In some respects, India seems to be doing everything wrong: regulatory protections for investors are weak, banks don’t lend much money to small- and medium-size businesses, and the country’s legal system is highly corrupt. Yet when it comes to growing its economy, India seems to be doing everything right.

How can this be? How can a country so freewheeling — with a “you scratch my back and I’ll scratch yours” approach to business — have an economy that has surged at an average annual rate of about 8% in recent years? Scholars at Wharton and three other business schools say in a new study that owners of small- and medium-size firms have found ways to finance their firms’ growth and settle their legal disputes outside the system. In this regard, India is not so different from China, another rapidly growing nation whose business and legal systems are often byzantine and far from above-board.

Indeed, the study, “Financing Firms in India,” challenges the conventional wisdom among academics and public policy experts that corruption automatically impedes economic advancement of developing countries, according to Wharton finance professor Franklin Allen, one of the authors of the study.

“The academic literature says developing countries need a good legal system and honest government to grow,” Allen states. “We found, however, that a low level of corruption is not a significant impediment to growth because businesses can obtain financing and settle legal differences outside the legal system in ways that are quite effective.”

“Small- and medium-size Indian companies have found ways to get around [the limitations of the country’s financial and legal systems],” says co-author Sankar De, clinical professor and executive director of the Center for Analytical Finance at the Indian School of Business in Hyderabad. “They depend on informal mechanisms for dispute resolution. They lend and borrow from each other. In many ways, they bypass formal financial markets and courts of law.”

The study is timely in that it addresses issues that are high on the agenda of policymakers and non-government officials who deal with emerging economies. At a September meeting in Jakarta of the Emerging Markets Forum, a group that sees itself as a Davos for developing markets, the consensus view of corruption’s effect on these economies was on display. An article in London’s Financial Times about the forum put it this way: “The development of emerging market economies continues to be held back by corruption and poor governance in spite of their increasing influence on the global stage and growing foreign direct investment in other countries. That was the most striking message from a two-day meeting of current and former central bankers, development experts, finance ministers, investors, and presidents of countries such as Brazil, India and Tanzania.”

The forum happened to take place following another gathering where corruption was a hot topic of debate. At a meeting of the World Bank in Singapore, Bank president Paul Wolfowitz was criticized by participants for launching a campaign against corruption in countries that receive lending from the agency.

Allen and De conducted the study with Rajesh Chakrabarti of the Georgia Institute of Technology, Jun Qian of Boston College and Meijun Qian of the National University of Singapore. The researchers analyzed India’s business and legal environments, financing channels and governance mechanisms, and compared them to those of other countries.

Strong Protections, but Only on Paper

Although India has a democratic government and its English common-law origins provide strong legal protections on paper, corruption within the government and the legal system is so rampant that, in practice, investors in India’s economy have weak protections.

The seeds of India’s corruption can be traced back to the mid-20th century. When it became independent from Great Britain in 1947, India inherited one of the world’s poorest economies, but also one with arguably the best formal financial markets in the developing world. It had four functioning stock exchanges with clearly defined rules governing listing, trading and settlements; a well-developed equity culture, if only among the urban rich; and a banking system with well-developed lending norms. In terms of its corporate laws and financial system, India was far better endowed than most other former colonies. The 1956 Indian Companies Act, as well as other laws that govern the functioning of joint stock companies and protect investors’ rights, were built on this foundation.

But India’s embrace of socialism after independence put in place a “regime and culture of licensing, protection and red-tape that bred corruption and stilted the growth of corporate sectors,” Allen and his colleagues write. Heavy industries and strategic sectors were controlled by the government and placed off-limits to private enterprise. Two rounds of nationalization brought about 90% of the banking sector under government control. At the same time, though, steps were taken to promote employment and to pay homage to Mahatma Gandhi’s vision of village self-sufficiency. India restricted several areas for the so-called “small-scale sector,” where individual businesses could not grow beyond a certain size.

Formal non-state enterprises, such as joint-stock corporations, were restricted to a middle area between these large and small sectors, and subject to the “License Raj” where government permission was required for an ever-increasing list of business decisions. “Corruption, nepotism and inefficiency became the hallmarks of the Indian corporate sectors,” according to the study. “Exorbitant tax rates encouraged creative accounting practices and complicated compensation structures designed to beat the system.”

In 1990 and 1991 a balance-of-payments crisis threatened a default in India’s foreign-debt payments. While some business friendly reforms had begun in the 1980s, this crisis, and the conditions imposed by the International Monetary Fund as part of an assistance package that followed, ushered in an era of reforms. As in many other countries around the globe, this consisted of deregulation, liberalization of the external sector and partial privatization of some state-owned enterprises. In many ways, the reforms that started in 1990 have transformed the economy through the twin forces of globalization and competition. For over three decades after independence, India grew at an average rate of 3.5% and then accelerated to an average of about 5.6% since the1980s. India’s annual growth rate of 7.9% from 1990 through 2005 ranked second highest among the world’s largest economies, behind only China’s 11.8%.

Nonetheless, because of the corruption that continues to be endemic today, India’s stock market has not played a dominant role in resource allocation and providing external financing to firms, the study says. Although the size and importance of stock markets have grown significantly in recent years, external financing through equity and bond markets remains dominated by banking and alternative sources. Listed firms have concentrated ownership and low valuations, and they pay low dividends relative to firms from countries with strong legal protections.

Screening Business Partners Carefully

A significant part of the study consisted of extensive surveys of non-state, non-listed private firms of small and medium size, one of the most successful sectors in the Indian economy. These firms have grown faster than the rest of India’s economy during the past 15 years, even though the financing of this sector is clearly different from that of state and listed firms, according to Allen.

De notes that these businesses account for more than 40% of the total value added in Indian manufacturing. “Neither the absence of formal legal processes nor the [lack of] access to financial markets and credit seem to have impeded their growth rate,” De says.

The authors’ survey included 213 entrepreneurs and executives of firms in and around the southern Indian city of Hyderabad (76 firms) and the Delhi-Gurgaon area of northern India (136 firms). The firms operate in manufacturing industries and range in age from less than one year to 85 years, with the median being 21 years. The firms employ two to 350 workers, with the median being 10. In about 85% of the firms surveyed, the largest owner is the founder’s family, while over half of the firms have unlimited liability. When asked how the owners with unlimited liability would protect their personal assets in case of business failure, 151 out of 157 respondents said they would negotiate with lenders for an extension. Only 22 respondents said they would also file personal bankruptcy.

The three most important financing channels for these firms during their start-up and growth periods are founders’ family and friends, trade credits and loans from financial institutions, such as state-owned banks and banks specialized in lending to small- and medium-size firms. These include the Small Industry Development Bank of India and State Financial Corporations (SFCs). A “trade credit” often involves nothing more than one firm lending a hand to another by giving a customer more time to pay an invoice or by doing a special deal to help a supplier in a time of need, according to Allen. However, credit availability is not uniform across the surveyed firms, and the market for bank credit is clearly relationship-driven. Over 70% of the respondents said that their firms had to meet operating and profitability criteria to obtain their largest loans, while the median “monitoring” frequency of the banks (when bank employees contact borrowers about loans) is once per quarter.

The researchers also discovered that informal governance mechanisms based on trust, reputation and relationships are much more important than legal remedies in resolving disputes and enforcing contracts. For example, when asked about the consequences of delay of payments or non-payments and breach of contracts, the respondents ranked loss of future business opportunities, reputation and personal assets as main concerns, while fear of legal remedies was the least important. When asked who would be the best mediator for disputes, 46% said “mutual friends and business partners” and 26% specified a non-government organization like a trade association. Only 20% chose “going to courts.”

When asked how a firm ensures payments, 53% of respondents said they screen their business partners carefully so that such issues do not occur, while 59% said they would go to court but would leave negotiation possibilities open. When asked about the role of government regulatory authorities in such actions as obtaining a license to start a business, the survey found that corruption is part of doing business. The two most common methods to overcome corruption are bribes and using friends of government officials.

Allen and the other researchers analyzed how entrepreneurs and investors alleviate and overcome problems associated with government corruption. According to the commonly accepted view, poor institutions, weak government and powerful elites should severely hinder India’s long-term economic growth. The study, however, showed that corruption has not prevented a high rate of growth for India’s firms, especially small- and mid-size firms, where legal protection is perhaps weaker and problems of corruption are worse compared to firms in other sectors.

“Perhaps one of the most effective solutions for corruption for firms in this sector is the common goal of sharing high prospective profits,” the study says. “This common goal can align interests of the investors and government officials with entrepreneurs and managers to overcome numerous obstacles. Under this common goal in a multi-period setting, implicit contractual agreements and reputation can act as enforcement mechanisms to ensure that all parties, including government officials, fulfill their roles to make the firm successful.”

Another potentially effective solution for corruption can be competition among local bureaucrats from different regions within a country. Entrepreneurs can move from region to region to find the most supportive government officials for their private firms, which in turn motivates officials to lend “helping hands” rather than “grabbing hands,” or else there will be an outflow of profitable private businesses from the region. “This remedy should be typically available in a big country with multiple regions like India,” the authors write.

In and Out of Court

The Wharton study also found that the majority of Indian entrepreneurs resolve disputes outside of courts, which is similar to survey results from other emerging countries, such as China and Vietnam. But Allen and his colleagues learned that some Indian entrepreneurs and their business partners also rely to an extent on the legal system to resolve disputes and enforce contracts.

Looking ahead, it is possible that legal systems will play a more important role in supporting the development of stock markets and attracting more foreign capital inflows in India and other emerging countries. For this to happen, however, it must be noted that the costs of improving the legal system vary significantly across countries. With a small and homogenous economy, a country can adjust its legal and financial systems to the strengths of its economy more economically than can a large country such as India.

Allen stresses that the study should not suggest that corruption is acceptable. But he does conclude — at least when it comes to the issue of economic growth — that corruption does not seem to be a serious impediment. Furthermore, academic researchers and policy makers at institutions like the World Bank should recognize that not all corruption is the same and that different kinds of corruption pose different levels of threat to a well-functioning business environment and a healthy economy.

“Some kinds of corruption are not too bad and others are very bad, and we probably lump the two together a little too much,” Allen says. “For example, low-level regulatory officials in India and other emerging economies do not get paid well, have little power and feel it necessary to bribe business owners who need licenses and approvals. It’s not necessarily bad in my view, as long as they aren’t huge bribes. Bribes often are just an alternative to paying taxes in these countries. But if you have government ministers taking bribes, that can be really bad.”

What would be needed to improve India’s judicial system, where it can take years — and sometimes more than a decade — for a court case involving businesses to be heard? “Courts are very heavily backlogged, so the size of the judiciary needs to be a whole lot larger than it currently is,” says De. “The system is backlogged and that creates corruption.”

It is impossible to say when the legal system may show significant improvement, but there is some reason for optimism, De adds. “First, public consciousness of the problem is now increasing. Secondly, the Right to Information Act [a sweeping anti-corruption, pro-transparency law passed in 2005 that gives Indians the right to access government records] is being used more frequently. So there are indications that cases of corruption are more likely to be discovered sooner than they have been in the past.”

Financing Firms in India