Their role an d importance for development C. P. Chandrasekhar Among the institutions whose role in the develo pment of the less developed regions is well recognised but inadequately emphasised are the development banks. Playing multiple roles, these institutions have helped promote, nurtu re, support and monitor a range of activities, though their most important function has been as drivers of industrial development. All underdeveloped countries launching on national development strategies, often in the aftermath of decolonisation, were keen on accel rating the pace of growth of productivity and per capita GDP. This was the obvious require ment for alleviating poverty and reducing the developmental gap that separated them from the developed countries.

To realise this goal, they considered industrialisation to be an important prerequisite. This stemmed from the perspective that modern economic growth was a process characterised by an increase in the share of employment in the non-agricultural sector, and within the latter by a change in the scale of productive units, the growth of f ctory production and a shift from personal enterprise to the impersonal organisation of economic firms. Besides the apparent universality of this trajectory across countries, a range of arguments were advanced to justify the centrality afforded to modern factory industry. First was the conclusion derived from trends in consumption styles across the globe and embodied in rudimentary form in Engels’ Law that the demand for non-food commodities in general and manufactures in particular grows and diversifie s as incomes increase. Growth must therefore e accompanied by a process of diversification of economic activity in favour of manufactures. Second was the belief that, gi ven the barriers to productivity increase characteristic of predominantly agrarian economi es, the diversification in favour of industrial production is an inevitable prerequisite for a rapid increase in per capita income.

Third was the view that beyond a point even agricultural growth is predicated on the availability of a range of manufactured inputs, particularly, chemi cal fertilisers. Fourth was the evidence that ependence on primary production places a nation at the losing end of the shifting terms of exchange in international trade, necessitating industrialisation as a device aimed at garnering additional benefits from trade and overcoming external vulnerability. And, finally, the idea that given the ‘learning by doing’ characteristic s of industrial capability, delaying entry into the spectrum of industrialisers makes en try more difficult as time goes by. Industrialisation recommended itself also because of the benefits associated with late entry. There already existed a range of productive tec niques in the form of a shelf of blueprints that can in principle be accessed. Late industriali sers, as the cliche goes, need not reinvent the wheel. Nor are they excessively burdened by outmoded capital stock that is yet to be written off, which is the penalty paid by the early starter. This makes the prospect of exploiting the benefits of the productivity increases associated with factory production even more encouraging. It was this set of factors that appeared to justify a strategy of development based on the rapid growth of factory production. Capital requirements

The difficulty, of course, was that the take-o ff 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 establis h or expand particular activities was greater than what would have been required earlier. Moreover, catching-up requires not merely 2 establishing or expanding particular activities ut 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 rojects 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. Hence, the allocation of investment may not be in keeping with that required to en ure a certain profile of production needed to accelerate growth. 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 facilitat or of growth in other sectors. But the infrastructural sector is charac terised 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 heir capital-intensive nature demands that a disproportionate share be diverted to them. This “short-termism” can result in inadequate invest ment in sectors with long-term potential from the point of view of growth. Given the “econo my-wide externalities” associated with such industries, inadequate investments in them wo uld obviously constrain the rate of growth. Role for the state Thus, even in late-industrialising economies providing an important role for the private sector, state intervention is crucial. And a ppropriate financial policies are an important component of such intervention.

Realizing a growth-oriented pattern of production of goods and services requires the state to guide the allocation of investment, using a range of mechanisms such as directed credit and differential interest rates, besides public investment financed with taxation. Even in developing countries that successfully adopted outward- oriented industrialisation strategies or a more mercantilist strategy of growth based on rapid acquisition of larger shares in segments of the world market for manufactures, the relevant segments were in practice identified by an agency other than individual firms.

Experience indicates that the state has the capacity to assess and match global opportunities and economy-wide capabilities. Through its financial policies, the state must ensure an adequate flow of credit at favourable interest rates to firms investing in these sectors, so that they can not only make investments in frontline technologies and internationally competitive scales of production, but also have the means to sustain themselves during the long period when they expand market share. Financial policies were an important component of the strategic policies pursued by countries like South Korea and Taiwan on the way to competitive 3 uccess. These included interest rate differentials and bank financing of private investment, resulting from the channelling of corporate finance through a still largely regulated banking system. Since one of the objectives of these actions is to guide investment to chosen sectors, the rate of interest on loans to favoured sectors may have to be lower than even the prime lending rate offered to the best borrowers, judged by credit-worthiness. That is, differentials in interest rates supported with subsidies or enabled by cross-subsidization is part of a directed lending regime.

Finally, even if credit is available, private expectations of “normal” returns on capital and additional premia to cover risk may be such that the cost of such capital maybe too high for investment in certain crucial sectors. If credit is to facilitate investment, it must be available at terms that can be borne by the returns likely to be earned by investors in different sectors. If it is not, then again investment and growth will be constrained. Thus, state intervention is needed because the relationship between financial structure, financial growth and overall economic development is indeed complex.

If the financial sector is expected to autonomously evolve and is le ft unregulated, market signals would determine the allocation of investible resources and therefore the demand for and the allocation of savings intermediated by financial enterprises. This could result in the problems conventionally associated with a situation where private rather than overall social returns determine the allocation of fina ncial savings and investment. It could also limit the flow of savings to sectors that are a pre-requisite for industrialisation because of their “externality effects” as noted above.

Secondly, if only private financial intermediari es are relied upon, the sheer availability of long-term finance may be inadequate. Many factors influence the incentives to invest and, therefore, the level and structure of intended investments. However, some or a substantial share of those intentions may remain unrealized, even when potentially viable, because of lack of access to the capital needed to financ e such investments or the insurance needed to guard against unforeseen risk. This has obvious implications for growth. Hence, the financial structure matters, even if not as the principal driver of investment and growth.

As noted elsewhere (United Nations, 2005), left to themselves, private financial markets in developing countries usually fail to provide enough long-term finance to undertake the investments necessary for economic and social development. As a result, firms in developing countries often hold a smaller portion of their total debt in long-term instruments than firms in developed countries. Private institutions may fail to provide such finance because of high default risks that cannot be covered by high en ough risk premiums because such rates are not viable. In other instances, failure may be becaus of the unwillingness of financial agents to take on certain kinds of risk or because anticipated returns to private agents are much lower than the social returns in the investment concerned (Stiglitz, 1994). Development banking Given these features, the financial sector must be designed to include institutions, sources of finance and instruments that can bridge the sign ificant mismatches in the expectations with regard to maturity, liquidity, risk and interest rates between savers and investors. One way to deal with this problem is to encourage the growth of equity markets.

This is seen as attractive because, unlike in the case of debt, risk is shared between the financial investor and the entrepreneur. This enhances the viability of the firm in periods of recession. However, the evidence shows that even in developed countries equity markets play a relatively small role in 4 mobilizing capital for new investments. Even where markets are active, it is the secondary market that is of significance. An important institutional innovation in many late-industrialising developing countries was the creation of what are broadly called develo pment banks, which most often are public or oint sector institutions. Development banks are in the nature of “universal banks” undertaking a wide range of activities besides those undertaken by commercial banking institutions. Commercial banks, which mobilise finance through savings and time deposits, acquire liabilities that are individually small and protected from income and capital risk, are of short maturity and are substantially liquid in nature. On the other hand, the credit required for most projects tends to be individually large, subjec t to income and capital risk and substantially illiquid in nature.

Consequently, commercial banks conventionally focus on providing working capital credit to industry. This is lent against the collateral constituted by firms’ inventories of raw materials, final products and work-in-progress. Though this can involve provision of credit in relatively large volumes, with significant income and credit risk and a degree of illiquidity, it implies a lower degree of maturity and liquidity mismatch than lending for capital investment. This makes traditional commercial banks less suited to lending for capital investment. To cover the shortfall in funds required for ong-term investment, developing countries need to and have created development banks with the mandate to provide long-term credit at terms that render such investment sustainable. They tend to 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. 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. Since very often lending begins at the stage of the formulation of project itself, development banks are also involved in decisions such as ch oice of technology, scale and location. This require more than just financial expertise, so that development banking institutions build a team of technical, financial and managerial e perts, who are involved in the decisions related to lending and therefore to the nature of the investment. This close involvement makes it possible for these institutions to invest in equity as well, resulting in them adopting the unconventional practice of investment in equity in firms they are exposed to as lenders. This would in other circumstances be considered an inappropriate practice, since it could encourage development banks to continue lending to insolvent institutions since they are investors in the firms concerned and may suffer significant losses due to closure.

Given their potential role as equity investor s, development banks provide merchant banking services to firms they lend to, taking firms to market to mobilise equity capital by underwriting equity issues. If the issue is not fully subscribed the shares would devolve on the underwriter, increasing the equity exposur e of the bank. Firms using these services benefit from the reputation of the development bank and from the trust that comes from the belief of individual and small investors that the banks would safeguard their investment by monitoring the firms concerned on their behalf as well.