Journal Issue
Share
Finance & Development, September 1973
Article

How Relevant is Finance for Development?: Existing financial policies, practices, and institutions in many developing countries are a major obstacle to economic growth.

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
September 1973
Share
  • ShareShare
Show Summary Details

Anand G. Chandavarkar

Despite years of study, discussion, and practical effort economists still do not agree either about the mainsprings of economic development or even about the constraints on it. The constraints have been variously sought in terms of deficiencies of domestic savings, foreign exchange, knowledge and skills, attitudes and institutions, etc. The lack of foreign exchange was seen by some as the great obstacle; if this obstacle could be surmounted the way to economic development would be clear. Now, all that one can confidently assert is that there is increasing, and justifiable, skepticism about the validity of “single-barrier” explanations of economic backwardness and underdevelopment in the third world.

But while recognizing the complexity of economic phenomena and the causes and constraints on economic development, neither economists nor policymakers can afford to remain paralyzed in diagnosis or decision making. Rather the endeavor should be toward identifying specific bottlenecks in a spirit of “piecemeal social engineering” which does not involve grand holistic designs. One such area of policy in the less developed countries (LDCs) is “finance,” which broadly covers all (i) financial assets i.e., money and near-money assets such as time and savings deposits with banks, claims on government, financial institutions, and corporate entities in the form of fixed-interest and variable dividend securities, etc.; (ii) the financial institutions that issue such liabilities, e.g., the central bank, commercial and development banks, etc.; (iii) the markets in which financial assets are bought and sold; and (iv) the overall financial policies that determine the quantity and prices of assets as well as their macroeconomic effects.

The question then is: what precisely is the bearing of “finance,” as described above, on the pace and direction of economic development? How valid is Joan Robinson’s view that “by and large, it seems to be the case that where enterprise leads finance follows” (“The Generalization of the General Theory” in The Rate of Interest, Macmillan, 1954) which suggests that finance is a mere camp follower? Or could one be more eclectic and say that “development involves finance as well as goods?” (J. G. Gurley and E. S. Shaw, “Financial Aspects of Economic Development” American Economic Review, September 1955). If the former approach is regarded as plausible, it has to be reconciled with two pervasive development phenomena. The first is the widely observed feature of an increase in the proportion not only of money but of all financial assets relative both to tangible forms of wealth and to gross national product (GNP). The second is the constant concern of authorities in the LDCs with the expansion of the banking system and the creation of ever more specialized financial institutions to meet the requirements of agricultural and industrial finance. In the first instance enterprise is not following finance that already exists; in the second, enterprise is leading but finance is not following, at least automatically—if it were, then the authorities would not be so anxious to help it on. If the more eclectic standpoint is realistic, what are the possible causal interrelationships and feedbacks between financial development and economic growth? These are among the various aspects which have to be explored in finding an answer to the central question posed in this article—how relevant is finance for development?

How development needs finance

It can, of course, be readily appreciated that the shortage of money or finance is not a constraint on overall development in the same sense as a shortage of food, raw materials, fuel, capital equipment, technical skills and know-how, or foreign exchange. In fact, since the creation of money does not absorb real resources, its supply to the economy as a whole is infinitely elastic and can always be adapted to the requirements of the real variables of the economic system. On the other hand the mere creation of money cannot accelerate economic development if the basic preconditions for it are lacking. In an ultimate sense, it is only man and environment which together determine growth and development. Thus it is only from the aggregative point of view (and for a centrally planned collectivist economy) that money and finance may appear in the role of a camp follower. In any market-oriented economy, which relies largely on the price mechanism to allocate resources among competing uses, the availability and cost of money and finance (measured by rates of interest) are highly relevant to the spending and saving decisions of households and firms. Thus “enterprise” may be flourishing in a modest way, but cannot expand if the money that is supposed to “follow” is in practice too expensive to find borrowers.

Economic growth and development imply among other things, rising output over time, and this in turn necessitates expansion in money supply. First, as GNP increases, the demand for money to mediate the increasing volume of economic activity also increases (transactions balances); second, the monetization of the subsistence sector in the economy also requires additional money; third, as per capita real incomes rise, the demand for money in the form of precautionary and speculative cash balances also tends to increase, although not necessarily in proportion.

One sign of economic development is “product-differentiation”—as people become better off they demand a wider variety of goods. On the financial side, an analogous process of asset-differentiation also takes place or else has to be deliberately induced, thereby leading to growth not merely of money but also of quasi-money (e.g., savings and time deposits with banks) and financial assets. In a sense, asset-differentiation is implicit in the very nature of the development process, because once the limits of self-finance are reached the (net) investing units have to raise external funds through sale of financial instruments (in the “differentiated” form of debt, equity, or preferred stock) to the (net) saving units in the economy. It is at this stage that the process and policy of financial “intermediation” (mediating between ultimate lenders and borrowers) is peculiarly relevant for the developmental process.

Role of financial mediation

Through financial intermediation, the types and forms of assets desired by savers and investors are matched in terms of yield, safety, liquidity, and convenience with the forms of financing desired by business enterprises and institutions—thereby facilitating the accumulation of capital and economic development. While the amount of saving (abstinence from current consumption) in an economy is obviously important, the form in which savings are held is relevant to the efficacy of financial policies and through them to the pace and direction of economic development. For instance, if a person decides to refrain from consumption and holds the resultant saving simply as cash, he is releasing real resources for investment as much as if he held it in the form of bank deposits or government or industrial securities. But by holding it in the form of financial assets he adds to the pool of aggregate savings (through the capital market) which are then available for investment and are channeled to investment outlets.

Admittedly, the imperfections of the capital market may distort the efficacy of this allocative mechanism but even so it remains superior to self-finance. The greater the proportion of current saving held in the form of financial assets, the greater is the scope, and consequently the efficacy, of overall monetary and financial policies. For instance, the higher the ratio of bank deposits to money supply, the easier it is for the central bank to control the cash base of the banking system and its credit creating potential through variation of cash and liquidity reserve ratios, etc. These possibilities are not open to the monetary authorities if the bulk of money supply is held in the form of currency balances—gold coins, for example. Similarly, if the banking habit is well developed and the public settles most of its transactions by checks instead of currency notes the “leakages” from the credit circuit are correspondingly less. This further enhances the credit-creation potential of banks. To extend the same line of reasoning, the diversion of savings from currency balances to institutions also helps the process of financial intermediation. In his recent study—Financial Intermediaries and National Savings in Developing Countries (Praeger, New York, 1972)—U Tun Wai found that financial intermediation, measured by the proportion of financial savings and by the number of bank offices per million of population, appears to have had a positive influence on national savings in the majority of the developing countries. In fact, it could be said that savings are responsive to the number, availability, and efficiency of financial institutions, instruments, and markets. It is an observed fact that a multiplicity of savings media in the form of different complementary types of financial assets helps to increase net saving. This is true even after allowing for the inevitable diversion of savings from one form to another which sometimes has the effect of merely changing the composition of saving without increasing its net amount.

Capital market and controls

Generally, financial strategies in the LDCs seem to be more directed at the need to multiply assets and institutions than to adopt appropriate overall policies and evolve new saving and lending techniques geared to local, requirements. But, given the accepted objective of promoting greater financial intermediation, there is a seldom noticed element of contradiction in the thinking and approach of bankers and official authorities alike in a number of LDCs. On the one hand, there is a constant exhortation to the banking community to open new branches in neglected areas. But together with this expansionist approach on the structural side of banking, there exists a “restrictive” attitude to the pricing of both the “inputs” (deposits) and “outputs” (loans and advances) of the banking industry. This usually takes the form of interbank cartel-type agreements which, through the imposition of ceilings on rates of interest on deposits and “floors” on loan rates of interest, ensure semimonopolistic profits to participant banks. But it is neither logical nor realistic to expect to mobilize savings in the LDCs or to promote lending merely through multiplication of banking offices without, at the same time, offering a realistic (market-determined) price for savings by abolishing regulated interest rates.

The dubious economic rationale of imposing controls only on interest rates (the price of capital) when other key prices such as wages, rent, profits, and dividends are left free to the interplay of market forces seems to be seldom questioned in the LDCs. It is often overlooked that the rate of interest (which is only another name for the price of capital) is just one price in the market and like other prices should as far as possible reflect the economic cost of the commodity (in this case, capital) thereby ensuring that it flows where it is most needed. There is a tolerance of detailed regulation of the financial sector—faintly reminiscent of medieval doctrines of “just price”—which would generally be regarded as unjustified if applied to firms producing commodities or providing nonfinancial services. This intervention extends far beyond the minimum necessary to safeguard the solvency and liquidity of banks and such other financial institutions. It is based on a peculiar “inarticulate major premise” that banks are inherently prone to adopt unsound business practices from which other business enterprises are, for unexplained reasons, supposedly immune.

Admittedly, money and capital markets are imperfect, but even second-best market-oriented solutions would help to allocate savings more efficiently than “administered” interbank agreements which are often based on ad hoc, historical, and purely judgmental considerations. It is revealing to note that empirical studies have established that the net effect of regulation of interest rates and the financial structure in developed countries has been to foster and sustain monopolistic profit-making positions rather than to protect the financial system and its users; and that many of the alleged shortcomings of the financial system stemming from competition actually seem to be the result of malfunctioning of the regulative machinery. This could be presumed to apply also to the circumstances of the LDCs. Without liberalization of their financial systems, a mere multiplication of institutions could scarcely be expected to achieve the objectives of greater financial intermediation of their economies. It is significant that authoritative inquiries into the financial system of developed countries (e.g., the Hunt Commission in the United States and the Report on Bank Charges in the United Kingdom) have consistently emphasized the need for a more competitive financial order to promote a more efficient allocation of resources. In this respect at least the experience of the developed world is highly pertinent to the present-day concerns of the Third World.

The unimportance of collateral

Yet another gap in the financial strategies of the LDCs is what may be called the “banking collateral syndrome.” This describes the attitudes and procedures of lending institutions, often a replica of those prevailing in the developed countries, which are based on a rigid insistence on approved securities as collateral (e.g., real estate or government securities), rather than on an evaluation of the viability of the project and the character of the borrower. This naturally inhibits the extension of credit to many deserving borrowers in economies deficient in assets that can qualify as collateral for bank loans. Often, it is the rigid insistence on collateral requirements rather than the prevailing rates of interest, that curtails availability of credit in the LDCs. This has the effect of converting commercial banks into glorified pawnshops instead of genuine creators of productive credit. The endeavor should be to move away from conventional philosophies and procedures of lending and thus to circumvent the shortage of bankable assets which has hampered extension of credit to key areas such as cottage and small-scale industries, trade, agriculture, housing, and educational loans. Financial policies should be geared to growth potential rather than being determined by pre-existing collateral. Too stringent a rationing of credit on a narrow interpretation of risk criteria involves substantial social costs in the form of forgone economic opportunities and activities. Equally, it is a fallacy to believe that the “no collateral” loan is necessarily more risky than a fully secured loan or, conversely, that the latter is always more productive.

Fundamental challenges

To sum up, finance is relevant for development. But its more basic causal links are not so much through the number and variety of financial institutions and- instruments as in the adoption of appropriate policies, notably the liberalization of the financial structure, the exposure of its inputs and outputs to market forces of supply and demand, and the reorientation of lending attitudes, techniques, and procedures away from the traditional preoccupation with “collateral.” These are fundamental challenges facing the LDCs. Therefore, the debate about whether financial intermediation and development is a “demand-following” or a “supply-leading” phenomenon is comparatively subsidiary to the question: whether, after having set up the requisite financial institutions, the LDCs have the necessary insight and economic statesmanship to adopt appropriate and realistic pricing and other policies?

annual reports from the World Bank Group

Annual Reports for 1973 of the World Bank and its affiliates, The International Development Association (IDA), and the International Finance Corporation (IFC), will be presented at the Annual Meeting of the Board of Governors to be held in Nairobi, Kenya, September 24-28, 1973. The record of Bank and IDA operations will be in a joint publication, while that of the IFC will be reported separately.

Copies of the reports in English, French, German, or Spanish may be obtained free of charge from either address:

World Bank Group

1818 H Street, N.W.

Washington, D.C. 20433

World Bank Group

66, Avenue d’lena

75116 Paris, France

Other Resources Citing This Publication