Debt Contract Enforcement and Product Innovation: Evidence from a Legal Reform in India

Journal: The Journal of Law and Economics

The article examines how improvements in a country’s legal system can shape firms’ innovation, focusing on India’s debt recovery reforms in the 1990s. In many developing economies, banks struggle to recover loans when firms default due to slow and unpredictable court procedures. Weak enforcement discourages lending, particularly for long-term and risky activities such as developing new products. The authors ask a simple but important question: Does faster and more reliable loan recovery encourage firms to innovate?

To answer this, the study analyzes the introduction of Debt Recovery Tribunals (DRTs) in India. These specialized courts were rolled out gradually across states between 1994 and 1999 to speed up the resolution of bad loans. Because states adopted the reform at different times, the authors are able to compare otherwise similar firms before and after tribunals were introduced, providing credible evidence on cause and effect.

Rather than relying on patents – which are rare and often poor indicators of innovation in developing countries – the study tracks new products introduced by firms. Indian law requires companies to report detailed product-level information, allowing the authors to observe when firms expand into entirely new product lines, including products that are new to the market.

The central finding is that stronger debt enforcement leads to more product innovation, but the gains are uneven. Larger firms with substantial physical assets – such as plants and machinery – benefit the most. For these firms, faster loan recovery reassures banks, improves access to long-term and secured credit, and enables higher investment in research, equipment, marketing and product development. Many of the products introduced after the reform were not just new to the firm but new to the Indian market, suggesting genuine innovation rather than simple diversification.

Smaller firms, however, do not experience similar benefits. In some cases, stronger enforcement raises fears of liquidation, leading these firms to cut back on borrowing and risky investment. This highlights an important trade-off: while legal reforms can stimulate innovation, they may also widen gaps between large and small firms when credit supply remains tight.

The policy message is clear. Legal efficiency matters for innovation, especially in economies that rely heavily on bank financing. But enforcement reforms must be carefully designed. Systems that improve resolution without aggressively threatening liquidation appear more supportive of innovation and inclusive growth than harsher creditor regimes.

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