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Time to rethink theory on the role of finance in development

The primary role of finance is to serve the ‘real economy’¬—the part of the economy that produces goods and services. Yet in practice, the financial sector often excessively indulges in speculative activities rather than performing its main functions, such as channeling saving for productive investments and diversifying risks. In our new book for the Cambridge University Press and UNU-WIDER ‘Elements’ series, we explore the core question of how finance can better meet the needs of the real economy.

We challenge the prevailing perspective that the financial structures of high-income countries are the benchmark for Global South countries when considering reforms to their financial systems. This approach neglects the fact that the real economies of these countries have different industrial sectors with distinct financing needs and risk profiles which defy a one-size-fits-all approach.

Another conventional perspective is that it is financial development, or the overall size of the financial sector rather than its structure, that matters in determining long-run economic growth. Hence, governments should develop enabling legal and regulatory environments to foster overall financial sector development, instead of pushing the financial system toward a specific structure (for example, bank-based or capital market-based). Yet this approach fails to realize that different financial arrangements may have distinct comparative advantages in meeting the specific financing needs of different industrial sectors. For example, public development banks—which rely on sovereign creditworthiness and issue bonds to fund their operations—are better positioned to provide long-term finance than commercial banks that are mainly funded through short-term household deposits.

A new perspective fit for purpose

We introduce an alternative framework that rethinks the role of finance in the real economy based on New Structural Financial Economics (NSFE).

NSFE is a sub-discipline of New Structural Economics (NSE). Drawing on the development experiences of successful economic structural transformation in various countries in East Asia and other parts of the world, NSE represents a third generation of development thinking.

Structuralism—the first generation of development thinking popular in the post-World War II era—emphasizes the need for government interventions to overcome market failures in the development of modern industries. Neoliberalism, the second generation of development thinking influential after the 1970s, emphasizes the need to avoid government failures by adopting well-functioning market institutions. NSE proposes that successful structural transformation requires both a facilitating government and effective markets.

From the NSFE perspective, an appropriate financial structure should meet the distinct financing needs of industries in the real economy. It should provide financial resources to industries with comparative advantages to enable their emergence and continued operation until they lose comparative advantages. Comparative advantages are, in turn, determined by the factor endowment structure (what an economy has—such as labour, capital, and natural resources).

Thus, NSE questions a one-size-fits-all approach to financial arrangements and encourages a more nuanced approach. For example, at the early stage of development, small and medium-sized enterprises (SMEs) in labour-intensive industrial sectors are predominant. Compared with original innovation in advanced capital-intensive industries at the global technological frontier, firms in labour-intensive industries can adopt existing technology to produce a mature product—and face lower technology innovation risk and product innovation risk in doing so. 

Despite their relatively small financing needs, these SMEs often lack the collateral and sufficient credit records to secure the services of international financial institutions. Hence, local banks are better positioned to provide credit to industrial development than capital markets or large banks.

Public development finance done right

In some cases, governments should facilitate provision of public development finance to address market failures. Public development finance can take many forms including specialized public development financing institutions (PDFIs), providing state guarantees to incentivize commercial banks, and setting up state-owned venture capital funds to incubate frontier technologies and industries.

PDFIs are public financial institutions initiated and steered by governments with an explicit official mission to fulfill public policy objectives. The mainstream perspective contends that PDFIs are doomed to fail. Yet according to the first global database on PDFIs—initiated by the Institute of New Structural Economics at Peking University and in collaboration with the French Development Agency—PDFIs are prevalent worldwide. Over 520 PDFIs are in the database, representing more than 150 countries with aggregate total assets of more than USD 23 trillion.

Furthermore, there are many examples of successful PDFIs. For instance, the China Development Bank is critical to infrastructure construction in China and the Korean Development Bank plays a pivotal role in promoting industrial upgrading and enhancing economic structural transformation in South Korea. From the NSFE perspective, it is important to go beyond unproductive debates on whether PDFIs are needed and investigate how to make them work better.

Matching policy to the financial structure

There is no universal optimal financial regulatory scheme for all countries. Instead, tailored financial regulation should be made based on the specific characteristics of financial markets, institutions, instruments, contracts, and so on. Even though the Basel Accord is designed to regulate global systemically important commercial banks, a survey finds that some national development banks are being required to comply with the Basel Accord. This risks undermining their ability to fulfill public policy objectives. Hence, it is crucial to make tailored financial regulations in line with the characteristics of specific financial arrangements.

Regarding financial reform, conventional wisdom holds that financial repression results in inefficiencies which leads to the policy prescription to end financial repression. Yet the shock therapy of financial liberalization reforms in Global South countries has resulted in financial crises and economic recession. From the NSFE perspective, financial repression in a labour-abundant country is often a way to subsidize comparative advantage-defying capital-intensive industries in its government’s import-substitution strategy. Accordingly, financial liberalization is likely to cause the bankruptcy of nonviable firms in priority capital-intensive industries. Hence, governments should pragmatically take a gradual approach to financial reforms, improving, simultaneously, the viability of priority industries rather than adopting badly-sequenced financial liberalization.

Our book provides alternative perspectives on what should determine the appropriate financial structure in an economy, what determines it and its evolution, and what the adequate role of the state is in shaping the financial system, and how to enhance the financial system’s contribution to development. Future scholarship on this topic can develop rigorous theoretical models and conduct empirical studies to test and further these theoretical insights.

New Structural Financial Economics: A Framework for Rethinking the Role of Finance in Serving the Real Economy is now available from Cambridge University Press. It is published as a part of the UNU-WIDER and CUPS ‘Elements in Development Economics’ series and digital copies are available free to download under Open Access. Download your copy today.

The book, New Structural Financial Economics: A Framework for Rethinking the Role of Finance in Serving the Real Economy by Justin Yifu Lin, Jiajun Xu, Zirong Yang, and Yilin Zhang, is now available from Cambridge University Press. It is published as a part of the UNU-WIDER and CUPS ‘Elements in Development Economics’ Series and digital copies are available free to download under Open Access. Download your copy today.

Justin Yifu Lin is Professor of Economics, Dean of Institute of New Structural Economics, and Dean of Institute of South-South Cooperation and Development at Peking University.

Jiajun Xu is Associate Professor and Principal Investigator of Public Development Finance Research Program, Peking University.

Zirong Yang is Associate Professor, Institute of World Economics and Politics, Chinese Academy of Social Sciences.

Yilin Zhang is Associate Professor Lingnan College, Sun Yat-sen University.

The views expressed in this piece are those of the author(s), and do not necessarily reflect the views of the Institute or the United Nations University, nor the programme/project donors.