A group of industrialists from one of India’s big business lobbies met the Prime Minister in January 2004, at a time when companies had begun to invest in new projects after a long hiatus. The industrialists reportedly told the Prime Minister that business investment would stagnate as long as their companies did not get long-term funding of the sort that was once provided to them by the likes of ICICI, IDBI and IFCI. It was a view that was fondly held by many economists as well.
These three development financial institutions were originally established many decades ago by the government to provide funds for industrial investment. India then had a small financial sector and corporate balance sheets were weak. Specialist banks were needed to provide funds for industrial growth.
The trio had a big role to play in the growth of industries from the 1950s to the 1980s. But they also lent to all sorts of unviable projects, often under pressure from their masters in New Delhi. By the mid-1990s, each of the three national development financial institutions was in deep trouble. ICICI successfully converted itself into a consumer bank. IFCI struggled from crisis to crisis, and is currently being chased by investors for bits of its investment portfolio. IDBI has managed to be somewhere in between.
And today, three years after those industrialists met the Prime Minister, India is in the midst of a splendid investment boom. Their dark prophecy did not materialize. Companies have used their internal cash, and borrowed from the domestic and international financial system, to invest in new capacities. The old development financial institutions are not missed.
Curiously, a variant of this desi debate has now broken out in the global arena. The protagonists of this battle are the World Bank and the Asian Development Bank (ADB). Both were set up for the same reason that ICICI, IDBI and IFCI were—to fund clients (war-shattered and poor countries, in this case) that could not get money from the capital markets. But, as countries developed and financial markets become more sophisticated, the importance of subsidized funds from the World Bank and ADB has declined.
In a recent article in the Washington Post, columnist George Will writes about a study by Adam Lerrick of the American Enterprise Institute, a conservative think tank based in Washington DC. Lerrick says that over the past five years, 90% of the money lent out by the World Bank went to 27 middle-income countries, rather than to poor countries. And private capital flows to these 27 countries were a hundred times more than what the World Bank gave them. This is one indication of how an institution such as the World Bank has been replaced by capital markets.
Meanwhile, closer to home, there is a huge debate on the future of ADB. It is likely that by 2020, thanks to the economic transformation of China and India, nearly 90% of the people living in the region will be in middle-income countries. How can ADB alleviate poverty when there will be so little of it? A group of experts has published a new report that suggests ways ADB can reinvent itself—from helping build pan-Asian infrastructure to promoting green growth. The World Bank, too, often talks about such issues these days.
There are striking parallels between what happened to India’s development financial institutions and what is being currently debated in the World Bank and ADB. The growing importance of private capital is dragging these institutions towards irrelevance.
Yet, the idea that a sector or a country needs a specialist financial institution has been resurrected. The current favourite is a funding agency for infrastructure. Once again, it is the same manufactured fear—that projects will be starved of funds unless the government sets up a specialist infrastructure finance company. It could be set up with the help of a raid on the Reserve Bank of India (RBI). There are several reasons to criticize the plan to use foreign exchange reserves to finance new roads, ports, industrial parks and the like. The government will, though in a roundabout way, borrow money from RBI. Hence, it amounts to nothing more than deficit finance by another name. Worse, the India Infrastructure Finance Company is almost structured like a hedge fund, with its meagre equity leveraged several times over.
The current debates on the future of the World Bank and ADB should tell us a lot. Private capital markets, if adequately developed, do the job of funding development far better. The way to channel money into infrastructure projects, assuming they are commercially viable, is by developing the market for long-term finance in India. That means boosting the bond market and fast-tracking pension and insurance reforms.
Setting up a modern version of IFCI is not much of a very attractive solution—other than to politicians who can use this public treasure to shovel money towards their friends and their companies.
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