Financialization and industrial development

1. Financializationand industrial development C. P. Chandrasekhar Jawaharlal Nehru University New Delhi

2. Finance and development • Mainstream view: financial development and deepening favour growth in general and industrialization in particular because of the multiple functions that finance performs • While there appears to be some relation between level of development and financial development, countries at the same level of development can display significant differences in the degree of financial development • Moreover much evidence recently that financialization hinders industrial development in many ways.

3. Financialization in the developing world • Rising financial assets to GDP ratio, increased financial intermediation, high share of financial transactions within the financial sector and real actors turning to finance. • Occurs after financial liberalization in DCs • Financial reform involves reshaping of financial systems in developing countries in the image of the ‘market-based’ systems that emerged and evolved in the US and the UK since the 1980s

4. Finance for industrialization: the developmentalist view • Financial policy is an instrument to further industrial development in late industrializers: stressed by Gerschenkron among others • Some degree of pre-emption of credit for government spending and through imposition of sectoraltargets • Use of state banking and specialized development banking institutions to direct credit • Regulation of interest rates to reduce competition and keep them in line with real rates • Regulation of entry and diversification besides prudential regulation

5. Financial structure, financial growth and development • Investment and growth • Finance and investment: finance only one of the technologies, with others like taxation and terms of trade adjustments available • The question was one of real resources • However, structure of output influences the investment ratio and growth • Role of finance lies primarily in influencing allocation of investment and composition of output

6. Finance and mercantilist strategies • For growth based on a rapid acquisition of larger shares in segments of the world market for manufactures, target segments have to be identified by an agency with greater seeing power than individual firms • That agency must also ensure an adequate flow of cheap credit to theseentities so that they can make investments in frontline technologies and internationally competitive scales of production, as well as have the wherewithal to sustain themselves during the long period when they build goodwill.

7. Finance and industrial policy: components • Moving large volumes of capital to selected units, including capital meant to close the shortfall in long-term finance • Using the leverage provided by this activity to coordinate and influence investment decisions across the industrial sector • Recognising the performance interdependence of finance and the real sector • Choosing an appropriate institutional framework and an appropriate regulatory structure.

8. Market driven finance • Private rather than overall social returns determine the allocation of savings and investment • With financialization expectation of profit rates increase • Allocation may not be in keeping with that required to ensure a certain profile of the pattern of production, needed to raise the rate of saving and investment.

9. Outcomes • Basic and Heavy industrial or infrastructural sectors characterised most often by lumpy investments, long gestation lags, and (relatively) lower profit bypassed • Given the “economy-wide externalities” associated with such industries, inadequate investments would constrain growth. • Inherent tendency in markets to direct credit to non-priority and import-intensive but more profitable sectors, to concentrate funds in the hands of a few large players and direct savings to already well-developed centres of economic activity.

10. Financialization and banking • A liberal banking policy is a prerequisite for financialization since financial proliferation requires the prime depository institutions, which are the first port of call for a nation’s savings, to enter and experiment with new markets, institutions and instruments. • Means of managing risk. • One is a growing emphasis on capital adequacy, • The second is the sharing of risk, through the transfer of credit risk.

11. Sources of fragility • Credit becomes a tradable asset that banks (because of their credibility and reach) can easily create and pass on for a fee • Inevitable tendency towards credit proliferation. • Creator of the credit asset is not carrying the risk. Opaque assets. • Expanding the universe of borrowers requires bringing a larger number of “retail borrowers” into the credit net: borrowing to invest in housing, to buy automobiles or durables, or just enhance current consumption with the asset as collateral

12. Consequences • Creates a banking ethos in which there is less willingness to lend to productive sectors • Reduced lending long-term to industrial projects that are considered less lucrative and more risky credit targets. • The task of closing the gap for long term finance remains uncompleted • Lending is not broad-based or inclusive • Fragility increases

13. Financialization and financial fragility • Financial markets left to themselves are known to be prone to failure because of the public goods characteristics of information which agents must acquire and process • Since expected private returns increase, it could result in a situation where market-driven players take on unnecessary risks in search of high returns.

14. Effect on investment • Inasmuch as speculative bubbles lead to financial crises, they squeeze liquidity, induce distress sales of assets and result in deflation, all of which adversely impacts on employment and living standards. • Inasmuch as the maximum returns to productive investment in agriculture and manufacturing are limited, there is a limit to what borrowers would be willing to pay to finance such investment.

15. Why does this happen? • “Tolerated” partly because of the demand side effects of the proliferation of credit • State uses the financial system to engineer reasonable or even creditable growth in the real economy. • Loans finance housing investment and consumption, on the one hand, and speculation in stock and real estate markets on the other. • Asset price inflation that such speculation generates magnifies the value of the wealth held by households, encouraging them to borrow and spend even further.

16. Financialization and the real sector • Growth led by the demand not supply side, which for a variety of reasons is not accompanied by inflation in the prices of goods but only in the prices of assets. • To keep this process going, credit has to go to those who borrow beyond what their incomes would warrant at terms they couldn’t afford making asset price inflation the unstable anchor to which the system is tethered. • The relationship between finance and industrial development depends on the phase of the cycle being observed.

17. Financial liberalization and fiscal policy • Financialization results in the substitution public sending (including debt-financed public spending) with debt-financed private expenditure as the principal stimulus for growth. • Undermineswhat has been an important stimulus for industrial growth • Inasmuch as financial liberalization increases the presence of financial agents in the economy, it forces the state to adopt a deflationary stance to appease financial interests.

18. Financial liberalization and monetary policy • Finance favours reliance on monetary policy pursued by an “independent” central bank rather than on fiscal policy. • Focus on inflation rather than growth or employment targeting • Even limited deficits that occur should not be “monetised” • Since the interest rate on such borrowing tends to be much lower than the interest rate on borrowing from the open market, its reduction results in a sharp rise in the average interest rate on government borrowing.

19. Conclusions • Financialization adversely affects availability of long term finance • Adversely affects financial broadening and inclusion • Shifts the role of finance away from the supply side to the demand side • Proliferates credit and risk increasing fragility • Leads to conflicts between the objectives of the State and the financial sector • Constrains industrialization