World Economic Forum – Financing for Development Workshop
Hong Kong – 15-16 March 2005.
SINGNIFICANCE OF LOCAL DEVELOPMENT FINANCIAL INSTITUTIONS
IN DEVELOPING COUNTRIES
(Relevance, Role & Suggested Framework)
Presentation by
Dr. Sailendra Narain[(]
The Proposal:
For decades, Development Financial Institutions (DFIs) have played significant role in the economic and industrial development of both developed and developing economies. However, of late faced with high cost of resources and stiff competition posed by commercial banks, most of the DFIs are converting themselves into Universal Banks shaking off their main function of providing long-term Financing for Development (FfD). This trend has received backing of Governments / Central Banks in many countries without realising the adverse effect and implication of the race - DFIs to Universal Banks. Many such countries have started registering slow or downward trend of growth for want of FfD. The World Bank itself had in late 1980s opined that ‘DFIs have no future’. Partially it came true in 1990s and more in 2000. Notwithstanding World Bank’s forecast coming true, the fact remains that DFIs have their own significance and relevance and they should not be allowed to perish.
Even at the cost of assertion, it may be stated that remedy does not lie in DFIs converting themselves into Universal Banks or commercial banks and in the garb of One-Window assistance, allowed to play dual role of both short term and long term lenders.
For enhancing long term investments, new from of Local DFIs is considered essential in the new emerging markets. Development Financial Institutions (DFIs) have significant and critical role in promoting investment climates and rendering financial assistance to various development programmes including infrastructural and thereby maintaining sustained economic growth of a country. To achieve this objective a strong network of local DFIs, today seems essential for FfD.
To meet this challenge, the proposal is either to (i) Restructure existing Development Financial network in developing countries so as to have more Local / Regional flavour without government’s intervention or (ii) Setup Local DFIs with new face as Public Private Partnerships (PPPs) or Joint–Venture Companies (JVCs) without government ownership.
The cardinal principles for both the forms being (a) less or no reliance on government’s support and donors’ grants / concessional funding for loan portfolio and (b) Self-reliance mainly on local resources, domestic and later international capital markets in due course.
The Benefits:
Private finance and investment are crucial for attaining sustained economic growth and for achieving the internationally agreed Millennium Development Goals (MDGs). However, few developing countries are able to mobilise sufficient private (domestic and foreign) finance and investment to meet this challenge. With this in mind, two central themes come to sharp focus, viz. (i) necessary conditions to mobilise private finance and investment in developing countries, and (ii) how donors’ and multilateral co-operation can best contribute to this objective.
(i) Mobilising Private Finance and Investment in Developing Countries:
The necessary conditions to mobilise private finance and investment in developing countries include good governance, private sector development, and regional integration.
Good governance of the public and private sectors is crucial to create an environment that will help mobilise domestic and international resources for development. Country-owned programs such as Kenyan Private Sector Corporate Governance Trust and the South African Corporate Governance Advisory Services provide good examples of how countries can develop and implement sound corporate governance principles by involving stakeholders, such as the public sector, the private sector, and NGOs.
Private sector development, especially domestic investment and entrepreneurship, is crucial for sustained growth. However, small and medium enterprises (SMEs), the backbone of developing economies, often lack access to financial services. Measures like strengthening domestic financial sectors, combining technical and financial assistance and implementing financial innovations to promote finance for SMEs are essential. For example, Vietnam's effort to develop its financial service sector include strengthening and developing banking services, the stock exchange, and investment funds is a case in point. Role of DFIs in providing financial and technical assistance to SMEs in India and of regional development banks in strengthening local financial systems, formulating policies for SME development as well as developing local and regional technical assistance programs for enterprises could be adapted for replication with suitable modifications. Small Industries Development Bank of India (SIDBI) provides direct assistance (such as project finance, venture capital, and export finance) and indirect assistance (such as promotional and development support services) to promote SME development and also provides resource support to Regional DFIs (like SFCs / SIDCs / RRBs) for lending to SMEs. However, experience of these Regional DFIs which had made significant contribution initially, is now adverse because of heavy governmental interference and legislative controls. For want of market led changes, they have become irrelevant with high NPAs and negative net-worth. Despite these adverse features, they have latent force and given proper restructuring support and new face, they would bounce back to profitable business.
Regional integration can promote countries' competitiveness and ability to meet the challenges and opportunities offered by globalisation. Regional integration can help create bigger markets and opportunities that stimulate private domestic and foreign investment. New Partnership for Africa’s Development (NEPAD) is a successful experiment, which is conceived as an overall continent-wide plan that will be implemented on a regional basis-provides an important opportunity for strengthening economic integration in Africa.
(ii) Donors’ and Multilateral Cooperation:
Who needs to do what?
Donors and Bilateral and multilateral agencies, in partnership with other stakeholders, such as, private sector and NGOs, could best contribute to efforts to mobilise finance for development, and in particular private finance and investment. Improving aid effectiveness, capacity-building efforts, and improving synergies between private finance and international network are the areas, which could be handled by them effectively.
Improving aid effectiveness for capacity building, the most effective instrument viz. business development service (BDS) is the key to achieving development objectives and help in pooling the resources to create an enabling environment for private investment and FfD. Enhancing aid effectiveness and efficiency requires improving country ownership, aid harmonisation, and donor co-ordination in delivering assistance.
Capacity building through technical and financial assistance is crucial to supporting developing countries' efforts to implement sound policies and schemes of DFIs. Reviews such as the World Bank/IMF Financial Sector Assessment Programs (FSAPs) and the Reports on Observance of Standards and Codes (ROSCs) as well as the proposed African Peer Review (APR) mechanism are useful diagnostic tools to assess a country's financial system, strengths and vulnerabilities. They also help identify development needs and policy priorities. In addition, programs that help pool donors' resources (and improve the effectiveness of such assistance) for strengthening the financial sectors, such as the Financial Sector Reform and Strengthening Initiative and the OECD/World Bank Global Corporate Governance Forum, are relevant. These programs can help broaden dialogue between the various stakeholders, act as a platform for exchanging experiences on good practices, and help mobilise the technical and financial assistance required to fill identified gaps in any development finance system.
Improving synergies between international investment funds and private finance can also help mobilise private capital, especially in the poorest countries that attract little or no foreign investment. This step must primarily be used to improve the domestic investment climate in developing countries, specifically by building Regional Local DFIs network. Public Private Partnerships can be instrumental in pooling the necessary resources for such investments, as domestic public and private resources alone are often not sufficient to meet needs, especially in the poorest countries. Examples of public-private partnerships were provided by Japan's ODA loan programme for basic infrastructure and human capital development in Asian countries, and Small Enterprise Assistance Funds (SEAF), providing risk capital and technical assistance to local SMEs. Transforming a portion of the Democratic Republic of Congo's foreign debt into an "International Fund for Investment and Reconstruction in the Congo (FIRC)" has been successfully tried.
Finally, it would be desirable to review the instruments that could also be used to mitigate investment risks, such as co-financing and joint venture funds, export and risk guarantees. These instruments would help leverage private finance and investment and reduce high-risk perceptions of private investors towards developing countries. For example, NEPAD in Africa envisages measures to lower investment risks, such as initiatives related to peace and security, political and economic governance, and infrastructure development. It also entertains interim measures to mitigate risk, such as credit guarantee schemes and investment incentives. In this context the Credit Guarantee Small Industries Fund scheme operated by SIDBI and Government of India might be a model to replicate. Under the scheme, only collateral and third party guarantee free loans are eligible for guarantee. This schemes which is in existence for past 8 years is performing well and banks are increasingly joining the scheme.
Suggested Framework:
In this backdrop, questions emerge as tohow to restructure Regional DFIs or setup new Local DFIs and better leverage official sector (multilateral development banks, bilateral donors, national governments and aid agencies) to catalyze private investments and how to bring financial governance capacity building to scale??The suggested framework is:
1. An awarenessmust emerge at the national and international levels that"Financing for Development" is different and essential segment and for which DFIs particularly Local DFIs are the best suited institutions. Commercial banks may not be able to perform this task effectively.
2. National governments must take necessary action to recapitalize/restructure ailing DFIs, [like State Financial Corporations (SFCs) and State Industrial Development Corporations (SIDCs) in India], which are nearer the ground and have better reach.
3. The Local DFIs must be promoted as NBFCs, PPPs or joint ventures in the private sectorto run on commercial links. Government should be only facilitators and not the administrators/ owners
4. Enabling environment mayhave to be created by Governments and Central Banks of the respective countries so that Local DFIs have "level playing field" for raising resources including Open Market Borrowings.
5. Multilateral and Bilateral donor agencies might become co-promoters and also extened“soft rate" support to the Local DFIs. Assistance towards Business Development Services (BDS) by DFIs should come as technical support. All assistance should be directly given to DFIs depending on their viability rather than routing through the government. This may increase the sense of accountability.
6. Restructuring / recapitalisation of Regional DFIs programmes shouldbe assisted by the Multilateral agencies. They should increasingly become co-promoters of such ventures.
7. SMEs should be encouraged to corporatise. This will help them to play effectively in the Local Capital markets and less reliance on institutional loans. All efforts should be to promote second tier Stock Markets for the SME sector.All this will ensure better financial discipline.
8. New and innovative financial instruments should be promoted and active equity markets be developed rather thanheavy reliance only on debts.
9. Special Development Funds like Technology development and Innovation Funds, Modernization Fund, Risk capital and General Fund, Small Equity Fund etc., to be co-promotedor jointly set up by the government and multilateral agencies, which might go a long way in promoting economic development.
10. Subsidized formal finance has failed. But is there scope for expanding informal finance, the most common source of credit for the poor, usually a forgotten but important segment in developing economy. Thus, an effective institutional mechanism should be developed to connect informal lending agencies with Local DFIs.
Despite its popularity and potential, informal finance has many drawbacks. Its separation from larger financial markets limits the lenders’ access to funds and reduces competition, and it rarely provides term finance or large loans. Some of these difficulties may be overcome through links between informal and formal Local DFIs, but much remains to be learned about these linkages.(World Development Report 1990)
The obstacles & limitations:
World over, statistics show that long term loans with longer gestation period, given by development financial institutions have playedsignificant and vital rolein economic development of a country. However, of late, DFIs role is sagging.
“Project investments may see big fall in FY04: RBI: The Reserve Bank of India (RBI) has said that fixed capital investments by corporates could be much lower in ’03-04, with no large projects sanctioned in the last two years. Accordingly to a recent RBI study, aggregate capital expenditure on projects in the current year in unlikely to be anywhere close to the previous years figure of Rs. 37.154 crore”. (See Economic Times, Mumbai, 9 December 2004).
Commercial banks which are encouraged to give long term loan also could not arrest this trend in India.
Many of the developing economies would not have attained the present level ofeconomic development had there been no or less support from the development financial system.There are various financial instruments like equity, promoters; contribution, startup loans, venture capital, R&D and innovation finance, technology upgradation, etc. etc, which are beyond the reach and capacity of commercial banking system, because by borrowing Short they can not lend Long, (History repeated itself : Asian Crisis). This trend supports the view that development finance is a must for developing economies.
Having said so, it is distressing to witness that in various countries development financial institutions (DFIs) are trying to convert themselves into Universal Banks so that they could compete with the commercial banks in the global market. This race (rightly or wrongly), is mainly prompted by "Cost of Resources". DFIs, due to various restrictions, are not able to mop up resources from public / markets at rates comparable to commercial banks. It is a matter of concern that in the name of opencompetition and market ledinterest rates structure,many of the countries (Central banks and governments) are not taking suitable steps to support DFIs. As such, development financing system is lagging behind affecting the development process.
In the name of “One window” assistance, commercial banks are being encouraged to lend both long term and short term loan assistance. While it may be suitable for small borrowers, bigger projectslike infrastructure, industrial estates, requiring longer gestation, may not get proper treatment at the hands of short term lending institutions. Development banking requires a different eye and a different mind-set.