Restructuring of financial system is needed to serve real economy, trade and development report says

​The financial system in most developed and developing countries fails to adequately channel credit towards productive investment in the real sector, argues a new United Nations flagship report. The study says that reform at the national and global levels is needed, not only to improve financial and economic stability but also to ensure that sufficient investment finance goes into productive activities and helps developing countries address the new development challenges that have emerged in the post-crisis environment.

Supporting productive investment would include greater long-term financing for industry, agriculture, services and infrastructure, the study notes. It says that credit – both currently and in the years leading up to the 2008 financial crisis – has too often been directed to consumption rather than to investment, and to asset bubbles in sectors such as real estate rather than to innovation and production.

UNCTAD’s Trade and Development Report 2013¹ subtitled Adjusting to the Changing Dynamics of the World Economy, was released today.

The report contends that a redesign of development strategies is not just a matter of reallocating existing resources; in most developing and transition economies, it also requires accelerating the pace of capital accumulation. Accordingly, these countries will have to organize and manage their financial systems in such a way that they provide sufficient and stable long-term financing for the expansion of productive capacities and for the adaptation of production to new demand patterns. These shifts should take into account a larger role being played by domestic and regional markets.

In attempting to spur productive investment, developing and transition economies should adopt a cautious and selective approach towards foreign capital flows, the report recommends. Such flows may be needed for financing imports of productive inputs and capital goods, but they have often tended to create macroeconomic instability, currency appreciation, and recurrent boom-and-bust financial episodes. The Trade and Development Report 2013 advises that these countries should rely increasingly on domestic sources of finance, the most important of which are retained profits and bank credit. Economic policies should therefore aim at encouraging the domestic investment of profits and at influencing the behaviour of the banking system so that it more consistently allocates credit to productive economic activities that will lead to job creation, sustained economic growth, and less vulnerability to global economic shifts.

For many years, foreign capital flows of almost any kind to developing countries were considered beneficial, as they were assumed to automatically expand investment rates. In some cases, capital inflows financed higher investment rates, either directly, as with greenfield investments, or indirectly, through loans effectively used for financing imports of capital goods. However, in the last three decades, excessive reliance on private capital inflows has tended to increase macroeconomic and financial instability, and to hamper, rather than support, long-term growth, the report says. In fact, a large proportion of foreign capital inflows has financed consumption or speculative financial investments that have generated asset price bubbles, led to currency appreciation, and made domestic financial systems more fragile. The subsequent drying up or reversal of inflows exerts pressure on countries’ balance of payments and on public- and private-sector financing.

The Trade and Development Report 2013 contends that what matters for developing countries is not simply access to external financing, but a degree of control over how that financing is used. These countries may have to apply macroprudential measures such as pragmatic exchange-rate policies and capital-account management to reduce vulnerability to external financial shocks and to help prevent lending booms and busts.

In addition, the report says, a more comprehensive change to the functioning of the financial system is needed in order to ensure that financing, both domestic and from abroad, is allocated to enterprises and investors who will use it productively. The Trade and Development Report 2013 argues that better regulation of the financial system is needed, aiming at both monetary and financial stability and at orienting the financial sector towards serving the real economy. This requires restructuring the financial system, especially banking. Such restructuring could include a larger and more active role for central banks, development banks, and specialized credit institutions.

Monetary policy alone is not sufficient to stimulate investment, as evidenced by large monetary creation in developed countries without a significant increase in financing for productive purposes, the report says. Several countries are introducing credit mechanisms to address what is perceived as a broken monetary mechanism; however, these are frequently introduced as extraordinary measures for dealing with the current exceptional circumstances. The report contends that there are strong arguments in favour of government intervention to positively influence the allocation of credit in normal times, especially in developing countries.

In particular, central banks should enlarge their mandates and, through a credit policy, play a much more engaged role in stimulating investment. Central banks should support maturity transformation in the banking system and encourage, or oblige, banks to provide more lending for the financing of productive investment. This is not radically new, the report notes; there are numerous examples from history and from developed and developing countries of central bank involvement in directing credit, including direct financing of non-financial firms, selective refinancing of commercial loans at preferential rates, and exempting certain types of bank lending from quantitative credit ceilings.

Credit policy can also be partly implemented by public, semi-public and cooperative institutions specializing in financing productive investment – say in agriculture, or to small and medium-sized enterprises – at preferential rates. National development banks should also provide loans and financial services that private financial institutions cannot or will not provide. These might include loans to borrowers perceived as too risky, such as start-ups, small businesses and innovative firms, or to long-maturing development projects in research and infrastructure. Such banks play an important role not only in providing an alternative source of countercyclical credit creation (as observed during the current crisis), but also because they contribute to ensuring a diversity of sources of finance. A network of diverse, specialized institutions is more likely to be efficient in directing credit to productive uses than is a system dominated by universal big banks that are not only “too big to fail” but also “too big to manage” and “too big to regulate”, the report contends.