The Role of Donor and Government Finance

Where do the considerations presented in this chapter leave donors who wish to make cash contributions to the development of rural finance? While there is clearly a role for funding technical assistance and advocacy efforts in developing rural financial intermediaries, do the lessons of experience suggest that no external funding should be contributed to them? Not necessarily:

152. See, for example, D. Villanueva and A. Mirakhor, 'Strategies for financial reforms: interest rate policies, stabilization, and bank supervision in developing countries', IMF Staff Papers, 37(3), September 1990, pp. 509-536.

153. A more detailed illustration of this issue is found in the appendix to Roger D. Norton, Agricultural Issues in Structural Adjustment Programs, FAO Economic and Social Development Paper No. 66, Food and Agriculture Organization of the United Nations, Rome, 1987.

154. J. Sayad, 'Rural Credit and Positive Real Rates of Interest: Brazil's Experience with Rapid Inflation', in D. W. Adams, D. H. Graham and J. D. Von Pischke (Eds), 1984, pp. 146-160.

155. R. Rock, M. Otero and R. Rosenberg, 1996, p. 1.

Not even an extremely far-reaching and successful financial sector reform would eliminate the need for specific efforts to initiate and support target-group-oriented financial institutions. There does not seem to be a "market mechanism" which would induce established financial institutions to start providing financial services to the lower-income target groups as soon as a financial sector reform has taken place. ... In the medium to long term [banks] will have other strategic options . .. and experience indicates that they prefer these other options and are reluctant to serve the poorer segments of the population if they are not given specific incentives and technical assistance.. . .157

There are four valid roles for external funding: (a) contributions to local intermediaries' pool of loanable funds, limited in relation to the amount of deposits mobilized, (b) start-up funding, especially if an institution begins life as a lender only and later acquires a capacity to manage savings deposits, (c) selected special incentives to offset higher costs of providing financial services to target groups, as in the case of subsidizing commercial bank branches in rural areas, and (d) filling the gap in long-term funding.

The first role can take the form of contributions to the fund of an apex organization in a system of 'mini-banks'. However, in such cases it is important to limit the amount of on-lending to the affiliates and to tie it to their own deposit mobilization. Experience has shown that a strict ceiling of this nature is important to maintain the integrity of the loan repayment response and the loan collection effort. Otherwise, the external support often generates the perception that the donor funding does not have to be repaid, and in turn that weakens the financial discipline of both borrowers and financial institutions.

Nancy Barry has made a case for limited financial support, specifically during a start-up period:

If financial intermediaries are to move to the significant volumes in microfinancing that are needed to make these programs sustainable, early operations will need to be subsidized. NGOs and other specialized financial intermediaries, which are not in the position to cross-subsidize microenterprise lending while they build lending volumes, will need some form of institutional subsidy for a period of five to seven years. Specialized institutions that meet performance standards need capitalization and low-cost, long-term funds, preferably repayable in local currency, while they expand their volumes to sustainable levels.158

The reasoning behind this argument is that unit administrative costs will be very high in the early stages of operation of a microfinance institution, owing to lack of economies of scale and the cost of learning, and that without a source of subsidy it would have to charge interest rates so high that they might discourage potential clients (or foster an adverse selection of clients). By the same token, it would be important to tie such funding to fulfillment of annual performance targets, and make the phase-out of the funding unmistakably clear from the outset.

Seed capital of this nature can perhaps be most effective when granted to a second-tier institution, or central fund, that oversees and supports a network of credit co-operatives or mini-banks. In addition, as noted, a case may be made for providing subsidies to encourage the opening of branches of rural financial institutions in remote areas, including commercial banks, in order to offset the higher unit administrative costs associated with their smaller scale of operations.159 In such cases, funding formulas have to be specified

157. J. Yaron, M. P. Benjamin and G. L. Piprek, 1997, p. 99, citing J. P. Krahnen and R. Schmidt, Development Finance as Institution Building: A New Approach to Poverty-Oriented Banking, Westview Press, Boulder, CO, USA, 1995, p. 8.

159. This suggestion has been made by Yaron, Benjamin and Piprek (1997, p. 39), and it has been prescribed in World Bank funding for commercial banks in rural areas of Nicaragua.

in advance to ensure that the assistance is tied to unavoidably higher administrative costs and that it does not, for example, compensate for lax loan recuperation. Another area in which external funding can play a crucial role is in training the managers and directors of rural financial institutions, including providing them with study tours to review successful experiences in other countries.

The argument for selective government support has been stated in the following ways:

Government interventions in rural finance . . . should be based on the principle of removing the causes of market failure in a cost-effective way. Ultimately, they should facilitate the effective working of market forces. This may include grants or subsidies for information generation and institution and capacity building, providing seed capital for capital enhancement of new rural financial intermediaries, providing rural financial intermediaries with access to refinancing facilities, in particular, to be used for term lending. Subsidies and grants, however, should always be transparent and temporary and provide incentives to strengthen the role of private sector operators in rural financial markets.160


in some areas public intervention to provide long-term resources might still be justified. Firstly, during transition periods of establishing efficient capital markets or periods of political and economic instability public involvement is needed. This involvement might be in the form of long-term credit lines, lending quotas or additional capital injections to rural financial institutions. However, it should be emphasized that, as the experience with public short-term finance in the past has shown, the private and voluntary mobilization of appropriate funding sources must not be discouraged or undermined.161

The conceptual argument for government intervention on grounds of market imperfections has been articulated by Stiglitz in a nuanced manner:

There is a role for the state in financial markets; it is a role motivated by pervasive market failures. In most of the rapidly growing economies of East Asia government has taken an active role in creating financial institutions, in regulating them, and in directing credit, both in ways that enhance the stability of the economy and the solvency of the financial institutions and in ways that enhance growth prospects. Although limitations on markets are greater in developing countries, so too, many would argue, are limitations on government. It is important to design government policies that are attentive to those limitations.162

The financial crisis in East Asia led to widespread questioning of government attempts to mold the development of financial markets. In response to assertions of the need to intervene in cases of market failure, the general point has been made that 'Direct measurement of the existence and extent of market failure is difficult and uncommon'.163

Given the poor track record of government interventions in financial markets, the thrust of policy at present has to lie on the side of encouraging private efforts at savings mobilization and innovative approaches to financial intermediation, aided by technical assistance and by relatively modest and temporary direct support.

It is clear that injections of cash into the rural financial system have to be limited in quantities and associated with very carefully designed

161. Thorsten Giehler, Sources of Funds for Agricultural Lending, Agricultural Finance Revisited No. 4, FAO and GTZ, Rome, December 1999, pp. 76-77 [emphasis added].

162. J. Stiglitz, 1994, p. 50 [emphasis in original].

163. J. Yaron, M. P. Benjamin and G. L. Piprek, 1997, p. 38.

programs for development of financial institutions. Nonetheless, public interventions on a larger scale can be directed toward ameliorating the conditions that cause rural financial markets to be inefficient:

Is there, then, any role for public policy? Greenwald and Stiglitz (1986)164 have recently shown that markets with imperfect information give rise to externality-like effects, for which government intervention may be most successful. In the context of credit markets, one externality is the reduction in information costs brought about by development in other markets. Examples are land titling and commercialization in goods markets. More generally, government expenditure on rural infrastructure that reduces farmers' risks will likely reduce the importance of information asymmetries, improve the level of competition, and therefore reduce the distortions in rural credit markets.

Another type of externality may reside in institutions which facilitate the overcoming of informational problems in rural credit markets. One such institution is that of small-scale peer monitoring. . .. Individuals form a small group which is jointly liable for the debts of each member. The group thus has incentives to undertake the burden of selection, monitoring and enforcement that would otherwise fall on the lender. . .. There is, however, an externality in this institutional innovation. An individual who bears the initial cost of organizing such an institution is providing a form of social capital from which all members of the group will benefit. As is well known, when this type of externality arises there will be an undersupply of the socially beneficial service, and there is therefore a role for the government to help organize and act as a catalyst in the formation of such institutions. . .. there are notable successes when the government has acted in this way.165

As noted, the Grameen Bank, of which the Bangladeshi Government owns 25 %, has invested considerable effort in organizing these kinds of groups. External donors have played the organizing role in other circumstances as well.

The above-mentioned donor-supported rediscount lines in special cases constitute the exception to Fry's argument about rediscount lines. Reforestation and sustainable forest management, for example, are activities that rarely can find the needed long-term financing from domestic banks, even though they may be highly profitable and consistent with a country's comparative advantage.

Vogel and Adams have made a spirited argument against the idea of rediscount lines, correctly pointing out that the emphasis should be on the development of viable institutions for financial intermediation,166 but in practice the gaps in availability of medium- and long-term financing are so critical that second-storey financial windows will continue to be used while financial markets develop. As Mark Wenner has recommended for the Inter-American Development Bank:

In order to improve the availability of long-term finance, the Bank should prepare operations that.. . provide temporary access to external funds through second-tier banks to compensate for the lack of funding sources. .. .167

164. B. Greenwald and J. Stiglitz, 'Externalities in economies with imperfect information and incomplete markets', Quarterly Journal of Economics, May 1986, pp. 229-264.

166. Robert C. Vogel and Dale W. Adams, 'Old and New Paradigms in Development Finance: Should Directed Credit Be Resurrected?', CAER II Discussion Paper No. 2, Harvard Institute for International Development, Cambridge, MA, USA, April 1997.

167. Mark Wenner, Rural Finance Strategy, Sector Strategy and Policy Papers Series, Sustainable Development Department, Inter-American Development Bank, Washington, DC, USA, December 2001, p. 20.

It is clear that such rediscount lines should be temporary, but it is equally clear that there are externalities to be reaped by inducing otherwise conservative commercial banks in developing countries to explore new areas of lending. In many countries, an argument could be made along these lines for a rediscount line for reforestation projects or fruit trees, for a period of five to ten years, after which the banks should have acquired sufficient experience in that field. By the same token, rediscount lines cannot be justified for well-established activities that already have been receiving commercial lending, e.g. production of grains and beef fattening in many countries. Too often, rediscount lines are used for this kind of purpose.

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