Change of heart

Lessons from meltdown

Read the following quotation: “The size and sophistication of financial institutions in the developed world are not appropriate in low-income markets. Small local banks are the best entities for providing financial services to the enterprises and households that are most important in terms of comparative advantage. The experiences of countries such as Japan, South Korea and China are telling. These countries managed to avoid financial crisis for long stretches of their development as they evolved from low-income to middle- and high-income countries. The experience of the United States is also instructive. For the early labour-intensive phase of America’s economic development, local banks were dominant. Relatively large foreign banks tend to serve relatively wealthy customers.”
The reader may be surprised to know that these lines are from an article by Justin Lin, the chief economist of the World Bank, and not by any Left of Centre economist from the Third World.

This is clearly a departure from what traditionally the official views of World Bank and IMF used to be. To them, financial sector reforms in the developing countries would primarily focus on opening up to big international banks, privatising state-owned domestic banks, modernising stock markets, liberalising capital accounts and following the ‘best practices’ of the financial institutions of the developed countries.

Financial crisis

Why is this change of heart and mind? Several factors may have contributed. First, the recent experience from the financial crisis at the doorsteps of the Fund-Bank in USA. It is the large US banks and financial institutions who not only started the crisis but also spread it to far corners of the world thorough their global networks. Countries like China and India that suffered least from the financial crisis had their banking system largely state-owned. Even their private sector banks were heavily regulated against excessive risk taking and global exposure.

Their economic slowdown was not caused by their financial sectors; it was mostly due to falling demand for their products in the recession-hit western economies. So, it is very difficult to preach the virtues of large-scale Western financial institutions even to the Western world, let alone the developing countries.

Second, the most frustrating issue before the US policymakers during the current financial crisis was that the major rogue institutions had become ‘too big to fail.’ So, the Fed and the US government could not let AIG or Citibank go bankrupt even though they had engaged in unsupportable business practices. Collapse of AIG or Citibank would have created such panic and widespread bankruptcies (through their sheer size and huge global networking) that the entire Western financial system may have collapsed.

Small’s beautiful

As a result, they had to be bailed out in the interest of averting a bigger debacle. To make the big culprits suffer for their sins, in this case, would have amounted to punishing millions of innocent ordinary people. Thus, policymakers and analysts of the crisis have once again come back to the dictum of ‘small is beautiful’.

Third, the success of micro-credit institutions in many developing countries in recent times to help the poor small entrepreneurs, documented in studies by World Bank and IMF, can not be ignored. Muhammad Yunus, the father of Bangladesh Grameen Bank movement, has now opened Grameen Bank branches in New York city to finance small entrepreneurs in the US. The big international banks do not provide loans to the underprivileged  people with no collateral in the Western world.

Fourth, the growing clout of  economists from the developing countries in World Bank and IMF. For example, Raghuram Rajan, an Indian, was the chief economist in the research division of IMF in recent times while Justin Tan, a Chinese, is the current chief economist at the World Bank. The experiences and views of such people do influence the research agenda and the dominant wisdom in the Fund-Bank. The revolt from within was started by Joseph Stiglitz, the chief economist of World Bank and a Nobel Laureate in Economics who severely criticised the conventional wisdom and working of the Fund-Bank in many areas.

Fifth, IMF (and to a lesser extent World Bank) has been criticised for pushing a remedial package to tackle the East Asian financial crisis in late 1990s which is now widely recognised to have aggravated the crisis by reducing government  expenditure, cutting off liquidity and raising interest rates. Even the IMF top brass has now recognised their folly.

They have suggested a policy package to tackle the ongoing  financial crisis in a totally different manner — basically by massive government stimulus packages, injecting more liquidity and funds in the beleaguered economies of the world going through a severe recessionary phase.

They can no longer suggest  that the business practices of the big Western financial institutions are the ‘best practices’ to be followed by others when some of these have turned out to be the worst possible practices, plunging the world into the worst recession since the Great Depression.

It is good to see that the conventional wisdom of Fund-Bank is changing for the better.

(The writer is a former professor of economics at IIM, Calcutta)

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