The Loss of Development Finance Jayati Ghosh

The financial tsunami that has already swept over markets in the developed world is now threatening to engulf many developing countries, including India, as well. And so now the dangers posed by unregulated financial markets are amply clear even to the most diehard market enthusiasts.

It was already known that financial liberalisation in developing countries resulted in an increase in financial fragility, making these economies prone to periodic financial and currency crises. But now that such a crisis has hit the core of capitalism, in ways that are still unravelling and which will take a long time to play out fully, in the industrial countries the talk is all about nationalisation of major financial institutions and introducing new regulation to control dodgy and potentially risky practices.

But as usual we in the developing world are late in coming to terms with reality. This is bad news, because financial liberalisation in developing countries has even worse consequences, because it can retard or even reverse the development project. There are several ways in which this happens. In addition to creating the conditions for greater fragility, financial liberalisation generates a bias towards deflationary macroeconomic policies and forces the state to adopt a deflationary stance to appease financial interests. It also reduces the ability of the state to direct resources towards developmental goals.

To begin with, the need to attract internationally mobile capital means that there are limits to the possibilities of enhancing taxation, especially on capital. Typically, prior or simultaneous trade liberalization has already reduced the indirect tax revenues of states undertaking financial liberalisation, and so tax-GDP ratios often deteriorate in the wake of such liberalization. This then imposes limits on government spending, since finance capital is generally opposed to large fiscal deficits. This not only affects the possibilities for countercyclical macroeconomic stances of the state but also reduces the developmental or growth-oriented activities of the government.

These tendencies affect real investment in two ways. First, if speculative bubbles lead to financial crises, they squeeze liquidity and increase costs for current transactions, result in distress sales of assets and deflation that adversely impact on employment and living standards. Second, inasmuch as the maximum returns to productive investment in agriculture and manufacturing are limited, there is a limit to what borrowers would be willing to pay to finance such investment. Thus, despite the fact that social returns to agricultural and manufacturing investment are higher than that for stocks and real estate, and despite the contribution that such investment can make to growth and poverty alleviation, credit at the required rate may not be available.

Not surprisingly, therefore, most late industrializing countries created strongly regulated and even predominantly state-controlled financial markets aimed at mobilizing savings and using the intermediary function to influence the size and structure of investment. This they did through directed credit policies and differential interest rates, and the provision of investment support to the nascent industrial class in the form of equity, credit, and low interest rates. They created development banks with the mandate to provide long-term credit at terms that render such investment sustainable.

Liberalisation can dismantle the very financial structures that are crucial for economic growth. While the relationship between financial structure, financial growth and overall economic development is complex, the basic issue of financing for development is really a question of mobilising or creating real resources. When the financial sector is left unregulated or covered by a minimum of regulation, market signals determine the allocation of investible resources and therefore the demand for and the allocation of savings intermediated by financial enterprises. This aggravates the inherent tendency in markets to direct credit to non-priority and import-intensive but more profitable sectors, to concentrate investible funds in the hands of a few large players and to direct savings to already well-developed centres of economic activity.

The socially necessary role of financial intermediation therefore becomes muted. This certainly affects employment-intensive sectors such as agriculture and small-scale enterprises, where the transaction costs of lending tend to be high, risks are many and collateral not easy to ensure. The agrarian crisis in most parts of the developing world is at least partly, and often substantially, related to the decline in the access of peasant farmers to institutional finance, which is the direct result of financial liberalisation. Measures which have reduced directed credit towards farmers and small producers have contributed to rising costs, greater difficulty of accessing necessary working capital for cultivation and other activities, and reduced the economic viability of cultivation, thereby adding directly to rural distress. In India, for example, there is strong evidence that the deep crisis of the cultivating community, which has been associated with to a proliferation of farmers’ suicides and other evidence of distress such as mass migrations and even hunger deaths in different parts of rural India, has been related to the decline of institutional credit, which has forced farmers to turn to private moneylenders and involved them once more in interlinked transactions to their substantial detriment.

By dismantling these structures, financial liberalisation destroys an important instrument that historically evolved in late industrialisers to deal with the difficulties of ensuring growth through the diversification of production structures that international inequality generates. This implies that financial liberalisation is likely to have depressing effects on growth and sustained development, even beyond the deflationary bias in public spending.

So in countries like India, it is even more important to have a controlled and regulated financial sector than it is in developed countries. Yet the Finance Minister is trying to meet the current financial crisis by doing exactly the opposite: more deregulation and more incentives for private finance! The tragedy is that such a strategy will be far more detrimental for the economy than even the real possibility of financial crisis: they can have long-term damaging consequences for the development project as a whole.