World Bank Reprint Series: Number Twenty-one REP21December 1974

V.V. Bhatt

Some Aspects ofFinancial Policies andCentral Banking inDeveloping Countries

Reprinted from World Development 2 (October-December 1974)

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World Development Vol.2, No.10-12, October-Deceinber 1974, pp. 59-67 59

Some Aspects of Financial Policies and Central

Banking in Developing Countries

V. V. BHATT

Economic Development Institute of the International Bank for Reconstruction and

Development

mechanism and agency as provided by the existence of aCentral Bank.

What needs special emphasis at an international levelis the rationale and urgency of evolving a sound financialstructure through the efficient performance of the twininterrelated functions-as promoters and as regulators ofthe financial system-by Central Banks.

1. SOME ASPECTS OF FINANCIAL POLICIES

.. . ~~~The main object of this Section is to show theEconomic development is not only facilitated but its . . .

pace is quickened by the appropriate development of the significance of saving and flow-of-funds analysis as anfinancial system--structure of financial institutions, indicator of a set of financial policies-policies relatinginstruments and interest rates.1 to the structure of financial institutions, instruments and

Instruments and interest rates.r interest rates-essential for resource mobilization andIn any strategy of development, therefore, it is allocation consistent with a country's developmentessential to emphasize the evolution of a sound and . 6 cwell-integrated financial system from the point of view objectives.

In a large number of developing countries, the onlyboth of resource mobilization and efficient allocation.2 reliable data available for understanding the trends in theIn Section I of this paper, an attempt is made to economy and for policy purposes relate to monetary

delineate the broad contours of a set of financial policies flows and the balance of payments. These data thusthat seems to be consistent with any sound strategy of assume critical significance. Flow-of-funds data are notdevelopment. In Section 11, the role of Central Banks is available for a large number of countries but are such asemphasized, not only as promoters but also as regulators

of sound integrated financial systems. These twofunctions are interrelated: the function of Central Banksfunctins is intefeacted rheinocdb hi function oCetaBans 1 See Raymond W. Goldsmith, Financial Structure andas regulators is m fact remforced by their function as Development (Vale University Press, 1969).promoters. 4

In spite of the dynamic catalytic role of the banking 2. See Ronald l.McKinnon, Money and Capital in Economicsystem in promoting economic development,5 it is some- Development (The Brookings Institution, 1973)

what strange that, at an international level, this role is 3. See R. S. Sayers, Ceitral Banking in Underdevelopednot sufficiently stressed in providing technical and Countries (Cairo, 1956).financial assistance to the developing countries for thepurpose of promoting the evolution of sound financial 4. See John I-licks, Capital and Growth (Oxford, 1965)systems. The International Monetary Fund emphasizes Chapter XXIII, p. 292. Hicks writes: 'There is a place for

monetary policy .... It can perform its function more satisfac-the regulatory role of Central Banks only, while the torily ... if it is backed by an efficient system of financialInternational Bank for Reconstruction and Development intermediaries.' See also pp. 290-2lays stress on the development of specialized financialintermediaries only. The result is that a large number of 5. See Joseph A. Schumpeter, Business Cycles (New York,central banks have not been appropriately oriented 1939) Volume 1, pp. 109-29. See also Alexander Gerschenkron,

Economic Backwardness in Histoncal Perspective (Cambridge,towards development objectives in general, and to the Massachusetts, 1962) pp. 10-15 and Rondo Cameron et al.

development of sound financial systems in particular. (eds.), Banking in the Larly Stages of Industrualization A StudyFurther, the evolution of specific financial inter- in Comparative Economic History (Oxford, 1967)mediaries takes place in such a way as to promote 6. For a discussion of saving and flow-of-funds analysis as afurther fragmentation of the capital market; or at any technique for financial planniing, see V. V. Bhatt, 'Saving andrate the policy of merely promoting specific financial flow-of-funds analysis: A tool for financial planning in India',intermediaries does not stress the need for an integrative The Review of Income and WVealth (March 1971).

60 WORLD DEVELOPMENT

Table 1. Sectoral surpluses and deficits (-): 1950-59

Percent of Gross Domestic Product

Developed Less developed Allcountries countries countries

1. Households 6.1 3.5 4.82. Enterprises' -7.6 -4.9 -6.33. Government 1.3 -0.7 0.34. Rest of the World -0.1 2.1 1.0

Source. R. W. Goldsmith, Financial Structure and Development (Yale, 1969) p. 441.

* Includes government enterprises.

Table 2. Pattern of household saving

India USA

(1963-4) 1909-14 1960-4Form of Saving % % %

1. Financial assets 66.7 98 123(5.5) (8.83) (10.09)

2. Financial liabilities -16.7 -46 -86(-1.4) (-4.17) (-7.06)

3. Physical assets 50 48 63(4.1) (4.35) (5.17)

4. Total (1+2+3) 100 100 100(8.2) (9.01) (8.20)

5. Percentage share of householdsaving in national saving 67.2 - 61

Figures in brackets indicate proportion of personal disposable income.

Sources. V.V. Bhatt, 'Saving and flow of funds analysis: A tool for financial planning in India', TheReview of Income and Wealth (March 1971). R. W. Goldsmith, 'Changes in the structure of personalsaving', Saving in Contemporary Economic Research (Congress Palace, Brussels, 1965).

can be reliably compiled and presented. The data the projected volume and pattern of investment.relating to corporate enterprises and financial inter- Further, various policy instruments can be rationallymediaries are available and can be consolidated in the used for attaining financial balance only when the degreerequired form with some effort. Similarly, data relating and nature of imbalances are clearly known throughto the, government sector and the balance of payments flow-of-funds analysis.are available and can be presented in flow-of-funds formalong with the data for corporate enterprises and A. Characteristic features of saving and flow of fundsfinancial intermediaries. The data relating to the govern- Saving and flow-of-funds analysis brings out thement sector, corporate enterprises and financial inter- crucial importance of household sector saving formediaries can provide the necessary information relating financing the saving deficits of the government sectorto the transactions of these sectors with the household and the private corporate sector. Generally, the lattersector-an omnibus term for the sector comprising all two are deficit sectors and the only surplus sector is theunincorporated enterprises and households. Thus, pro- household sector which finances directly and indirectly,vided the usefulness of flow-of-funds analysis is through the financial institutions, a part of the deficitsrecognized, it may not be difficult to collect and process of the other two sectors. The external sector financesdata in this form. the residual deficits.

Whatever the development objectives and whatever Table 1, on Sectoral Surpluses and Deficits duringthe nature of planning or programming, it is essential to 1950-59 in 14 developed countries and 10 developingaim at financial balance. This balance indicates that the countries, brings out this fact clearly. In the developinginvestment demand for resources of the deficit sectors is countries, both the government and business sectorsmet by the supply of required resources from the surplus have deficits-that is, their total expenditures exceedsectors. In most of the developing countries, and in the their incomes, while the household sector shows adeveloped countries, the surplus sector is the household surplus and finances, along with the external sector, thesector which provides resources directly, or indirectly deficits of the government and business sectors. In thethrough the financial intermediaries, to the government ueveloped countries, the government sector shows asector as well as to the corporate sector. The other surplus. However, in the data available, governmentsector which provides resources to these deficit sectors enterprises are included in the business sector; if thesein the developing countries is the external sector through enterprises were shown in the government sector, it isofficial external assistance and private foreign invest- likely that the government sector too would have been ament. For the viability of a development program, it is deficit sector.essential that these resource-flows are consistent with The second significant implication of the saving and

FINANCIAL POLICIES AND CENTRAL BANKING IN DEVELOPING COUNTRIES 61

flow-of-funds data is that the saving surplus of the these rates. And secondly, these high rates inducehousehold sector that can be potentially transferred to speculative investment-investment in land, realthe other two sectors is represented by the household estate, scarce commodities, gold and the like. Thus,saving in the form of financial assets. Of course, a part of on the one hand, potential productive investment isthis surplus returns to the household sector via its not taken up and, on the other, resources are divertedborrowing from the financial institutions. toward undesirable forms of investment.

Household sector saving is partly in the form of (iii) Because of the existence of this unorganizedphysical assets like residential housing, equipment, and market, government economic policies-credit as wellinventories of goods, and partly in the form of financial as fiscal policies-are not very effective in influencingassets. Saving in the form of physical assets represents the magnitude or the pattern of investment in thehousehold sector investment, which is financed partly by household sector.direct saving of the sector and partly by borrowing from (iv) Most of the plans in the developing countriesthe financial institutions. require a rapid growth of investment in the govern-

Table 2 shows the household sector saving pattern for ment sector and the private corporate sector. This isIndia (1963-4) and for the USA (1909-14 and not possible without an adequate transfer of house-1960-4). It appears from this table that about 50 per hold saving to these two sectors. Such a transfer cancent of household sector saving was in the form of net be facilitated only if a major part of household sectorfinancial assets (net of financial liabilities) in India saving were in the form of financial assets. In that(1963-4) and the USA (1909-14). Thus, the household case, government economic policies could be effectivesector transferred half of its saving to the other two in attaining an efficient allocation of saving amongsectors. the various sectors of the economy.

The USA data for 1960-4 reveal a picture that issomewhat different and possibly indicates the nature of C. Policy implicationsevolution of the household sector saving pattern for the For evolving an integrated and efficient capitaldeveloping countries. These data show that a dominant market, it is thus essential to induce the householdpart of the saving was in the form of financial assets and sector to save a greater part of its surplus in the form ofthat own saving used for direct investment was financial assets. The next logical problem is to find outnegligible. Household sector investment was financed the type of financial instruments that are consistent withcompletely by borrowing from the financial institutions. the saving preferences of the household sector.There was in fact excess borrowing (that is borrowing The structure of household sector financial saving isexceeded investment in physical assets) which financed shown in Table 3 for some developed as well as develop-the acquisition of consumer durables, which are not ing countries. This structure reveals that with the evolu-included in the data on saving. tion of financial institutions, the household sector

prefers to hold more than 50 per cent of its financialB. Desirable pattern of honsehold sector saving saving in the form of money and deposits. The second

It is quite likely that in the developing countries, too, significant preferred asset seems to be claims on socialsaving in the form of financial assets and borrowing from security institutions-life insurance, pension and pro-financial institutions would tend to dominate the saving vident funds and the like. Thus the major part ofpattern over a period of time. This may happen; how- financial saving seems to be in the form of claims onever, it should be the aim of financial policies to quicken financial institutions. Excepting in a few countries likethis process for several reasons: Belgium and Malaysia, saving in the form of direct claims

(i) It is quite likely that the full potential saving of on the non-financial sectors is less than 25 per cent ofthe household sector is not mobilized due to the the total financial saving; in the USA and UK it isinadequate development of financial institutions and negligible.instruments consistent with savers' preferences. In the The trend, thus, seems to be towards a financialdeveloping countries, the capital market in the rural structure in which indirect financial saving (that is,and semi-urban areas is highly fragmented. Potential saving in the form of claims on financial Institutions) issaving in one part cannot easily be transferred to gaining at the expense of direct saving (in the form ofother deficit units. Further, due to inadequate direct claims on the government and corporate sectors)facilities for borrowing on reasonable terms, the and in which borrowing is increasing in importance. Itpotential saving may be inadequate to finance invest- seems desirable for the developing countries to assist thisment required by these units. For both these reasons, trend and concentrate their efforts on bringing about orthis potential saving may prove abortive and be used facilitating those changes in financial structure, and infor consumption. 7 the laws and regulations which affect it, that will ensure,

(ii) The financial institutions finance a very small or at least make more likely, that a predominantlypart of household sector investment. In India, the indirect and institutional and largely contractual andproportion of investment financed by the financial compulsory flow of personal saving contributes as muchinstitutions does not exceed 15 to 20 per cent. A as possible to economic growth.8 For this purpose,major part of investment is, thus, financed by ownsaving and borrowing from the surplus units and 7. For the effects of a fragmented capital market and theprivate moneylenders/indigenous bankers, which con- significance of financial development, see Ronald 1. McKinnon,stitute the so-called unorganized market for capital Money and Capital in Economic Development (Washington,

funds. Interest rates in this market are very high and D.C. The Brookings Institution, 1973).

range from 20 to 35 per cent per year. These high 8. See R. W. Goldsmith, 'Changes in the structure of personal

interest rates have two consequences. Firstly, worth- saving', in Saving in Contemporary Economic Research (Con-

while productive projects cannot be implemented at gress Palace, Brussels, 1965).

Table 3. Structure of household sectors'financial saving

(in percentages)

Securities

Thrift Contractural Central govt. Other Corporate TotalMoney deposits saving bonds bonds stock Total Others saving

Z USA (1960-4) 8 52 37 2 4 -3 3 - 100g UK (1960-4) 27 38 76 12 17 -27 1 -42 100

France (1960-4) 51 23 4 - - - 18 3 1000. Germany (1960-4) 8 47 30 12 - 4 16 - 100> Belgium (1959-64) 45.7 20 - - - 33.8 0.4 100: Italy (1964-5) 61.7 11.5 - - - 14.1 12.8 100

Japan (1959-64) 19 44 10.0 -1 4 18 21.0 6.0 100_. Australia (1957-61) 18 33 25 -16 34 5 23 - 100X Greece (1961-5) 84.4 1.2 - - - 14.4 - 100C3 Korea (1958-9) 38 31 1 8 3 13 21 6 100

Malaysia (1955-8) 5.6 68.9 - - - 25.5 - 100Philippines (1956-60) 23 22 38 17 - 100Sri Lanka (1955-9) 45.2 43.6 - - 8.1 3.2 100India (1963-4) 53.4 27.7 11.0 - 7.9 18.9 - 100

Sources. R. W. Goldsmith, loc. cit. Organization for Economic Co-operation and Development, Capital Market Study (Paris, 1967-8). V. V. Bhatt, 'Saving and flow of fund analysis', ReserveBank of India Bulletin (September 1965). 'Measures for mobilising domestic saving for productive investment', Economic Bulletin for Asua and the Far East (December 1962). S. Joshi Madhusudhan,'Financial institutions and financial policy for economic development', Pralnan (Bombay) Vol. 1, No. 2 (April-June 1972).

\.0

FINANCIAL POLICIES AND CENTRAL BANKING IN DEVELOPING COUNTRIES 63

several important changes will be called for in govern- in the form of bank deposits rather than in the formment and business policies from those now accepted in of private lending, gold, real estate or inventories ofmany countries. To give just one example, governments commodities.12

will have to abandon the policy of attempting to bring (iv) Compulsory provident fund schemes haveback, or to create, a broad market for government and proved attractive in several countries like Malaysiacorporate securities among individual buyers. It does not and India. Such schemes should be introduced toseem to be essential for developing countries to pass cover wage arid salary earners in as many sectors asthrough that phase of the evolution of financial systems possible. Social security deposits have been a pre-through which the developed countries passed several ferred asset in both developed and developingdecades back. countries as we have discussed earlier. Their full

potential should be exploited.D. Framework Jor econonmic and financial policies (v) The other asset which savers seem to prefer is

To stimulate indirect financial saving, several institu- insurance policies. Life insurance facilities should betional and policy measures seem to be essential: expanded. For farmers, life insurance may not be as

(i) Since thrift deposits-saving and fixed deposits attractive as crop insurance; it may be possible to-seems to be a preferred asset, the institutional introduce compulsory crop insurance schemes thatdevelopment that should have first priority should be are attractive to farmers. For these purposes, bankthe widening and deepening of the geographical and branches can function as agents of insurancefunctional scope of the commercial banking system. companies so as to minimize administrative expenses.This system has already evolved in the developing Some bank deposit schemes can be linked with lifecountries but its scope is largely restricted to urban insurance as well as crop insurance. 1 3areas and to the financing of modern enterprises in (vi) To induce a higher rate of over-all savingindustry and trade. Instead of creating new institu- through saving in the form of specifie.d financialtions, it seems to be more rational and economical to assets, it is possible to exempt such saving for theexpand the scope of this system through the creation purpose of income tax by permitting such saving toof a nation-wide network of bank branches, and be deducted from taxable income.1 4 In a number ofenlarging their functional scope. Such a system need countries, provident fund subscriptions and insurancenot restrict its role to that of purveying credit and premiums are deductible for the purpose of incomedeposit mobilization; it can also provide entre- tax; the scope of such deduction can be widened bypreneurial and managerial guidance to agriculture and including all financial saving other than that in thesmall industry. The functions of such a system are form of currency and gold. 1 5discussed in my book, Structure of Financial Instito- These policy measures are likely to modify thetions. 9 pattern of household sector saving in favor of financial

(ii) Savers are likely to prefer a financial instrument assets. The saving-investment process thus can be madethat is simple, convenient and easily intelligible, that more efficient than it is. The allocative efficiency of andoes not involve transactions costs and that can be integrated capital market would be much greater thaneasily and without loss converted into money. that of the isolated markets existing at present. Thus,Interest-bearing deposits of various maturities do these measures would not only raise the rate of financialprovide such a financial asset. However, to make saving, but also improve the productivity of investment.them attractive to savers, it is essential to devise suchdeposit schemes as are linked to the basic motives tosave. Apart from the link of deposits with savingmotives, some deposit schemes should also be linkedwith certain services desired by savers. Some possibledeposit schemes are discussed in my book. 10 Thusthe real return on deposits-return inclusive of 9. V. V. Bhatt, Structure of Financial Institutions (Bombaytangible and intangible benefits other than interest Vora & Co., 1972).-would be sufficiently attractive to induce savers toprefer this form of financial asset to private lending 10. ibid.

or other physical assets like gold, real estate, com- 11. See Deena R. Khatkhate, Analytic Basis of the Working ofmodity inventories and the like. Monetary Policy in Less Developed Countries, IMF Staff Papers

(ih) Apart from this, the monetary yield on various (November 1972).types of deposits should be comparable to the yield,exclusive of risk premium, on private lending. 1 1 The 12. See Anand G. Chandavarkar, Some Aspects of Interest Rate

Policies in Less Developed Economies The Experience of Select-yield on private lending is high but involves a certain ed Asian Countries, IMF Staff Papers, Vol. XVIII (1971).degree of risk. If the banks enter the field of lendingso far monopolized by private lenders, the interest 13. See V. V. Bhatt, Structure of Financial Institutionsrate is likely to decline. Taking into account this (Bombay. Vora & Co., 1972).

possible decline in yield on private lending and the 14. See V. V. Bhatt, 'Taxation for economic development',risk premium attached to such lending, deposit rates Development Digest (October 1973) and Economic and Politicalshould be so fixed as to be comparable to these Weekly (24 Junie 1972).adjusted rates on private landing. Interest rates assuch may or may not have much impact on total 15. See Joseph A. Schumpeter, Capitalism, Socialisnm and Demo-

cracy, Third Edition (New York' Harper Torchbooks) pp.saving, but it certainly has a substantial impact on the 423-4, and Richard V. Clemence (ed.), Essays of J. A.

pattern of saving. The interest rate structure, then, Schumpeter (Cambridge, Massachusetts, 1951) pp. 245-6 andshould be such as to induce savers to keep their saving pp. 302-5.

64 WORLD DEVELOPMENT

Further, it would then be possible to regulate the Central Bank becomes not only 'central' but also amagnitude and allocation of investment by means of 'bank', its function to supervise and direct the growth ofavailable policy instruments.1 6 banking would be without adequate sanctions. It should

not be merely a lender of last resort; it has to be a lenderof early resort and in some cases a lender of primary

11. ON CENTRAL BANKING resort. This need not mean continuous indebtedness; thebanks, however, should feel free to approach the Central

There is a significant difference between the role of a Bank for help from time to time. Only then would theCentral Bank in a developed country and that in a banks have an incentive to listen to Central Bank advicedeveloping country; and this difference arises from their with respect.2 0

different stages of development. The monetary and For meeting the long-term credit needs of variousfinancial system was already well-developed when the sectors for financing investment projects, it is notCentral Banks were set up in the developed countries. In essential, in principle, to evolve separate institutions likethe theory and practice of central banking, hence, it is development finance companies. The banks, as thethe regulatory role of the Central Bank that is principal mobilizers of saving, should be able to performemphasized. 1 7 this function at least in the initial stages. With their

Central banking has to be thought of quite differently nation-wide branch network, it is the banks which wouldin the developing countries where the financial system have close and intirnate contact with agriculture andhas yet to evolve to a stage reached in the developed industry and, at the same time, it is they who would becountries. In these countries, the role of the Central in a better position to meet the term credit needs ofBank cannot be restricted to that of a regulator, for the these sectors than would a new institution without ainstitutions to be controlled and the credit system to be branch network and without the banks' resources. Forregulated have still to evolve to necessitate a regulator. 1 8 the purpose of division of labor and exploiting the

The role of the Central Bank has to be conceived in advantages of specialization and scale economies, thethe context of evolving a sound financial infrastructure banks could develop specialized departments orconducive to rapid development. It is the Central Bank specialized subsidiaries. 2 1

that has to take the lead in evolving the credit Such an evolution of the banking system has con-institutions, instruments and yield-structure that are siderable advantages from the point of view ofessential for: strengthening and fortifying the power of the Central

(a) the efficient mobilization of saving, and Bank to regulate credit; Central Bank policy instruments(b) the allocation of resources consistent with to affect the cost as well as availability of credit would

development objectives. be much more effective in influencing not onlyThis developmental function needs to be performed in inventory investment but also fixed investment than insuch a way that the Central Bank is able to maintain the case where term credit institutions were isolatedclose, continuous and active contact with the credit from the banking system. 2 2

system so essential for the success of its regulatoryfunction. If such contact were maintained, the ability of B. Regulatory functions: limitations

the Central Bank to regulate credit would be much A Central Bank's effectiveness is regulating creditgreater than it is in a developed country. depends upon the geographical and functional scope of

the banking system and the extent of the latter'sA. Promotional function dependence on the Central Bank for assistance.

In a large number of developing countries,commercial banks have evolved to finance the creditneeds of foreign trade, the industrial activities that are

nees o foeig trde,theindstral cmodtern indutaria 16. See V. V. Bhatt, 'Central banks: Their regulatory functions',ancillary to such trade and the modern industrial Development Digest (April 1974) and 'Industrial developmentstructure. However, the credit needs of agriculture, small bank of India: Recent evolution in its role and functions',business and industry and a large number of traditional Prajnan (Bombay), Vol. 1, No. 3 (July-September 1972).

enterprises are still met by the non-banking traditional 17. John Hicks, Cntical Essays in Monetary Tbeory (London:institutions like moneylenders. What is required in this Oxford University Press, 1967) pp. 158-9.

set-up is a wider geographical and functional penetration 18. See R. S. Sayers, Central Banking in Underdeveloped

of the banking system. It is the Central Bank that has to Countrnes (Cairo: National Bank of Egypt, 1956).take a lead in this matter.1 9

Again, it should be the Central Bank's responsibility 19. See Sayers, op. cit., p. 7. Sayers writes: 'Another serviceto ensure that the evolving banking system is viable, its having immense potentialities ... is the contribution a Central

Bank can make to the growth of a sound structure ofpractices sound and its venturesomeness tempered by commercial banks and other financial institutions .. . but the

wisdom. Regular periodical inspection of banks from emphasis in early days must be on the development of a bankingthis point of view is essential for the sound development system to control. This is not only a logical order; it is also theof banking. This would inspire confidence in the system. historical order of events in the underdeveloped country I haveTo inspire confidence among savers, some form of most studied the England of earlier centuries ... . it must bedeposit insurance would be necessary and to induce the not only central but also, and very actively, a bank.'banks to meet the credit needs of agriculture and small 20. See Sayers, op. cit., p. 13-14.enterprises of all types, some credit guarantee organiza-tion needs to be developed. 21. See Sayers, op. cit., p. 13-15.

Apart from these devices, it is essential for the 22. John Maynard Keynes, The General 7beory of Employ-

Central Bank to do banking business with the banks and ment, Interest and Money, First Harbinger Edition (1965) pp.the other institutions without inhibitions. Unless the 205-6.

FINANCIAL POLICIES AND CENTRAL BANKING IN DEVELOPING COUNTRIES 65

if the banking system's functions are restricted to modern sector and to the sectors linked to it. It can raisemeeting the credit needs of only modern industry and the cost of its credit to the banks which, in turn, wouldtrade, a Central Bank's power to regulate credit alloca- raise their rates to their borrowers. The increased cost oftion among the other sectors would be limited, as it has borrowing can be made effective by restricting thebeen in many countries. The funds in the so-called banks' lending power by raising their net liquidityunorganized market can be switched from one line to ratios-that is, the ratio of cash and liquid assets, minusanother in search of speculative profits and the Central Ccntral Bank borrowing, to total deposits.Bank would not have much control over interest rates or A Central Bank can also regulate credit to specificlending patterns. Of course, the over-all supply of funds sectors by means of selective credit controls operated inand over-all money supply would still be within the the context of over-all credit control. Since it haspowers of the Central Bank to regulate, but the lending sanctions, it can ask the banks to raise margin require-pattern and the yield pattern in sectors other than those ments as well as the cost of advances to specific sectorscovered by the banking system would be outside the which require separate regulation for example, whereCentral Bank's control. The availability of credit outside there is speculative stock building of commodities inthe system would affect the Central Bank's control over short supply.the modern sector also. It can, likewise, encourage banks to lend to specific

In such a situation, a Central Bank faces a dilemma. sectors by linking its own credit to banks with theToo tight control on the banks may mean starving the latters' credit to such sectors.modern sector of required credit, while lack of such The traditional central banking instruments like opencontrol would mean supplying 'resources to the un- market operations are unlikely to be successful in vieworganized market, over which the Central 13ank has no of the narrowness of security markets. Bank ratecontrol. This is, doubtless, one of the reasons why coupled with powers to vary reserve ratios and netcredit-creation by the Central Bank turns out to be liquidity ratios are likely to be much morc effective.excessive in some developing countries. Depending on the contact of the Central Bank with the

There is another reason for a similar situation to arise, banks and the latters' dependence on it, moral suasionand that is the excessive reliance of government on can also be quite effective in regulating the over-allCentral Bank credit.2 3 Being short of resources in volume and structure of credit.relation to mounting needs, governments tend to rely on The real limitations on the Central Bank arise as aCentral Bank credit to an extent that generates excessive result of:increases in money supply, with inflationary (a) the excessive reliance of the government onconsequences. Central Bank credit; and

In a situation like this, the Central Bank's ability to (b) the lack of integration of money and capitalcontrol and regulate credit again becomes limited. Of markets.course, it can tighten credit and make it costly for the The second limitation would be overcome with themodern private sector; but then this tends to affect geographical and functional extention of the role of theoutput in this sector adversely and thus aggravate banking system.2 4

inflationary pressures.D. Structure of interest rates

C. Regulatory function: policy instruments Central Bank policy with regard to interest rateA Central Bank's ability to regulate credit depends structure has considerable significance from the points

upon: of view of:(a) the extent of reliance of the modern sector on (a) inducing savers to invest in bank deposits and

bank credit; other financial assets; and(b) the reliance on trade credit from the modern (b) bringing about a rational allocation of

sector of the sectors linked with the modern resources.2 5

sector; Savers can be induced to keep their savings in the(c) the dependence of the banks on Central Bank form of financial assets if the yield on such assets is

assistance; and comparable to that on physical assets like real estate and(d) the policy instruments available to Central Bank. gold and commodities, after making allowance for riskIn a large number of developing countries, with a premia and transaction costs.

rapidly expanding modern sector, the latter does rely on In a climate of reasonable price stability and withbank credit to a significant extent. Again the modern such comparable yields on financial assets, it is possiblelarge enterprises do extend trade credit to sectors linkedwith them

The banks' dependence on Central Bank creditdepends on alternative sources of funds. If branches of 23. Hicks, op. cit., pp. 168-71.

international banks are dominant, their reliance on theCentral Bank may be marginal. If the inflow of banking 24. See Sayers, op. cit., pp. 19-25. He writes: . . . centralfunds is controlled and the modern sector is rapidly banks, if they are not narrowly conceived, can be a real help to

banks may fnd their ow resources these countries in making economic activity less irregular-butexpanding, banks may find their own resources that their power must remain slight if they have to work in ainadequate periodically to meet the credit needs of the banking vacuum. The encouragement of the growth of soundmodern sector. Again, if the Central Bank has powers to commercial banking throughout the economy must alwaysvary the net liquidity ratio of banks, it can make the occupy first place on the agenda of a new Central Bank' (p 24).

banks marginally dependent on Central Bank credit. 25. V.V. Bhatt, Structure of Financial Institutions (Bombay.

In such a situation, the Central Bank can regulate Vora & Co., 1972) Chapters 4 and 12. See also John Hicks,both the cost and the availability of credit, both to the Capital and Growtb (Oxford University Press, 1965) Chapter 23.

66 WORLD DEVELOPMENT

to raise the rate of financial saving and thus bring about high-almost double the rate in the USA, France orgreater integration of the money and capital markets. Germany. During 1960-9, this saving comprised 19 per

Again, to achieve a rational allocation of resources, cent of disposable income, as against 9.6 per cent in theinterest costs to borrowers should reflect the relative USA, 10.3 per cent in Germany and 10.0 per cent inscarcity of capital. The rate of interest on bank credit, as France. A much more important factor has been thewell as the interest costs of other forms of borrowing, dominance of financial saving (more than 11 per cent ofshould, therefore, be related to the yield on- real disposable income) and again the dominance of bankinvestment that is consistent with the attainment of deposits in financial saving (about 80 per cent or moregrowth targets. of financial saving being in the form of bank deposits or

It appears that, in most of the developing countries, bank debentures). 2 7

the lowest rate-that is the rate on one year's deposits- Thus saving of the household sector is mobilizedshould not be lower than 6 per cent per year and the primarily by the banks and it is they who financeannual rate of return on agriculture and industrial investment in the economy. Because of the high rate ofprojects should not be lower than 15 per cent. The other investment (about 40 per cent of GNP) and its rapidrates should fall within this range depending on risk growth, the business sector is able to finance only 46 perpremia, transaction costs, marketability and liquidity cent of investment by ploughing back profits; of theattached to specific financial instruments. This rate rest, more than 80 per cent is financed by the banks.structure should be in real terms. On the assumption of Straight issues of stock and foreign borrowing are ofprice stability, the rate structure should be as suggested. marginal significance.

The banks-the big city and long-term investmentE. Basic limitations of monetary policy banks-finance mainly large enterprises and their pro-

Central Banks had effective monetary policies in an jects, and the large enterprises finance-via trade credit-environment which now no longer exists-in which the small firms. Thus, the small firms too are indirectlygovernments had, by and large, balanced budgets and financed by the banks.exchange rate stability was the primary concern of Banks have even been willing to provide long-termpolicy. With other domestic objectives like full employ- credit by taking big risks involved in low cash ratios,ment and development becoming dominant, govern- 'operations at level of illiquidity that would drive anments have become aware of the monetary implications English or American banker into a state of permanentof fiscal policy. Monetary policies thus have become neurosis'.2 8 This is made possible by the willingness ofsecondary to fiscal policies and the latter have proved to the Central Bank to provide credit to banks, which, atlack the flexibility of the former. the peak of a boom, rises to as high as 10 per cent of the

On the other hand, with multinational firms and an banks' loans and investments.international banking system, the international Government accounts are generally balanced but tendmonetary system has evolved into a credit system. Now to show a surplus during boom periods, with expendi-this international credit system is as unstable and fragile ture lagging behind revenue. This permits the Centralas the domestic credit system had earlier become- Bank to take effective measures to regulate credit inevolving from a currency system. times of emerging payments problems even before the

For both these reasons, a Central Bank is no longer inflationary pressures become serious.central; in the domestic sphere, its flexibility is restricted The policy instrument, largely, is credit rationing.by government fiscal policy and, in the international Official interest rates are generally inflexible. The Banksphere, by an international credit system. The inter- of Japan is able not only to ration its own supply ofnational system now requires a 'central' bank to manage funds to the banking system, but also by other means toa system that is inherently unstable. But since in the exert a strong influence over the expansion of loans anddomestic system, governments are not willing to give thepower of control to their Central Banks, the question is:how will they entrust the power to regulate theinternational system to an international central bank?This is the dilemma at present with regard to the 26. John Hicks, Critical Essays in Monetary Theory, op cit.international monetary system. 2 6

Hicks writes! 'The remedy . . would be an International CentralBank, an International Bank which would underpin the creditstructure, but in order to underpin it must have some controlF. Central banking in Japan: a model for developing over it. That was what Keynes, who understood this inter-

countries national aspect very clearly, wanted to get at Bretton Woods, butMonetary policy in Japan has been very efrective- all he got was a Currency Board (for it is little more than a

and much more so than in any other country during the Currency Board, being so tied up with rules and regulations)-theIMF. That, we are finding-and Mill could have told us, onelast two decades. Since the financial structure in the hundred and twenty years ago, that it is what we should find-is

developing countries is likely to evolve on the Japanese not enough. But how should the powers, which governmentslines-and conscious attempts to do so may hasten the have been unwilling to entrust to their own Central Banks (onceprocess-it is worthwhile to know the factors behind the they have realized what is involved) be entrusted to ansuccess of Japanese monetary policy.Intemational Bank? That is the dilemmia, the old dilemma, tosuccess of Japanese monetary policy,.which we have now come back, on the international plane' (pp.

A significant factor in Japanese success in this field, 172-3).as well as in others, is the strong tradition of co-operation between business and government. But this 27, Organization for Economic Co-operation and Development,success is also due to its financial structure; and it is Monetary Policy in Japan (1973). See also 'Key to success', Thepossible to evolve such a structure in the developing Economist (27 January-2 February, 1973) pp. 41-2.countries. 28. Erik Lundberg, Instability and Economic Growth (Yale

The rate of household saving in Japan is very University Press, 1968) p. 334. See also pages 329-47.

FINANCIAL POLICIES AND CENTRAL BANKING IN DEVELOPING COUNTRIES 67

over the credit rationing carried out by the individual quickly, there are generally no longer-term dampeningbanks. In addition to moral suasion, a number of specific effects on fixed investment and growth. Equally, thedevices are used, such as reserve requirements, import elimination of the restrictive measures is also effective indeposit requirements, a complicated discount rate stimulating rapid expansion. Thus, the Central Bank isstructure (with penalty rates partly dependent on the effective both ways-in curbing booms and in effecting aamount of borrowing of the individual bank) and limits quick revival of business activity. In no other countryset on the loans and investments of each bank.29 has monetary policy been effective in both directions.

Because of the Japanese economic and financial The Japanese banking structure, be it noted, can bestructure, the monetary restraint measures work very duplicated easily in developing countries, but on onequickly, with a lag of barely a few months. Inventory condition: if the governments are prudent andinvestment is the first to be affected, along with imports, responsible in the management of the banking system.spreading from large firms to small firms through theeffect on trade credit.

Since the results of monetary restraint are attained 29. Lundberg, op cit., pp. 338-9.

THE WORLD BANKHeadquarters U1818 H Street, N.W.Washington, D.C. 20433 U.S.A.European Office66, avenue d'lena75116 Paris, FranceTokyo OfficeKokusai Building1-1 Marunouchi 3-chomeChiyoda-ku, Tokyo 100, Japan

World Bank reprintsNo. 11. Hollis B. Chenery and Helen Hughes, "The International Division of Labor:

The Case of Industry," El Trimestre Econ6mico [available in Spanish aspublished and in English translation]

No. 12. Bension Varon and Kenji Takeuchi, "Developing Countries and Non-fuelMinerals," Foreign Affairs

No. 13. P.B.R. Hazell and P.L. Scandizzo, "Competitive Demand Structures underRisk in Agricultural Linear Programming Models," American Journal ofAgricultural Economics

No. 14. Gabriel J. Roth, "Regulation of Buses in Cities," Highway Research RecordNo. 1 5. Bela Balassa, "Estimating the Shadow Price of Foreign Exchange in Project

Appraisal," Oxford Economic PapersNo. 1 6. Hollis B. Chenery, "Restructuring the World Economy," Foreign Affairs [also

available in Spanish as published in El Trimestre Econ6mico]No. 17. Helmut Schuster, "Transportation Planning Techniques: Problems and

Prospects," KyklosNo. 18. V.V. Bhatt, "Pattern of Income Distribution in India" [with P.D. Ojha],

Sankhya and "A Decade, of Performance of Industrial Development Bankof India," Commerce

No. 1 9. Michael Sharpston, "International Sub-contracting," Oxford EconomicPapers

No. 20. Hollis B. Chenery, "The Structuralist Approach to Development Policy,"American Economic Review

No. 21. V.V. Bhatt, "Some Aspects of Financial Policies and Central Banking in De-veloping Countries," World Development