benefited from comments from members of the Fama Miller Corporate Finance Reading Group at Chicago Booth and seminar participants at the Federal Reserve Bank of New York, Georgia Institute of Technology, Indian School of Business, Indiana University at Bloomington, University of Chicago, University of Illinois at Urbana-Champaign, University of Florida, and University of Notre Dame. All remaining errors are my own.