How Trade Liberalization Weakens Cronyism and Political Favoritism
Can international trade curb corruption? A new study shows that India’s 1990s trade liberalization reveals how international trade affects resource misallocation caused by politically connected firms.
Across many low and middle income countries, weak institutions enable politicians to influence firms’ access to permits, inputs, and services, favouring firms to which they have connections. When politically connected firms receive preferential treatment, resources are not necessarily allocated to the most productive companies, fostering corruption and misallocation, and harming overall economic performance. As these countries become more integrated into global markets, an important question arises: Does international trade reinforce these domestic distortions or help reduce them?
To answer this question, Roza Khoban, a senior researcher from our department, and her co author examine the consequences of India’s trade liberalization in the 1990s.
Studying India’s trade liberalization
The researchers empirically study how international trade influences the distortionary effects of political connections in the context of India, a lower-middle-income country where political favoritism plays an important role in firms’ access to resources. Crucially, India’s sweeping trade liberalization in the 1990s offers a natural experiment to examine this relationship.
India’s trade reform was rapid, externally imposed, and largely unexpected. Tariffs on imported goods fell sharply—on average, from around 80% in 1990 to 40% by 1996—generating substantial variation in trade exposure across industries. Combined with rich firm-level data and detailed electoral information, the setting provides a rare opportunity to study how global markets interact with domestic political institutions.
How political connections shape firm outcomes
As a first step, the study maps firms’ connections to state level politicians (Members of the Legislative Assembly) using a surname-based measure of social proximity. Leveraging political turnover from elections, the authors then estimate how these connections affect firm outcomes. By comparing changes in outcomes for firms connected to the winning politician to firms that were not, before and after elections, they identify the overall effect of political connections. This approach captures the distortionary impact of political connections, including channels that are difficult to observe directly, such as corruption and cronyism.
The results show that firms connected to winning politicians experience a 10--20 % increase in sales and expenditures. These gains stem from greater use of inputs (capital, labor, and materials) rather than improved productivity, suggesting that politicians indeed distort resource allocation by favoring connected firms.
Trade Liberalization and Tariff Cuts: Creating an Outside Option to Cronyism
The paper then asks the central question: how does increased trade exposure affect this politically driven misallocation? To assess this, the authors combine variation in firms’ political connection status with differences in tariff reductions across industries during India’s 1990s trade liberalization.
The analysis shows that tariff reductions substantially eroded the advantage enjoyed by politically connected firms. Importantly, this effect is driven almost entirely by reductions in tariffs on input goods, which improve firms’ access to foreign inputs. Specifically, the reduction of input tariffs during India’s 1990s trade liberalization decreased the size of politically connected firms by roughly 15 % relative to non connected firms. The results suggest that the trade reform reduced the value of political connections by diminishing the difference between firms with and without political connections.
Taken together, the findings suggest that greater access to imported input goods can substitute for political favoritism, directly reducing the distortions caused by political connections. To unpack this mechanism, the authors examine firms’ trade patterns and demonstrate that when tariffs are high, local politicians have more leeway to intervene in favor of connected firms – e.g., by steering scarce resources toward them. Better access to imported inputs therefore offers an outside option to political connections, diminishing firms’ dependence on politicians.
Does Trade Openness Reduce or Amplify the Harm Caused by Political Favoritism?
By studying India’s trade liberalization of the 1990s, the paper provides the first empirical evidence of how tariffs directly affect firms’ reliance on political connections. In particular, better access to inputs through lower tariffs on input goods reduces the distortionary effect of political connections. The results suggest a new margin for gains from trade in the presence of political distortions by showing a direct effect of tariff reductions on the implications of such distortions, effectively implying that trade policy can address a widespread source of productivity losses.
Questions
Why was India specifically interesting to study rather?
In many parts of the world, politicians use their power to favor firms they are connected to, creating misallocation and reducing aggregate productivity. We focus on India since it is an example of a country where firms face constraints, and earlier work shows that both social and political connections can strongly influence their access to inputs and services. Moreover, India’s rapid and unexpected trade liberalization provides an ideal setting to examine how global market integration affects the value of political connections.
Could the weakening of political favoritism through trade liberalization create pushback against globalization?
While our results show that trade policy can play an important role in addressing a common source of productivity loss, they also highlight a potential incentive for politicians and firms benefiting from cronyism to oppose globalization—a dynamic that warrants close attention going forward.
What are the topics you are currently working on?
My ongoing work continues to explore the intersection of international trade, development, and political economy, with a particular focus on how globalization reshapes political and institutional power. Having established that international trade reduces firms’ dependence on politicians—thereby weakening an important source of political power—I ask what happens to the distribution of power more broadly? How does trade reconfigure who holds de facto political and institutional power and influence? Specifically, I study how globalization affects power dynamics between firms, the state, and institutions.