The Credit Paradox: Why Bank Loans Spur Scale, But Not Innovation, in India

The International Monetary Fund’s Research Department, together with scholars from the National University of Singapore, Harvard Kennedy School, the University of British Columbia’s Sauder School of Business, and the IMF itself, has released a working paper exploring one of the most pressing questions in development economics: Does easier access to bank financing spur innovation in emerging markets? Authored by Siddharth George, Divya Kirti, Nils Olle Herman Lange, Maria Soledad Martinez Peria, and Rajesh Vijayaraghavan, the study focuses on India, where a 2006 policy reform dramatically broadened eligibility for subsidized lending. By raising the ceiling for firms to qualify as micro, small, and medium enterprises from 10 million to 50 million rupees in plant and machinery, the reform instantly made about ten percent of India’s manufacturing sector eligible for the Reserve Bank of India’s Priority Sector Lending scheme. These newly eligible firms represented roughly fifteen percent of total output, creating an ideal test case for understanding the relationship between credit and product innovation.

A Rare Window into Firm-Level Innovation

The research exploits a uniquely detailed dataset: the Annual Survey of Industries, a nationally representative record of Indian manufacturers between 2001 and 2010. Unlike many surveys, it contains information on product-level sales as well as borrowing, wages, materials, and profitability. This granularity allows the authors to construct three complementary measures of innovation. Product scope reflects how many different products a firm sells, product innovation marks the introduction of entirely new goods, and product complexity signals whether firms upgrade into more sophisticated items, more typical of advanced economies. The data show that Indian firms introduce a new product in almost half of the observed years, and roughly twelve percent of these innovations represent a step toward higher complexity. Contrary to the popular belief that only large corporations innovate, small and medium enterprises account for nearly half of all new product introductions, and more than ten percent of their innovations are exclusive to them, never adopted by larger firms.

Expansion Without Transformation

Given these patterns, one might expect that cheaper credit would unleash a wave of new products. Evidence from advanced economies supports this idea, showing that credit access often boosts research, patents, and novel goods. The Indian case, however, tells a different story. The reform unquestionably worked in expanding financing: newly eligible firms borrowed twelve to twenty-two percent more, bought over a quarter more raw materials, expanded worker days by nearly thirty percent, and paid significantly higher wages. Sales climbed by twenty-eight percent and net income by twenty-four percent, clear signs that credit translated into profitable growth. Yet when it comes to innovation, the picture is flat. These firms did not expand product scope, were no more likely to introduce new lines, and showed no movement into more complex products. The results are precise enough to rule out even small effects. In practice, extra credit made firms bigger, but not necessarily more inventive.

Barriers Beyond Finance

The authors explore two reasons why. The first lies in scale. Many Indian SMEs operate well below their efficient capacity because machinery and other inputs come in indivisible units. For them, the highest return from new credit is to ramp up production of what they already make, not to experiment with untested goods. The second reason is the weight of non-financial barriers. Using pre-reform data, the researchers identify ten distinct frictions ranging from erratic electricity and poor transport to congested courts, restrictive labor regulations, inefficient land markets, and small or highly concentrated local demand. The typical firm faces five such hurdles. Together, they blunt the innovative impact of credit, since even well-financed firms struggle to enter new markets or adopt more complex technologies when infrastructure, institutions, and demand conditions are weak.

The contrast is stark when looking at firms with no such barriers. For these firms, credit access works as theory predicts: product scope expands, the likelihood of new goods rises by double digits, and the odds of moving into more complex products increase substantially. In fact, the magnitudes are as large or larger than those recorded in studies of American or European firms. Each additional barrier, however, steadily erodes this effect, cutting innovation gains by several percentage points. For the average firm with five barriers, the impact of credit on innovation all but disappears. Growth tells a similar, though less extreme, story. Firms without barriers nearly double sales and profits, while each obstacle reduces these gains. The median firm still expands, but innovation remains elusive.

Rethinking Policy for Emerging Markets

The findings carry sobering lessons for policymakers. They show why strategies drawn from advanced economies cannot simply be transplanted into emerging markets. In countries like India, where firms are smaller and the business environment less supportive, credit alone does not unlock innovation. Instead, most firms channel financing into scaling existing products, a rational choice when they are financially constrained and operating below capacity. To turn credit into a true engine of innovation, governments must also tackle the infrastructure gaps, regulatory bottlenecks, and institutional weaknesses that hold firms back. The authors suggest that “big-push” policies, which loosen several constraints simultaneously, may be necessary to allow credit to play its catalytic role.

This study reframes the conversation around finance and innovation in developing economies. It does not deny the importance of credit, indeed, access to finance clearly boosts scale and profitability, but it insists that its transformative power is conditional. In supportive environments, bank loans can spark invention and move firms up the ladder of complexity. In less favorable settings, they fuel more of the same. For India and other emerging markets, the lesson is clear: credit programs should be paired with deeper reforms that remove the overlapping barriers holding back entrepreneurs. Only then can the promise of small and medium enterprises as engines of innovation be fully realized.