Focus should be on retained profits and creation of investment credit
by banking system, Trade and Development Report recommends
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Geneva, 4 September 2008 - High prices for the commodities developing countries have long sold on world markets have greatly helped those nations in recent years, but they must continue to focus on economic diversification and sustained industrialization, UNCTAD´s Trade and Development Report 2008(1) says. One of the key messages of the report is that higher investment is needed in creating new "productive capacity" -- the ability to manufacture more varied and sophisticated products -- in these countries, and that the financing of such investment can come increasingly from domestic sources if the monetary and financial systems are designed to encourage it. The report, subtitled "Commodity Prices, Capital Flows and the Financing of Investment," was released today.
To step up investments that accelerate such structural changes, developing countries do not have to rely on an increase in domestic household savings and inflows of foreign capital, the report says. Rather, domestic monetary policy and local financial systems must be designed in such a way that private firms have access to reliable and affordable financing for investments that enhance productive capacities, efficiency, and diversification.
With this view, the report, known as the TDR, challenges mainstream theories of development finance that see investment in developing countries as coming from savings pools created mainly by household savings complemented by capital imports ("foreign savings"). "Not only are the assumptions of these models far from reality, but also their predictions have been repeatedly refuted by empirical evidence," the report says. It suggests an alternative approach, based on the works of Schumpeter and Keynes and deriving from the experiences of post-war Western Europe and recent successful "catching-up" experiences in East Asia, where financing of productive investment was based primarily on retained corporate profits and the ability of domestic banking systems to create credit.
Among domestic sources of investment, self-financing from retained earnings is the most important and most reliable, the report says. Bank credit is the second most important source of financing for enterprises, particularly for new businesses and small and medium-sized firms. "It is very important that a substantial part of firms´ earnings be reinvested in productive capacity", notes UNCTAD Secretary-General Supachai Panitchpakdi in the overview to the TDR 2008. The report suggests that financing investments out of retained profits could be promoted by a range of fiscal incentives, such as preferential tax treatment for reinvested or retained profits, or special depreciation allowances.
The report emphasizes that the power of banking systems to create credit based on liquidity provided by central banks has to be combined with strong institutional arrangements and additional policy instruments to maintain price stability. In particular it calls for an income policy that prevents excessive nominal wage increases, and for a flexible fiscal policy. This has been a successful recipe in the newly industrializing economies (NIEs) of East Asia, where real interest rates have been considerably lower than in most countries in Latin America and Africa, where monetary policy has tended to focus almost entirely on avoiding inflation. That has yielded a result of low levels of investment and slow growth.
Experience in many countries has shown that policies of high interest rates -- based on the assumption that prior increases in household savings and inflows of foreign capital are a prerequisite for higher investment -- are counterproductive. High interest rates reduce business profits through lower aggregate demand and higher financing costs, depressing domestic investment and income growth. According to the TDR, this is probably the main reason why the financial reforms undertaken by many developing and transition economies in the 1980s and 1990s failed to raise investment ratios. Rather than bringing a sustained increase in bank lending to private enterprises for investment purposes, these reforms mostly led to a boom in lending for consumption and real estate acquisition, often ending in financial and banking crises.
Interest spreads between central bank rates and deposit rates, on the one hand, and lending rates on the other, are still excessively high in most developing countries. Commercial banks in these countries find it mostly more profitable and less risky to extend consumption and housing credits, or to purchase government securities, than to provide longer term loans for investment projects or new business activities. Access to bank credit also depends heavily on the size of the firm, so that new, innovative and small enterprises, in particular, often encounter severe financing constraints even when they are able to pay high real lending rates.
"From the perspective of financing for development, it is not only the microeconomic profitability of an investment project that matters, but also the external benefits the project generates for the economy as a whole," the TDR notes. UNCTAD economists therefore recommend a stronger role for governments in influencing the direction of credit to strategically important sectors and activities. This can take, for example the form of direct provision of credit by public financial institutions or interest subsidies for selected projects. Stricter control of lending for consumption or speculative purposes could also encourage credit allocation to investment projects. In instances where high lending rates reflect high perceived risks, government guarantees might be considered for loans to finance promising investment projects of firms that otherwise might have limited or no access to longer term bank credit. One way to bring both commercial and development considerations to bear on credit allocation could be through joint financing of certain investment projects by private and public banks, bringing together private sector expertise in assessing the viability of a project and the strategic considerations of public institutions, whose participation in the financing of a project would also reduce the risks to the commercial bank involved.