By Kasun Thilina Kariyawasam
“The great source of both the misery and disorders of human life, seems to arise from over-rating the difference between one permanent situation and another. Avarice over-rates the difference between poverty and riches: ambition, that between a private and a public station: vain-glory, that between obscurity and extensive reputation. The person under the influence of any of those extravagant passions, is not only miserable in his actual situation, but is often disposed to disturb the peace of society, in order to arrive at that which he so foolishly admires. ― Adam Smith, The Theory of Moral Sentiments
Credit plays a fundamental role in capitalism, more so than in any economic system that preceded it. In feudalism, means of production, such as land, are immovably fixed to a certain class. In capitalism, however, credit can entitle an individual to means of production. Therefore, under capitalism, systems of credit-provision are fundamental to lubricating the process of capital accumulation.
This process may seem more democratic since we tend to assume that credit is equally accessible to all. However, the etymology of the word credit - which comes from the Latin credere, meaning to believe or trust - reveals the asymmetrical requirement of being ‘creditworthy’, that underpins the system. Who or what is deemed credit-worthy is a political question.
Through historical evidence and contemporary banking practices, there are two broadly identifiable systems of banking, based on how each system provides credit: 1. the market-guided banking system and 2. the policy-guided banking system.
This categorisation is, for the most part, ideologically neutral and not too dependent on the existing state’s institutional base. For example, historical evidence shows that both monarchies and liberal representative democracies have used both methods of banking under different contexts.
Market-guided banking
In market-guided banking systems, credit is provided based on the viability of higher capital gains - in most cases short-term. In such systems, credit is often provided for socially harmful economic activities such as speculation, rent-seeking, and the creation of financial instruments. One high-profile example is the case of HSBC, which came under the spotlight for financing deforestation (ie. creation of new land markets) and was later fined.
In the last few decades, corporations in market-guided economies have become financialised. This means that corporations that primarily did manufacturing or services, have evolved into financial firms, following a path of short term value maximisation over long term business sustainability. These corporations have developed rent-seeking behaviours due to their easy access to credit for short-term gains. They borrow to reinforce economic rent through patents, advertising, public relations, and the buying back of shares rather than increasing productivity via research and development. Combined with lobbying power to suppress industrial disruption, these financialised corporations inhibit productive growth. Market-guided banking systems, therefore, have an innate tendency to create economic bubbles - the 2008 financial crisis is perhaps the classic example of market-guided banking systems’ self-destructive tendencies.
In developing countries like Sri Lanka, where banking is market-guided, industrial development is difficult to advance. In such situations, two outcomes are commonly seen. First, is the creation of asset bubbles (as seen in Colombo). Second, is the rise to credit consumption (as seen in the micro-credit bubble in the north and east), which ultimately serves as a subsidy to the merchant economy, which widens the trade deficit and eventually causes inflation.
Policy-guided banking
Policy-guided banking is a system where credit is provisioned according to policy criterion set out by a Central Bank. In most cases, countries pursue a mixed policy with certain percentages of credit allocated for policy-guidance and market-guidance. Within the allocations for policy-guidance, credit volumes can be prioritised for certain sectors and regions based on the capital composition of a country and its industrial development needs. Policy-guided banking is an effective method to kickstart infant industries, as well as to tackle the diminishing returns of older industries.
The idea of policy-guided banking was first developed in Germany’s Reichsbank (the German Central Bank, now Deutsche Bundesbank) in 1913, as a means to develop productive industries and expand the German economy. Germany, in particular, was motivated to pursue this credit-facilitation policy in order to compete with countries with larger colonial surpluses. In the early 1900s, Germany’s rate of profit in its industrial sector was falling compared to other industrial empires such as the UK, and especially the USA. With the rise of the USA as an industrial power, Germany had to develop its industrial cutting-edge and was pushed to find new methods of expanding its manufacturing sector. Furthermore, Germany’s surpluses in agriculture were not sufficient to refinance the industrial sector, even though agriculture was one of the main sources of its credit.
Imperialist Japan borrowed from the example that was set by the Reichsbank. In Imperial Japan, credit policy was set by the Emperor, in consultation with state advisors, in a method called Fukoku Kyōhei (Enrich the Country and Strengthen the Armed Forces). In a nutshell, the Japanese had a policy goal of expanding industrialisation and military power via credit guidance.
By the 1920s, the model set by Germany’s Reichsbank, and later Sweden’s Kreditpolitik (credit policy), gained increasing space in international debates on credit provision. In the policy-guided model, central banks had to play a key role and many abandoned ‘neutrality’ to pursue an ‘interventionist’ policy. In some countries, ‘neutrality’ remained as a historical residue of colonial rule, which was designed to protect foreign economic interests. Sri Lanka is a good example, where credit for industries is sparse and banks favour pre-existing merchant capital (real estate, imports, tourism, etc.).
Many countries that have pursued a path of industrial development have resorted to variations of the policy-guided banking system with different nomenclature. In post-war Japan, this system was called windows guidance; in India, it is called the credit authorisation scheme; in Thailand, the credit planning scheme (See Richard Werner); and in Latin America, it was known as directed credit.
Implementing policy-guidance
For policy-guidance to be successful, strong institutional arms are required. This can be challenging as national economies contain a multitude of interests. Any policy-guided system needs to be equipped with industrial insights which in turn requires highly skilled labour. This is why most successful industrial economies, such as those in Scandinavia, still have a strong publicly-funded education system. Developing countries like Sri Lanka however, have been unable to mobilise such labour capacities due to privatisation and/or underfunded institutions.
One of the first steps in implementation is to categorise credit by sector, by amount, by the size of the industry, by market capitalisation, by locality, and so on. Therefore, to create a rational institutional pipeline to accommodate the dynamics of total lending, a level of decentralisation is needed. When banking systems are overly centralised, they often deviate from social needs and derail industrial growth. One such example is the Bank of Japan, which in the 1980s provided excessive credit for superficial consumption and speculation, leading to a devastating recession in the 1990s.
In most decentralised models, central banks are equipped with a set of satellite institutions. This can most clearly be seen in the case of China’s Central Bank, known as the People’s Bank of China, which has several institutional arms such as a Research Bureau which studies Chinese industries and, in 2015, published a landmark report on green finance which was praised by the United Nations Environment Authority.
Decentralisation can be structured based on regional units (such as provinces, districts, villages, etc.), or particular economic functions (such as manufacturing, agriculture, etc.). Regional decentralisation is useful as the economic interests of localities can vary based on their geography, climate, demographic composition, and so on. Regional decentralisation can help promote relatively even regional development and rural industrialisation. One good model for regional decentralisation is the German communal banking system known as Sparkassan which is nearly 170 years and has never needed to be bailed out. Sparkassan is known to be committed to local growth, is profitable (though not profit-oriented) and reinvests profits on local education and cultural activities.
Functional decentralisation is useful as it enables a smooth pipeline of credit to particular economic sectors. For example, loans for the agricultural sector should be guided by the corresponding institutions (such as the Ministry of Agriculture), which in turn should have it’s own research and development arms. A strong contemporary model for functional decentralisation is China, which has a range of banks dedicated to particular economic sectors such as the Agricultural Bank of China, the China Construction Bank, and the Industrial and Commercial Bank of China.
In practice, regional and functional decentralisation are not two contradictory models but systems that must be interwoven based on the implementing country’s particular developmental needs. For example, banks based on economic function could have regional units and/or banks based on the region could have functional units. Regardless of the particular institutional setup, credit lending units and policy research units of banks should be separated to maintain secularity and transparency in the lending process.
Finally, one of the most important parts of the policy-guiding process is auditing. As an exception to the earlier preference for decentralisation, auditing should be done by a centralised and independent body to avoid conflicts of interest. The process of such audits, alongside their findings, should be publicly available information, as only then can policy outcomes be fairly debated and adjusted.
Emphasising manufacture and exports
Most policy-guided banking systems have a common set of administrative tools to evaluate how credit should be guided. One of the main criteria is to look into how much a prospective borrower will contribute to the GDP of the manufacturing sector. In market-guided banking systems, manufacturing tends to receive less credit as it is a long-term investment that only generates profit in the long-run.
Since a country’s economic development is dependent on its capacity to accumulate capital, it is vital to promote manufacturing over services. The service sector contributes very little to capital accumulation since its value addition comes from the exchange, not production. In industrialised economies, the service sector emerged as value addition to the existing manufacturing sector and so policy should guide credit towards the latter. However, this doesn't mean that policy-guided banking should ignore the service sector completely. During the 1970s and 1980s in South Korea, the manufacturing sector received 46% and 54% of credit respectively, whereas the service sector received 29% and 24% respectively.
Policy-guided banking can help develop not only the consumer goods manufacturing sector but also the capital goods manufacturing sector, which is a key indicator of industrial development. A major difference between consumer goods and capital goods manufacturing is that the latter requires highly skilled labour, extensive industrial insights, and much more long-term financing. However, capital goods much more massive surpluses and the state can eventually regain its investments via taxation. The manufacturing of capital goods needs to be guided to help domestic industries reduce production cost and increase productivity.
A second criterion to consider is whether the prospective borrower is investing in production for export. Exports are important for policy-makers to emphasise since the foreign currency earned can be used to finance sovereign debt and necessary industrial inputs. However, caution must be exercised when emphasising exports, as export-guided business models can disrupt local industries, impoverish the home market, and lead to export dependency.
Guiding businesses towards productive industries requires a degree of consultation and intervention. For example, to incentivise the private sector to invest in strategically important industries, some of which require long gestation periods and therefore entail a degree of risk, public banks must provide risk-partnership. In other cases, borrowers from infant industries may need consultation and ‘mentoring’ to identify their industrial capacity and market niche. Sweden, which has the second-largest startup hub in the world, provides a good model for the ‘mentoring’ of infant industries by public institutions.
Emphasising SMEs and employment
When a firm is in at a level where it can raise its own funds based on market principles, it should be given the opportunity to do so. Mature and well-established industries have the freedom to take risks and maintain credibility in financial markets. Larger enterprises also often require larger amounts of credit. Therefore it can be most effective for policy-guided banking systems to focus on small and medium enterprises (SMEs), as these have more room to innovate as well as a tendency to create more jobs as a ratio of the credit they receive. In the EU and Japan, 70-80% of total employment was in SMEs in 2017. Due to their small size, SMEs can also provide better labour conditions, such as a share option for employees.
Since SMEs cant enter capital markets they often depend on developmental loan packages. Under market-guidance systems, large scale banks do not typically lend to SMEs since they expect high returns. Smaller banks may be more likely to lend to SMEs but they tend to be limited to their localities. This is why a decentralised developmental banking system is beneficial to stimulating industrial growth and employment opportunities, particularly in SMEs.
Problems with policy-guided banking
As with any other policy path, there are a number of common hurdles policy-makers may face when attempting to implement a policy-guided system of banking. These can be tackled based on contextual study and experience of countries that have previously faced such issues.
- Inflation - A common alarm raised by mainstream economists is the boogeyman of inflation. Credit should not be extended to consumption or welfare as these do create inflation and can trap consumers in debt. Consumption and welfare can be financed by progressive taxation policies. Policy-guided credit is specifically for developing industries and productive capacity. In post-war Japan, extensive loans with an interest rate of 3.5% were given out to industries, yet inflation stayed within single digits.
- Fiscal burden - Another common concern about policy-guided banking is that it could pose a fiscal burden, providing subsidies for rentier corporations that do not invest in industrial growth. In the short run, this is true, however, in the long run, when policy-guided industrial investments start to generate returns, these can be collected by the state via taxes. Therefore, it is crucial that policy-guided banking is complemented with strong direct taxation policy with an emphasis on capital gains.
- High-interest rates - In some cases, if private banks are allowed to play the role of provisioning credit in a policy-guided framework, they may charge higher interest rates as part of their administrative cost. This can price credit out of the intended market and disrupt policy implementation. Therefore, it is most efficient for public banks to take on the responsibility of providing policy-guided credit.
- Loan guarantee - Regulations should be in place to avoid turning loan guarantees into a source of financial instruments such as Collateralised Debt Obligations (CDOs). In some banking systems, liabilities can be turned into Asset-Backed Securities (ABS). However, this method of wealth creation is merely a process of extraction and can cause a financial domino effect as seen in the 2008 global financial crisis.
- Default - In the event that a borrower cannot pay back their loans, the bank will end up with a ‘junk bond’. An easy solution to this, as was practiced by Imperial Japan for their war bonds, is for the Central Bank to buy the junk bond from the bank and register the bond in the bank's reserve account at the Central Bank. No inflation is incurred in this process as no additional money is made.
- Stereotyped credit packages - when credit provision is left in the hands of financial institutions with a market-guided setup, credit schemes are often packaged into highly generalised and stereotyped packages. This is problematic as credit needs cannot be fitted into a one-size-fits-all package. Ideally, public banks should be funded and staffed in such a way that credit can be provided on a case by case basis. Otherwise, stereotyped credit packages have the effect of filtering out borrowers whose market segment or capital composition cannot neatly be fitted into a predetermined package.
- Cash flow - Most borrowers under policy guidance are likely to require long term credit, especially if such credit is meant to kickstart productive industrial activity. However, policy-guided banks need to maintain a smooth flow of cash, therefore, is necessary to maintain an ideal ratio of short-term loans to ensure that there is enough cash flow to keep servicing the main market segment, which is borrowers for long-term loans.
- Market ceiling - Determining the market ceiling for lending can be a challenge for policymakers and must be done on an aggregate level. This issue can be minimised by sectioning out credit volumes for priority market segments and industries.
Why Sri Lanka should adopt policy-guided banking
In recent years, Sri Lanka has adopted the exact opposite of policy-guided banking, as seen most evidently in the exponential growth of micro-credit in the northern and eastern provinces after the end of the armed conflict in 2009. With a relative lack of pre-existing funds to invest in the industrial development of the north and east, credit was logically needed to kick-start the capital accumulation process. However, the private financial institutions that performed this task operated with little to no public oversight and policy-guidance - creating a vicious cycle of debt in the region.
While debt traps are not unique to the north and east, it should be noted that the southern provinces have a much stronger presence of regional development banks. Though these banks are now dysfunctional due to institutional neglect, they are much more democratically organised and accountable to the community compared to their private-sector counterparts. This partially explains why the north and east has been so viciously ravaged by micro-credit compared to other provinces.
More recent initiatives like Enterprise Sri Lanka have sought to trigger entrepreneurial activity through loans. However much of the loan packages outlined have been directed towards superficial consumption, import-dependent services, and real estate speculation. Nearly every loan package in this scheme breaks the fundamental rule of credit which is to kick start productive industries and capital accumulation. If Sri Lanka is to learn from the industrial development of the Asian tiger economies, learning from the lessons of their policy-guided banking systems is an easy start. In Sri Lanka, since the opening up of the economy, the orthodox approach to encouraging private sector investment has been tax breaks, privatisation, and austerity. However, none of this has been successful in meaningfully transforming the economy on an industrial path. With policy-guidance, the state can use credit rather than tax breaks as a leveraging tool to guide private enterprises onto a path of industrial growth. Combined with a progressive taxation policy, this method can also ensure the continued funding and expansion of the country’s treasured welfare net.