Stifling growth

Liberalisation has damaged the structure of development banking, which is bound to affect the manufacturing sector.

EVEN as the Indian government persists with its policies of financial liberalisation, two arguments are frequently advanced in support of these policies. The first is that there is no other direction in which an emerging nation can go. The second is that India has been far more cautious with regard to financial liberalisation when compared with other emerging markets, opting only for those features of the Anglo-Saxon model that promote growth and stability.

These are large and complex issues to address in a single article. But a cursory examination of one segment of the financial sector in two comparable countries, India and Brazil, is indeed educative. That segment is development banking. Development banks are institutions that have helped promote, nurture, support and monitor a range of activities though their most important function has been to promote industrial development.

The reason for this, of course, was that the take-off led by factory-based industrialisation required substantial investment. On the one hand, given the advances in technology between the period when developed countries of today had launched industrialisation and the point in time when less developed countries had the option to take a trajectory of industrial development, the investment required to establish or expand particular activities was greater than what would have been required earlier.

Moreover, catching up requires not merely establishment or expansion of particular activities but engagment in a whole cluster of them, since some crucial requirements for development such as infrastructural services of different kinds (roads, power, communications and the like) cannot be imported and because not all traded goods can be imported given the limited foreign exchange available to individual economies. If larger sums of capital are required for investment in each of a cluster of activities, the total investment requirement will indeed be high.

This creates a special problem in the so-called mixed economies, where the private sector is expected to play an important role. Backwardness implies that the investor classes would include only a few individuals with adequate capital to invest. Their own capital would have to be substantially backed with credit.

And such credit would not be backed with adequate collateral, other than the assets created by the investment itself.

Moreover, many of these investments involve long gestation lags and commercial production would take a long time to commence and profit would be late in coming. Most savers, on the other hand, would not like to lock up their capital for long periods, especially in projects that are inevitably risky. This would imply that in the market for finance there is bound to be a shortage of long-term capital, with savers looking for investments that are more short-term, liquid (in the sense that they can be exchanged for cash without too much difficulty) and not too risky.

Further, even to the extent that long-term capital is available it would be less than willing to enter certain areas if it is driven purely by private incentives. For example, it is known that certain sectors infrastructure being the most obvious are characterised by significant economy-wide externalities. That is, their presence is a prerequisite for and a facilitator of growth in other sectors. But the infrastructural sector is characterised most often by lumpy investments, long gestation lags, higher risk and lower monetary returns.

Hence, if private rather than social returns drive the allocation of financial savings, these sectors would receive inadequate capital, even though their capital-intensive nature demands that a disproportionate share be diverted to them. This short-termism can result in inadequate investment in sectors with long-term potential from the point of view of growth. Given the economy-wide externalities associated with such industries, inadequate investments in them would obviously constrain the rate of growth.

To deal with these difficulties, many late-industrialising developing countries established development banks that are public or joint sector institutions serving to cover the shortfall in long-term capital. They lend not only for working capital purposes but to finance long-term investments also, including investment in capital-intensive sectors. Having lent long, they are very often willing to lend more in the future. And if and when required they even hold equity in the firm concerned so as to reduce its repayment burden.

Since such lending often leads to debt-to-equity ratios that are higher than normal, development banks closely monitor the activities of the firms they lend to in order to safeguard their resources. This results in a special form of relationship banking. Often this involves nominating directors on the boards of companies who would then have an insider's view of the functioning and finances of the companies involved. In case of any signs of errors in decision-making or operational shortcomings, corrective action can be undertaken early.

Thus, development banks lend and invest. They leverage lending to influence investment decisions and monitor the performance of borrowers. They undertake entrepreneurial functions such as determining the scale of investment, the choice of technology and the markets to be targeted by industry, and extension functions such as offering technical support. Stated otherwise, they are a component of the financial structure that can ensure that lending leads to productive investment that accelerates growth and makes such lending sustainable.

According to an estimate of the Organisation for Economic Cooperation and Development (OECD), there were about 340 such banks in some 80 developing countries by the mid-1960s. Over half of these banks were state-owned and funded by the exchequer; the remainder had mixed ownership or were private. In short, handicapped by colonial legacies, international inequalities and various systemic biases, these kinds of institutions seemed a must for developing countries.

Two experiences

Two developing countries that relied heavily on development banks in their post-War industrialisation effort were Brazil and India. In Brazil, the principal development bank is the Brazilian Development Bank (BNDES) established in 1952. Over time, the government has used measures such as special taxes and cesses, levies on insurance and investment companies and direction of pension fund capital to mobilise resources for the industrial financing activities of the BNDES. The size of the BNDES' support for investment increased significantly with a transition in 1965 when the BNDES' support rose from below 3 per cent of capital formation to 6.6 per cent. There was also a shift in the focus of the BNDES' activities.

While sectors such as transport and power overwhelmingly dominated its lending initially, there was considerable diversification later in its support to sectors such as non-ferrous metals, chemicals, petrochemicals, paper and machinery.

Further, while the BNDES' investments were focussed on the public sector in its early years, there was a significant shift in favour of the private sector in later years. In the period 1952-66, 80 to 90 per cent of financing was directed to the public sector. That figure fell to 44 per cent during 1967-71, and then to between 20 and 30 per cent.

India adopted a more elaborate structure. Apart from setting up an Industrial Finance Department (IFD) in 1957 within the Reserve Bank of India (RBI) and administering a credit guarantee scheme for small-scale industries from July 1960, a series of industrial credit institutions were promoted, which in fact had begun earlier with the setting up of the Industrial Finance Corporation of India (IFCI) in July 1948 for rendering term-financing for traditional industries.

In addition, State Financial Corporations (SFCs) were created under an Act that came into effect in August 1952 to encourage State-level medium-size industries with industrial credit. In January 1955, the Industrial Credit and Investment Corporation of India (ICICI), the first development finance institution in the private sector, came to be established with the encouragement and support of the World Bank in the form of a long-term foreign exchange loan and backed by a similar loan from the Government of India financed out of Public Law (PL 480) counterpart funds. In June 1958, the Refinance Corporation for Industry (RCI) was set up. The next major step in institution-building was the setting up of the Industrial Development Bank of India (IDBI) as an apex term-lending institution, which commenced operations in 1964.

The importance of these institutions is clear from the fact that their investments (disbursals) in Net Fixed Capital Formation in India rose from less than 10 per cent before the 1970s to around 35 per cent in 1988-89. Over 70 per cent of sanctions went to the private sector and took the form of lending as well as of underwriting and direct subscription of shares and debentures.

The similarities between Brazil and India with respect to development banking are clear. However, a real difference between the two occurred in the early 1990s when the government in these two countries opted for internal and external economic liberalisation. In Brazil, reform notwithstanding, the BNDES has grown in strength. Its assets totalled 277.3 billion reals (close to $120 billion) at the end of 2008. This has served Brazil well. The bank's role increased significantly when private activity slackened in the aftermath of the financial crisis. This counter-cyclical role helped Brazil to face the crisis much better than many other developing countries.

According to reports, the BNDES has stepped in to keep business credit going when private sector loans dried up in 2008. It lent a record 168.4 billion reals ($100.8 billion) in 2010, which was 23 per cent higher than the previous record in 2009. As a result, the country's credit to gross domestic product ratio continued to grow after the onset of the financial crisis.

Structure damaged

On the other hand, liberalisation has damaged the structure of development banking in India. On March 30, 2002, the ICICI was, through a reverse merger, integrated with ICICI Bank. That was the beginning of a process that led to the demise of development finance in the country. The reverse merger was the result of a decision (announced on October 25, 2001) by the ICICI to transform itself into a universal bank that would engage itself not only in traditional banking but investment banking and other financial activities.

After that reverse merger was put through, similar moves were undertaken to transform the other two principal development finance institutions in the country, the IFCI and the IDBI. In early February 2004, the government decided to merge the IFCI with a big public sector bank like the Punjab National Bank. Following that decision, the IFCI board approved the proposal rendering itself defunct.

Finally, the IDBI was merged with IDBI Bank, which had earlier been set up as a subsidiary. With this creation of a universal bank as a new entity that has multiple interests and a strong emphasis on commercial profits, it is unclear how the development banking commitment can be met. These decisions are bound to aggravate the shortage of long-term capital for the manufacturing sector, especially for medium-sized units seeking to grow.

These two experiences point to the two very different directions that development banking has taken. Some countries like India are doing away with specialised development banking institutions on the grounds that equity and bond markets will do the job. This is bound to lead to a shortfall in finance for long-term investments, especially for medium and small enterprises. Fortunately, there are some others such as Brazil that have thus far not opted for this trajectory.