Even
as the Indian government persists with its policies
of financial liberalisation, there are two arguments
that are frequently advanced. 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,
Indian 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 as drivers of 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 current day developed
countries had launched on industrialisation and the
point in time when less developed countries had the
option to launch on 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
establishing or expanding particular activities but
engaging in a whole cluster of them, since some crucial
requirements for development like infrastructural
services of different kinds (roads, power, communications
and the like) cannot be imported from abroad and because
not all traded goods can be imported given the finite
volume of 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 would 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
who would have adequate capital to undertake the required
investments. 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 take long to go into commercial production
and return a profit. 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, are ''liquid'' in the sense that they can without
too much difficulty be exchanged for cash, and are
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 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,
which 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 investment as well, including 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 higher than normal
debt to equity ratios, development banks to safeguard
their resources closely monitor the activities of
the firms they lend to, resulting in a special form
of ''relationship banking''. Often this involves nominating
directors on the boards of companies who 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 OECD estimate, 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 various
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 BNDES support for investment increased
significantly, with a transition in 1965 when 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 BNDES activities. While initially sectors like
transport and power overwhelmingly dominated its lending,
subsequently there was considerable diversification
in support, to sectors such as nonferrous metals,
chemicals, petrochemicals, paper, machinery, and other
industries. Further, while in its early years BNDES
investments were focused on the public sector, there
was a significant shift in favour of the private sector
in later years. In the period 1952-66, 80-90% 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 percent.
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 (IFC) 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 from 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 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 PL 480 counterpart
funds. In June 1958, the Refinance Corporation for
Industry 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 loans as
well 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 emerged occurred in the
period since 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
Reals 277.3 billion or 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 countercyclical role helped Brazil 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 percent 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.
On the other hand, liberalisation has damaged the
structure of development banking in India. On March
30 2002, the Industrial Credit and Investment Corporation
of India (ICICI) was, through a reverse merger, integrated
with ICICI Bank. That was the beginning of a process
that lead to the demise of development finance in
the country. The reverse merger was the result of
a decision (announced on October 25, 2001) by 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
Industrial Finance Corporation of India (IFCI), established
in 1948, and the Industrial Development Bank of India
(IDBI), created in 1964. 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, 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 would 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.
