Revisiting development finance

For a return to development finance, successful businesses must draw market attention

In his interim Budget speech of February 3, the finance minister indicated something of a return to the 'development finance' model. The Industrial Development Bank of India (IDBI), which was the lead institution when this model was in vogue, is once again expected to play a leading role.

There were few specifics in the speech about how the model would play out in the current economic environment. However, the fact that it was referred to at all reflects the growing concern in the country about the absence of any mechanisms to channelise long-term finance to industry.

This concern was voiced during the parliamentary debate on the legislation that was moved to convert this same IDBI into a universal bank.

Considering that this move itself was originally motivated by a feeling that the concept of development banking itself was obsolete in the deregulated industrial scenario, views on the matter appear to have come full circle.

In the debate, many people expressed the view that even as IDBI reinvented itself as a bank, it should not abandon its developmental orientation, i.e., it should continue to focus on supplying long-term funds to industry.

This concern is of great significance in the current economic scenario. It is almost universally believed that the sustainability and acceleration of growth is dependent on the revival of investment activity.

Large investments in new capacity across a broad swathe of industries have really not been visible since the mid-1990s boom. Between then and now, the industrial sector has performed indifferently, at best, with the couple of recoveries that we saw not really stretching existing capacity.

Simultaneously, productivity improvements have increased the effective capacity of investments already made. Large investments were, therefore, never on the cards. No one was particularly agitated over the weaknesses in the financing mechanism.

Until now. For the first time since the mid-1990s, the possibility of fresh investments looms large. A highly favourable set of macroeconomic conditions and six quarters of respectable industrial growth suggest this.

But, even if conditions are ripe and entrepreneurs are willing, will the financial system accommodate them? Is it possible that long-term funding will become a constraint that will nip the anticipated investment recovery in the bud?

Let's take a historical perspective on these questions. In fact, it was precisely the investment boom of the mid-1990s that got the so-called Development Finance Institutions (DFIs) into trouble and signalled their obsolescence.

To cut a long story short, theirs was a lending model based on the mitigation of business risk through licensing. A licence granted by the government to an entrepreneur effectively created a monopoly (or at worst, an oligopoly).

If the business failed, it wasn't because of competitive pressure or any external factor; it was simply inept management. Lending under such circumstances was relatively safe.

The lender did not have to go through the process of evaluating business risks; the fact that the borrower had been issued a licence was good enough.

he end of licensing changed the scenario dramatically. Now, a lending decision had to be based on due consideration of both internal and external factors.

The mounting burden of non-performing assets as the industrial sector became increasingly volatile and turbulent indicates that the institutions, collectively speaking, didn't do a particularly good job.

But, that need not have been entirely their fault. A look at other development banking models also indicates the key role of outside agencies in mitigating business risks by controlling competition.

Japan, a notable example of bank-led industrial development (many moons ago!) is a case in point. There was close coordination between government, finance and business in deciding who was to be in what business and how it was to be financed.

Korea, following a similar model, followed an active 'priority sector' policy to direct bank lending. My objective in citing these examples is not to get into issues of success or failure.

Rather, it is to highlight the fact that industrial development based on bank financing has typically worked in an environment of explicit or implicit policy-driven mitigation of business risk.

Therefore, when the policy regime distances itself from risk mitigation, which India did through a combination of delicensing and trade reforms, the validity of a bank-led industrial development process must be called into question, which it clearly was.

No amount of romanticising is going to change the hard fact that, in a highly competitive environment, with all industries subject to cycles of varying and unpredictable duration, a bank, which raises its funds in the form of public deposits and lends to businesses for creating new capacity is simply not the optimal arrangement.

The risks inherent in its loan portfolio will require provisioning of such high magnitudes that profitability is bound to suffer. We are in danger of reverting to the bad old days of subsidies, bailouts and what-have-you; ultimately, the government is the risk-bearer of last resort.

The critical attribute of feasible financial arrangements in an open, competitive economy is an ability to spread risk as widely as possible. Stocks and bonds are obvious ways of doing this.

However, companies that raise money from markets typically do so on the basis of some kind of track record. In other words, they need to have been in business for a while with reasonable success before the public will consider investing in them.

For start-up businesses, this is clearly a Catch-22. Venture capital has provided a partial answer to this problem, but its interests are confined to technology and innovation-driven businesses, which generate enormous returns if they are first to reach the market. Bread-and-butter manufacturing businesses, which offer no such bonanzas are not particularly attractive to this channel.

So, it appears that markets and venture capitalists will take care of the requirements of established businesses and ones that offer high returns.

In our own recent experience, there is hardly likely to be any business in these two categories, which has not been able to grow because of financial constraints. But, are the needs of entrepreneurial start-ups in manufacturing and, importantly, services, being adequately provided for?

If there is any yearning for a return to the development finance model, it must be confined to this sector and this sector alone. The orientation must shift from 'small-scale industry' to 'small business'.

The exposures to individual businesses must be small, so that even a high probability of failure can be managed with moderate, even publicly funded, prudential requirements.

And, most importantly, a successful business venture must be allowed to graduate as quickly as possible to the attention of the financial markets. This is unlikely to happen by simply re-jigging existing institutions. If at all, something new is called for.

(The writer is Chief Economist, CRISIL. The views expressed are personal)