Credit Constraints and Outsourcing in India: Why Do Firms with Foreign Institutional Investments Delegate Production?

Many small and medium sized firms suffer from lack of access to formal credit in developing countries. The World Bank estimates a total credit gap for small and medium-size enterprises between $2.1 and $2.6 trillion in the last decade. Thus, greater flow of credit should lower the borrowing cost and improve financial access for firms. Contrary to such belief, we show that when manufacturing firms (2298 units between 2001 and 2023) across various industrial classifications in India receive foreign institutional investments (FII), a large section of these units outsource manufacturing jobs and do not expand. For small and mid-sized firms the cost of expansion outweighs the benefits from rise in the supply of credit, such that all specifications show that a flow of FII unambiguously leads to outsourcing. However, for firms with sales volume in the top quartile outsourcing falls abruptly with FII. Such production reorganization is unusual in view of a large literature identifying credit constraint as a disadvantage for growth at the firm level. We conducted panel fixed effects regression, supported by dynamic panel data estimates and two layers of robustness checks to address bias arising from possible endogeneity. We use sales, fixed assets, power and fuel charges, interest payments etc. as covariates in support of this outcome for small and mid-sized firms in particular. This also shows that via outsourcing, the percolation of FII is deeper for firms in India than normally accounted for.