Does financial deepening affect capital investment by credit-constrained firms? We examine this question by exploiting a nationwide branch expansion policy in India that incentivized banks to open branches in “underbanked” districts: districts where the ex-ante bank branch density was less than the national average. Extending a regression discontinuity design, we find large increases in both capital expenditures and credit growth undertaken by manufacturing establishments in underbanked districts following the policy intervention. The increase in capital spending is driven by small and young establishments, which are also the most likely to be credit constrained. Two
key channels explain our findings: increased physical proximity of lenders to borrowers and the comparative advantage of select banks in lending to small manufacturing units. Our results show that financial deepening can aid in the relaxation of credit constraints in developing economies with
imperfect capital and credit markets.
