Policy options

Development finance policy needs to be addressed from both the supply and demand side. The design and implementation of the policy package depends on the economic and political context of the country in question, but most African countries and LDCs will benefit from some policy based on each of the following aspects of development finance.

(a) State-led development financing: With the right political and institutional conditions, many of the market failures and imperfections associated with financing development can be addressed through allocating resources to government-controlled development banks, and channelling rents towards firms or sectors that

are considered as priority areas for spurring productive development. The key roles of development banks are to provide countercyclical assistance, to aid capital development, to support new ventures and to address development challenges (Mazzucato and Pena, 2015; Guadagno, 2016; Ferraz, 2016).

During the late twentieth century, development banks in different countries used an array of mechanisms to lead in the financing of structural transformation, with varying degrees of success: The Korean Development Bank was heavily involved in buying equity from priority firms, while Mexico’s development bank formed numerous partnerships to help organize local firms and offer technical assistance.

In Brazil, BNDES actively established a stock market, while the approach of India’s development bank was more direct, for example in supplying foreign and local currency loans (Amsden, 2001:132). It is vital that development banks use different policy instruments, depending on the needs of the productive entities of the country in question, to be effective.

Political influence, however, can be a key constraint on the effectiveness of development banks. Policies offering State-led financial support to priority firms must be monitored and disciplined through a “carrot-and-stick” approach, in the sense that assistance to non-performing industries should not be sustained (Amsden, 2001). The capacity of Governments to enforce strict rules surrounding development finance and ensure such rents are not open to political capture ultimately depends on the political settlement of the country in question (Khan, 2013b).

(b) Mobilization of private finance: Public institutions can also use financial instruments to incentivize the private financial sector to invest in manufacturing firms. Table V.1 provides some possible tools that could be implemented to mobilize private finance (Tyson, 2017:16).

Table V.1

Development finance institution policy instruments for manufacturing and agricultural processing

Source: Tyson (2017 :16)

(c) Macroeconomic policy: Macroeconomic policy is multifaceted and can encourage/discourage productive investment in different ways, depending on the country context. Three key macroeconomic variables that can be manipulated to adjust financing pathways are: real effective exchange rate (REER), inflation rate, and interest rate.

(i) REER: Undervalued currencies typically can aid growth (Rodrik, 2008;

Habib et al., 2016), although they can also boost inflation (Wondemu and Potts, 2016). On the other hand, an overvalued REER can function as an import subsidy and a tax on exports (Papadavid, 2017). The heterogeneous economic structures of countries, sectors and firms mean that the benefits arising from either overvaluation or undervaluation will vary depending on, for example, how import-dependent the entity might be (ibid.).

(ii) Inflation: Inflation itself discourages investment because it increases the cost of accumulating retained cash earnings and encourages speculation and investments in assets such as property, as well as capital flight (McKinnon, 1973).

Moreover, high inflation and inflation volatility foster uncertainty, which further discourages investment (Baharumshah et al. 2016).

(iii) Interest rates: Interest rates have important effects on the cost of finance, which is especially significant for manufacturers with long investment periods – for example, extractive industries (Papadavid, 2017). High lending rates increase the cost of finance for firms in need of capital, while low interest rates on savings reduce the amount of potentially investable deposit funds that could be channelled towards productive industries (Akinlo and Owoyemi, 2012). Moreover, the interest rate spread (i.e. the difference between interest rates on loans and savings deposits) can significantly affect development finance. The Chinese Government enforced a policy of interest rate spread protection during its economic development, whereby the deposit rate was maintained below equilibrium level.

According to Zhao (2017), this policy grew China’s private financial sector profits, as they were not obliged to pay high interest on savings deposits, thereby increasing the funding available to invest in productive firms. Conversely, in the Republic of Korea in the 1970s, all interest rates were supressed in order to reduce the interest rate burden on borrowing firms, which it was able to do through State ownership of banks (Lee, 2017).

(d) Cautious financial sector development: While financial development is important for Africa and LDCs, the finance mobilized has not always found its way into the manufacturing sector (Tyson, 2017; Papadavid, 2017). Financial development does increase domestic bank capital and lending, but there is some evidence that it also reduces the amount of FDI being channelled into manufacturing, and therefore has a substitutional relationship with manufacturing, rather than additive (Tyson, 2017). An example of this is Kenya, where manufacturing sector development has been limited compared to the growth of other sectors, despite the country having one of the most developed financial markets in East Africa (Papadavid, 2017).

(e) Heterogeneity and evolution of financing needs: What is fundamentally missing from the supply-side-focused literature is that policies aimed at channelling economic resources, mobilizing private finance, improving macroeconomic conditions and developing financial systems affect different industries disproportionately. For example, the impact of supply-side financial policies on those firms relying on internal finance, versus those dependent on external funds, is likely to be different (Rajan and Zingales, 1998). This highlights the structural differences in the financial needs of distinct industrial sectors.

Taking this one step further, the financial needs of industrial sectors are defined by the financial needs of the firms within those sectors, which themselves are heterogeneous by nature. However, going beyond conventional studies, firm heterogeneity cannot be defined simply by establishment size, age, ownership and source of funding. Other structural factors that must be considered when assessing

the finance-production nexus can be clustered into three groups: market factors, technology and production:

(i) Market factors: What is the degree of access, direct or indirect, that firms have to final markets via final or intermediate products? What is the size composition of these markets, and are they domestic or external?

(ii) Technology: How complex are the adopted technologies and how long is needed for the absorption of these technologies and their successful deployment? How much risk is associated with different technology types (especially green technologies), and the infrastructures needed to complement these technologies?

(iii) Production: Firms differ hugely in company size and production scale, the composition of factor inputs, production cycles and firms’ position in global and local production networks. Which finance channels will best contribute to structural transformation through local production system development?

These firm-specific factors, in turn, shape the heterogeneous financial needs of industrial sectors as a whole. Moreover, these needs are dynamic in that, as a country moves along its structural transformation pathway, the financial requirements of productive enterprises change as well.