Introduction to contemporary issues in development finance
The importance of finance in the economic growth and development process cannot be overemphasised. The literature is replete with evidence that suggests that finance contributes significantly to the economic growth and development process in any county. Although the extant literature generally supports the fact that finance and, for that matter, the financial sector are necessary for spurring economic growth by mobilising savings for investments, some have argued in recent times that it can also be a cause of fragility (where regulation is ineffective), as witnessed during the global financial crisis, the eurozone crisis, and the banking crises observed in certain economies. When the financial sector does not function properly, opportunities for growth and development are lost, resulting in inequalities and in some cases crises. However, when the financial sector functions efficiently, it provides the avenues for market players to take advantage of investment opportunities by channelling funds for production, thus driving economic growth and development.
Discussions in the finance and growth literature thus focused on the level of financial sector development. This was also in line with the view that the finance-growth link is stronger in well-developed financial systems and led to substantial dialogue around the depth, size, efficiency, and outreach of the financial sector. The type and the structure of the financial system in particular, whether bank based or market based, also became important points of debate in the finance-growth nexus. By the mid 2000s, however, the discussion moved to financial inclusion and emphasised access to financial services by the low income. The development of mobile money as a way to increase access further boosted this literature on financial inclusion. Financial inclusion soon became a prominent part of growth-enhancing strategies of countries and international finance institutions. Here the main difference between financial inclusion and financial sector development is that the former concentrates issues of access and use of financial sendees for the unbanked, while the latter deals with the development of the financial sector in general. Indeed, this difference becomes hazy because both can mean the same from a measurement point of view.
Economic growth has to do with the increase in the productive capacity of an economy in a year in relation to the previous year as measured by real gross domestic product (GDP). Economic development is also concerned with the process of creating and utilising physical, financial, human, and social assets to improve the economic well-being and quality of life of people in a community, region, or country. Whereas economic growth is a phenomenon of market productivity and an increase in nominal or real GDP, economic development is associated mainly with the economic and social well-being of people in a community, region, or country. The economic development efforts of countries must be sustained over time in order to produce positive economic and social outcomes. In the view of Seidman (2005), the economic development process creates assets that enable the community, region, or country to sustain and recreate its desired economic and community outcomes.
Unsurprisingly, the discussions in literature also moved to incorporate the need for inclusive growth. The emphasis was on the idea that growth must be beneficial to all and in particular for poverty reduction to be effective. Amid all of this has been the ever-constant debates around issues of causality: whether finance causes economies to grow, whether it is instead growing economies that result in higher financial development, and whether causality goes both ways and depends on stages of a country's development. There is also the vibrant debate on whether financial development can lift the welfare of poor households.
These discussions, however, do not question the fact that financing economic growth and development, especially in developing and emerging countries through the mobilisation of domestic resource as well as an appropriate level of external capital inflows, is an important issue. However, a financing gap develops when the financial system is inefficient and ineffective and when governments are also unable to mobilise resources. Precisely, development finance focuses on how domestic and the global financial systems facilitate the economic growth and development process. It also deals with structuring and reforming the financial system in ways that promote growth and development at both the macro level and the micro level in developing and emerging economies.
At the macro level, the focus is on financing the design and implementation of national development strategy, which is critical to the realisation of the country's development goals. Achieving country-specific development goals may also be related to the global development agenda. With respect to global development, the present emphasis is on how to finance the sustainable development goals (SDGs), which were set by the United Nations (UN) with a 2030 timeline (Biekpe, Cassimon, & Verbeke, 2017). The SDGs, otherwise known as the global goals, include 17 specific goals, which build on the progress made with respect to the millennium development goals (MDGs) and incorporate additional goals. Some of these new goals include reducing inequity, ensuring sustainable consumption and production patterns, combatting climate change and its impact, promoting peaceful and inclusive societies, and providing justice, among others. Also, at the micro level, the concentration is on how individual households, local communities, and firms are able to access the necessary finance to support their growth and development aspirations. However, a certain financing gap tends to constrain the achievement of these development targets - hence the need to design the financial system to be able to support the growth and development process.
PURPOSE OF THIS BOOK
This book examines issues in development finance by focusing on how financial systems and innovations in financial resource flow can drive the economic growth and development process. This emerging discipline seems to be gaining widespread recognition and importance across the globe and in Africa in particular. The literature on development finance is enormous. However, no recent text is available that covers the wide range of the literature in this area. The main contribution of this book is that it provides comprehensive coverage of the various critical and contemporary issues in development finance by carefully integrating relevant theoretical underpinnings, empirical assessments, and practical policy issues. With the expansion of economic development initiatives across the globe comes an urgent need for expertise and skills in development finance to drive, support, and manage them.
The book tries to be as complete and up to date as possible regarding recent theoretical discussions in the broad field of development finance. Therefore, the book provides a valuable resource for development finance researchers and for students taking courses in, for example, development finance, finance for development, development economics, international finance, financial development policy, and economic policy management. Every chapter contains a set of review questions, which may be helpful for students to better absorb the information provided. Given that we deliberately avoid overly technical discussions in the main text - more technical details are provided in 'boxes' - also practitioners with only a limited theoretical economic background will find the book a useful reference.
This first introductory chapter provides an overview of the other chapters in the book. In different chapters, the book pays attention to the general theoretical and empirical discussion on the relationship between financial development and economic growth; the importance of microfinance; the role of different types of external capital flows, distinguishing between external private flows, foreign aid, and international remittance; the importance of international financial architecture; the role of sovereign debt and wealth management; the role of financing different sectors in the economy, such as medium-size enterprises, infrastructure, the agricultural sector, and the external sector; and the recent discussion on financial inclusion and economic growth, including issues like mobile money transfers. However, because development finance emerged as a result of market imperfection and limited capital available, this chapter starts by discussing market imperfections and development finance. It also examines development finance interventions aimed at minimising the market imperfections and establishing development finance institutions to provide direct financing in the market. Finally, the chapter briefly discusses recent developments regarding financial inclusion and fintech.
MARKET IMPERFECTIONS AND DEVELOPMENT FINANCE
Development finance recognises the need to fill the gaps between capital required and capital available through various interventions. The financing gap is a result of financial market imperfections or the failure of financial markets to provide the requisite finance to support economic activity. Development finance interventions are aimed at ensuring the availability of capital when financial markets fail to supply the needed capital. These interventions include trying to curtail the imperfections in financial markets and institutions in order to improve the level of efficiency and establishing alternative development finance institutions to provide direct capital in the market.
At this stage, we bring up and discuss the concept of financial market imperfections. Financial market imperfection is concerned with the failure of financial markets to supply the required capital to finance economic activity. Market imperfections or financial market gaps occur when capital is not allocated in the most productive manner.
Microeconomic theory suggests that in perfect capital markets, capital is allocated perfectly, under the assumptions of complete markets, the perfect rationality of agents, and perfect or full information. Under these conditions, equilibrium is established when the interest rates clear the market when the supply of capital is equal to the demand for capital. However, when these assumptions are not present, market imperfections tend to occur. In the absence of perfect competition, suppliers of capital may seek to determine their own terms and may not be mindful of ensuring efficient allocation of capital. The high transaction costs and lack of information are a direct consequence of market imperfections.
Transaction costs are the costs of using the price mechanism, which include the cost associated with discovering relevant prices and the cost of negotiating and concluding contracts (Coase, 1937). In the financial market, financial institutions play an important role in contributing to reducing transaction costs. Minimising transaction costs is regarded as a necessary condition but not a sufficient condition for improving financial and economic efficiency. We now discuss how asymmetric information explains financial market imperfections. We also look at how imperfection in financial markets results in credit rationing.
A key feature of financial markets that results in market imperfection is asymmetric information1 between users of finance and providers of finance. The application of asymmetric information to explain financial market incompleteness, imperfections, and credit constraint is attributed to the work of Joseph Stiglitz in the 1980s. The problem of asymmetric information or information asymmetry arises because borrowers and providers of finance do not have equal access to information regarding the creditworthiness of the potential borrower. In more general terms, asymmetric information, sometimes referred to as information failure, describes a situation where one party to an economic transaction has better access to information than the other party does, resulting in an imbalance of power in transactions, which may cause the transaction to be skewed. The information-deficient party might make a different decision provided the information being withheld was made available. Asymmetric information may result in adverse selection and moral hazard.
ADVERSE SELECTION Adverse selection occurs when the lack of information in the financial market puts the lender in a position of being unable to distinguish good borrowers from bad ones. It occurs ex ante: before the lender provides a loan, or debt, contract to the borrower, on the basis of available information by the time of the event. It happens when the lender does not have the necessary tools to screen the borrower types and is thus unable to ascertain whether the borrower engages in riskier projects. For risky borrowers, there is a higher probability that projects will fail than for safe borrowers. However, if the project succeeds, the return will be higher for risky borrowers. In this situation, risky borrowers are likely willing to pay a higher interest rate than safe borrowers are. The consequence is that in case the bank increases the interest rate, safe borrowers decide not to borrow anymore, such that the bank ends up with a portfolio of only risky borrowers, a process indicated by the term 'adverse selection'. The bank does not know who the risky borrower or the safe borrower is but realizes that an increase in interest rates may have 'adverse selection' effects. To avoid this, the bank may decide in times of access demand for credit not to increase the interest rate but simply to ration credit. Box 1.1 provides further discussion on credit rationing and its implications.
Stiglitz and Weiss (1981) explain that the adverse selection theory of credit markets is based on two key assumptions: lenders are not able to differentiate between borrowers with different levels of risk, and the loan contracts are subject to limited liability in the sense that in the event that the project generates returns lesser than the debt obligations, the borrowers will not be responsible for paying out of pocket. The consequence of adverse selection is that financial markets are not efficient, in that good projects will not be funded, while bad projects will be selected.
MORAL HAZARD Moral hazard results from the lack of information regarding the ex post behaviour of borrowers - that is, the behaviour of borrowers after a debt contract has been signed with a bank. In more general terms, moral hazard occurs when after entering into a contract, the incentives of the two parties involved change, to the extent that the risk associated with the contract is altered (Heffernan, 2006). It refers to the borrower's engaging in high-risk strategies and applying the funds acquired for a purpose different from that for which they were sourced. After acquiring loans, borrowers may undertake risky projects, since they are not fully responsible for the funds, and the inability of the lender to control how the borrower applies the funds may lead to moral hazard. With increases in interest rates, the borrower is likely to be involved in such risky projects so as to increase the expected returns, and if the project is successful, the borrower gains, but if it fails, the lender assumes the default risk.
The default risk is one of the conditions of an imperfect market. The borrower may be in financial distress or become bankrupt, thus being unable to fulfil their indebtedness. Therefore, the promise and level of commitment by the borrower plays a significant role in the lending arrangement. One way by which the lender can secure the loan is to request the borrower to pledge collateral. Ray, Ghosh, and Mookherjee (2000) suggest that collateral minimises the default risk (for incentive reasons) and the lender's exposure in the event of default. In terms of reducing the default risk, the collateral makes the borrower's expected return of selecting risky projects lower than the expected return of safer projects. Thus, the borrower has no incentive for choosing risky projects. In the case reducing the lender's exposure, the loan contract is structured in such a way that the collateral provides the means by which the lender is able to recover all or substantial part of the loan given out in the event of default. There are, however, costs associated with the lender's seizing the pledged assets in the event of default.
BOX 1.1 Credit rationing and its implications
The concept of credit rationing has developed following the seminal papers by Jaffe and Russell (1976) and Stiglitz and Weiss (1981) and can be depicted by the market for supply and demand of loans.
An interest rate r* maximizes the expected return to the bank. Excess demand can exist at this interest rate but not induce banks to increase the interest rate above r*. Under such conditions, banks cut the supply of loans (backwards-bending supply), at interest rates above r* where demand DL exceeds the supply of funds (SL). Unsatisfied borrowers bid up the interest rate until rm, which marks the beginning of credit rationing. Some individuals can acquire loans, albeit at a higher interest rate, while others cannot. However, hiking the interest rate or reducing the collateral requirement could increase the riskiness of the lender or loan portfolio of the bank, either by discouraging safer investments or by encouraging borrowers to undertake riskier investment projects, thus reducing the lender's profits. The implication is to reduce the number of loans that the lender provides. In an extreme case, the backwards-bending supply curve touches the interest rate (vertical) axis, and there is full rationing and total exclusion for some large portion of individuals and entities.
FIGURE 1.1 Credit rationing and its implications
Credit rationing is a result of capital market imperfections, which are characterised by information asymmetry and its consequent adverse selection and moral hazard.
Keeton (1979), Stiglitz and Weiss (1981), and Jaffe and Stiglitz (1990) provide specific definitions of two types of credit rationing:
Type 1. Pure credit rationing happens when some individuals acquire loans, while apparently identical individuals, who are ready to borrow on exactly the same terms, are not able.
Type 2. Redlining arises when some identifiable groups of individuals, given a particular supply of credit, are not able to acquire loans at any interest rate, but given a larger supply of credit, they would.