The comeback path for DFIs is strewn with strategic challenges4 min read . Updated: 12 Jan 2021, 09:53 PM IST
The idea of development finance institutions is being revisited but they’ll have new realities to face
Are development finance institutions (DFIs) about to make a comeback in the Indian financial landscape? The first hint was offered by finance minister Nirmala Sitharaman in her July 2019 budget speech. She spoke about the need for a specialist DFI to channel funds to the ₹1 trillion of infrastructure projects planned over the next five years. Not much happened after that. Then K.V. Kamath, who led the successful transition of the erstwhile ICICI from a development bank to a universal one, said in an interview to Bloomberg Quint in early December that India may need to consider a new DFI.
These statements could be mere straws in the wind. They come nearly two decades after India decided that its financial system was mature enough to do away with the specialist institutions set up after independence to fund large industrial projects. India no longer faced the problem of incomplete financial markets that led to the creation of specialist DFIs in the first place. There was also a lot of hope at the turn of the century that the corporate bond market would reach maturity soon.
The idea that a country entering late into the development game would need a special category of lenders to push industrial investment is an old one. In his classic work on economic backwardness, first published as an essay in 1951, Harvard University economic historian Alexander Gerschenkron showed how countries that were late off the block had created state institutions to promote growth. Among these new institutions were lenders that would channel savings into industrial investment, as was done by countries such as Germany and France in the 19th century.
Gerschenkron wrote about institutional innovations in Europe. Something similar happened in Asia as well. Countries such as Japan and South Korea set up development banks after the end of World War II. India had its own tryst with such specialist financial institutions. Among those set up during the high noon of national planning were IFCI in 1948, ICICI in 1955 and IDBI in 1964. A bunch of state financial corporations were established as well, after Parliament cleared an enabling law in 1951.
These DFIs were meant to fund industrial initiatives that had long gestations as well as high project risks, which often meant that they could not get funding from the commercial banks of the time. I have been recently reading the collected writings of H.T. Parekh, institution builder extraordinaire, who helped set up ICICI and then HDFC. In a speech he gave in Tehran in October 1963, Parekh pointed out that the total financial assistance provided by Indian DFIs was nearly a third of the targeted private-sector industrial investment that year.
Much of the discussion on DFIs tends to be focused on the asset side of the lending business—and especially the type of projects they fund. However, the equally important part of the Indian DFI experience, and which remains relevant in case a new DFI is in the offing, is on the liabilities side of the balance sheet. These institutions had a special status in the financial system, which allowed them to borrow at low rates.
First, large DFIs had access to soft loans from international agencies, at a time when Indian companies did not have direct access to dollar funding because of capital controls. Second, DFIs benefitted from financial repression, as the rupee bonds they sold qualified as statutory liquidity ratio (SLR) holdings for banks. Third, the DFIs got direct funding from the Reserve Bank of India under its Long-Term Operations (LTO) kitty, which has since been disbanded.
This extraordinary regulatory largesse helped traditional DFIs raise money at significantly lower interest rates compared to what they would have had to borrow at in the open market, and in effect kept interest rates at the long end of the market relatively low, an incentive for industrial investment. None of these three advantages would be available to a new DFI in the contemporary financial system.
The old DFIs played a big role in supporting industrial investment in an economy with a shallow financial system. However, lending decisions were inevitably riddled with political influence, and many DFIs were tottering at the brink when regulators began to encourage them to change their business model in the late 1990s. A new-age DFI would have to come to terms with governance issues if it is not to eventually become a fiscal burden. One way would be to subject it to the discipline of the stock market.
In an article published in The Economic Weekly in February 1954, when the Indian government had begun negotiations with its US counterpart as well as the World Bank to set up a new industrial lender, H.T. Parekh wrote that the new corporation should provide equity capital rather than act as a lender. “In fact, it could best function as an investment trust specialising in making available to private enterprise a part of the risk capital required… It is easier for an industrial concern to raise loan capital than to raise equity capital."
Much has changed since then, but his words remind us that several strategic issues need to be dealt with if the government is thinking of a DFI 2.0.
Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics