Debt contract enforcement and product innovation: Evidence from a legal reform in India

Abstract

Due to a legal challenge, there was a staggered introduction of fast track debt recovery tribunals (DRTs) across the states of India in the 1990s. Exploiting this plausibly exogenous variation in the efficiency of debt contract enforcement and using detailed information on product lines produced by the manufacturing firms, we study the causal effect of debt contract enforcement on product growth. We find that DRTs account for over 15% of the observed increase in firms’ product scope during our sample period. Firms enter into new product lines in industries outside of their current scope of operation suggesting bolder innovation moves in response to DRTs. This increase in product scope is driven by firms in the top quartile of tangible asset distribution. These firms increase their borrowings and investments in R&D, plant and machinery, and selling & distribution expenses. There is also a significant improvement in their performance as measured by sales and profitability. In contrast, low tangible asset firms experience a decline in their sales and profitability. DRTs also increase the firm level Total Factor Productivity (TFP) and improve the allocative efficiency within industries.