Economists have long understood that bad money drives out good; a bigger danger today is bad financial systems driving out good. After 30 years of financial liberalisation and deregulation, many developed countries have been left with a bad system that does not protect people’s savings or mobilise for productive investment. Even before the crisis of 2007-2009, it was clear that stable and inclusive growth was incompatible with speculative market behaviour, boom-and-bust cycles and mounting household debt.
The scale of the crisis opened a window for change. However, economist and Financial Times columnist Martin Wolf has recently concluded that the system which has emerged from the crisis is little more than “a chastened version” of what was in place before. This says much about the capture of political and regulatory processes in advanced countries by their financial elites; but by failing to downsize the financial sector and harness it to the real economy, a short-term speculative culture has persisted, leading to the weakest economic recovery on record.
The idea of developing countries wanting to replicate this same system would seem far-fetched. More so as the failure of the IMF to cajole and persuade many of those countries to go down this path in the 1990s is one of the reasons why growth in the developing world picked up pace before the crisis and the rebound has been quicker.
Still there has been a worrying drift towards deeper financial integration in recent years, with an increased presence of foreign banks and investors in credit and asset markets. Bilateral and regional trade agreements are pushing aggressively in this same direction, while the donor community’s love affair with microfinance continues, despite its well-documented limitations and failures. This is not the route to a more stable and inclusive financial system.
Financial inclusion is the result of rising living standards, as small farmers and working people begin to save and move beyond a purely cash economy. This does not happen when the financial sector becomes disconnected from the real economy; when there’s debt-driven growth, and when the economy’s rooted in micro-lending or too-big to fail banks.
The challenge for developing countries is keeping finance harnessed to the needs of the real economy. For most, industrial development is still a priority because of the opportunities it provides to raise productivity and incomes, and to increase trade. But investments in other sectors, particularly in agriculture and public infrastructure, are also needed to ensure that measures to diversify economic activity are consistent with job creation, and food and energy security.
Left to themselves, private financial institutions often fail to provide credit on a sufficient scale or on appropriate terms. In particular, projects that have large up-front costs or delayed rates of return (such as infrastructure) are starved of finance even where they are needed to support growth elsewhere in the economy. At the same time, small and medium sized enterprises, because of perceived high risks, are also often deprived of the credit needed to maintain existing working capital, let alone to expand.
When it comes to mobilising long-term finance, new institutional arrangements need to be considered. Central banks must take a more activist role in credit allocation while regional financing arrangements, despite current difficulties in the eurozone, can play a larger role. Recent initiatives such as the Brics Development Bank and the China-led Asian Infrastructure Investment Bank are encouraging steps forward.
But given domestic-resource mobilisation is key to long-term growth, national development banks can play an essential role in supporting any investment push by filling financing gaps, whether at near-commercial rates on a general basis and on more favourable terms to selective sectors and/or by providing other investment support services.
Advocates of deregulation have not looked kindly on these institutions. However, state-owned banks have been, and remain, a prominent part of the financial landscape even in many advanced countries, such as Germany, France and Japan. It has been estimated that state-owned banks still account for 25% of the total assets of the world banking system. China’s specialised development banks have, of course, been key to its transformation, but Mali (in agriculture), Brazil (in infrastructure), Chile (primary sector) and Turkey (tourism, agriculture and energy) have success stories to report too.
This is not to overlook past problems, including excessive top-down lending practices. But past failures have also given rise to local initiatives at the city and provincial levels such as the Oportunidades Bank in Medellin, Colombia and the Bank Pembangunan Daerah Bali, Indonesia.
As developing countries seek to maintain their strong growth performance the real challenge for policymakers is to keep finance in check and develop institutional arrangements that protect savings and scale-up productive investment. The best lessons are on their own doorstep.
Richard Kozul-Wright is director of Unctad’s division on globalisation and development strategies.
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