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The high-flying dinosaur

Manas Chakravarty

Everybody knows that the age of Development Financial Institutions is over. A term-lending institution like IDBI, once the pride of the Indian financial sector, has its back to the wall.

IFCI is on a life support system. ICICI has reincarnated itself as a commercial bank. Even a newly-minted institution like the IDFC, created expressly for financing infrastructure, fights shy of calling itself a development bank. Development banks are losers, remnants of a discredited economic system. They are dinosaurs in today's world.

That's the received wisdom about DFIs not only in India, but in most of the world. Yet it wasn't too long ago that development banks were the locomotives of developing economies, raising resources and directing credit to industries in accordance with national plan priorities. Asian countries, in particular, were awestruck by Japan's success in economic development, and that state-led model's high growth, technological achievement and conquest of world markets.

Learning from Japan was the rage. Singapore launched a "Learn from Japan" campaign in 1978, Malaysia began a "Look East" policy in 1982, and South Korea transplanted the Japanese model wholesale on Korean soil. The ability of the state to direct capital to preferred industries was a very important factor in this growth model, and state-owned development banks were the cornerstones of the development strategy.

But all that is history. The Asian crisis derailed the developmental state, and Japan's decade of stagnation exposed the cracks in its economic model. The route to development followed by the Germans, the Japanese and the Koreans has been all but abandoned. Market ideology rules unchallenged.

Not entirely, however. The fastest-growing economy in the world, China, may have accepted those parts of the market that suit it, but its love affair with development banks continues unabated.

China Development Bank is an outstanding example of this. Set up by the Chinese government in 1994 as a wholly-owned development bank, CDB's primary function is to foster the economic development of China by financing key projects and initiatives in the government's national economic development plan. CDB lends to infrastructure and basic industries. It is a key player in the government's efforts to develop the central and western parts of the country.

Over the past year, CDB disbursed a total of Rmb161.3 billion ($ 1 = Rmb 8.28; Rmb 1 = Rs 5.90 approximately) of mid- and long-term loans. Loans worth Rmb 149.9 billion, or 93 per cent of the total, have been granted to projects in the power, highways, railways, oil and gas, petrochemicals, urban infrastructure and telecom sectors.

In the last three years, the bank has seen an annual lending increase of Rmb 150 billion (around Rs 88,500 crore (Rs 885 billion) - in comparison, home-grown State Bank of India's advances grew by about Rs 11,000 crore or Rs 110 billion last year). Rmb 81.9 billion, or 51 per cent of the loans, have gone to the underdeveloped central and western regions of China.

Is this yet another disaster in the making? Will all these loans turn into non-performing assets? Not if the figures are right. Indeed, in 2001, CDB achieved its best-ever operating results. In end-December 2001, the CDB's ratio of non-performing loans to total assets, both measured in terms of the Chinese central bank's five-category asset classification (which is close to international norms), was a respectable 3.91 per cent, down from over 18 per cent two years ago.

The loan principal and interest recovery ratio are 99 per cent and 95 per cent, respectively. The CDB's pretax profits for 2001, net of Rmb 10.6 billion bad loan provisions, were Rmb 3.73 billion, and its assets have grown to Rmb 911.4 billion.

Clearly, this particular dinosaur seems to be flying high. Better still, these figures have been audited by Arthur Andersen, although, of course, that's no guarantee of their veracity these days. Nevertheless, the CDB is rather transparent about its not-so-good ratios as well, such as its capital adequacy of only 7 per cent, or its Return on Assets of a low 0.44 per cent.

In fact, the CDB's financial position has shown marked improvement in the last three years. It has been using a variety of strategies. It has carried out credit reforms and has focussed on risk prevention and risk mitigation.

It has developed market-based project development and screening mechanisms, built firewalls to control risks and has linked principal and interest recovery to loan disbursement.

Further, CDB has forged ties with local governments and industrial administrations in an effort to help government authorities tap their organisational strength as a source of credit strength.

Such efforts have enabled CDB to significantly enhance the quality and performance of its lending activities and asset portfolio. The upshot has been the optimum use of CDB's access to cheap funds as a result of the sovereign guarantee.

Supported by sovereign credit, CDB leverages the advantages of being a wholesale bank. Through market-based issues of bonds, CDB helps transform short-term funds into long-term capital and plays an active role in long-term financing, thus making up for the weak presence of commercial banks in long-term lending and delivering a boost to China's immature capital markets.

The bank has employed US-based Boston Consulting Group to make a diagnosis on its structure and risk control. It has founded an International Advisory Council to brainstorm on a wide range of financial and economic policy issues.

But nagging doubts persist. After all, CDB has a large exposure to the Three Gorges Dam: many questions remain about this project's viability. And surely the high debt-equity ratios - a result of the state-led model - are indefensible. Perhaps not. Economist Robert Wade has pointed out that in Asia, risk preferences are such that savings are, for the most part, deposited in banks rather than invested in equity.

Therefore, banks must intermediate a huge inflow of savings. Since households and government are non-borrowers in most of east and south-east Asia, the borrowers must be firms and other investors. So the system is biased towards high ratios of debt to equity in the corporate sector. In other words, high savings lead to high debt-equity ratios.

The trouble is that firms with high levels of debt to equity are vulnerable to shocks, because debt requires a fixed level of repayment while equity requires a share of profits. Ergo: banks and firms must cooperate to buffer systemic shocks and it is necessary for government to support their co-operation. The necessity for government support gives the government a powerful instrument to influence the behaviour of firms as well as banks.

This, in a nutshell, is the rationale for the partnership between the government, banks and corporations that characterise the Asian model.

In fact, some views the Asian crisis as resulting from the partial dismantling of the development state, rather than being the result of its flaws.

For instance, in South Korea, the government of President Kim Young Sam, which came to power in 1993, proclaimed financial deregulation as an important policy objective, partly in order to facilitate its acceptance into the OECD.

It marginalised and then abolished the Economic Planning Board, and abandoned its traditional role of coordinating investments in large-scale industries. This made it easier to develop excess capacity in automobiles, shipbuilding, petrochemicals, and semiconductors. Further, the government relaxed its monitoring of foreign borrowing activities.

As for Japan, one school of thought believes that what created the problem in the first place was not a function of Japan's economic model per se. The Japanese bubble had its origins in the Plaza agreement of September 1985, under which central banks agreed to revalue the world's major currencies against the US dollar.

The dollar devaluation and yen revaluation had two immediate consequences. First, Japanese exports became more expensive. Second, Japanese assets were revalued, leading to the escalation in Japanese property and land values, and the rise of the Tokyo stock market to unprecedented heights. But the bubble could not continue indefinitely. Its collapse in the beginning of the 1990s was to send Japan into a debt deflation from which it is yet to recover.

The point these arguments make is that the reasons for the crises in East Asia and Japan may have little to do with the flaws in their model of development. To be sure, there were many things wrong with that model and with the old development banks.

And it is also possible that the bankruptcy of China's ramshackle state-run companies will lead to the collapse of the state-owned banks. But China Development Bank's approach has been to try and fix its problem - not abandon its development function.

The bank's guiding philosophy is simple: it recognises the need for reform, but believes that rapid growth can ease the disruption caused by reform, and that development banks can catalyse growth. In our eagerness to trash development banking, are developing countries throwing the baby out with the bathwater?

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