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24 February 2022, Gateway House

Enhancing Regional Financial Intermediation in the Indo-Pacific

Financial intermediaries are critical lubricants for business, growth and development. The Indo-Pacific countries are industrializing, but smaller nations lag behind economically. The Quad countries can aid the advancement of the financial architecture in the Indo-Pacific by helping to develop an ecosystem, modelled on the examples of Japan and India.

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With the Indo-Pacific becoming a center of global attention, the time has come for policy makers to set right the region’s financial ecosystem. In the process, they have an opportunity to establish a new, sustainable development model. The logic for new approaches is overpowering: Financial intermediaries are critical lubricants for business, growth and development – an economic truism that has acquired even greater relevance in the wake of the COP26 meeting in Glasgow, with its unspecific and inadequate promises of financial support for material carbon mitigation and reduction. With some notable exceptions, too many countries in this vast swathe of the globe – defined by the eastern end of the Indian Ocean, the western end of the Pacific Ocean and the north and south 30th parallels – have been held back by weak financial systems.

Prior to British colonialization, the old maritime sailing sweep of Indian trade ranged from the nations of eastern Africa, the Arabian Gulf and South Asia eastwards to the Indonesian islands. Colonialism and the industrial revolution brought a shower of sand to the gears of the region’s progress, reducing the Indo-Pacific countries to suppliers of raw materials and commodities for the factories of the colonial masters. Development has been uneven since then. The Indo-Pacific countries have made valiant attempts to industrialize, and thereby follow the classic economic development path involving the transfer of surplus labor from agriculture to manufacturing and services. Some countries – notably the Asian Tigers and, to a lesser degree, countries of the Association of Southeast Asian Nations (ASEAN) – have made the transition well. West Asia has surged ahead on the back of oil wealth. But much of eastern Africa has stagnated despite immense mineral wealth.

Financial Intermediaries and Growth

Many reasons have been offered for the disparities, but one thing is clear: An effective and inclusive developmental ecosystem for financial institutions and intermediaries would spread that pattern of growth. India, because of its experience over the past decades in utilizing a mix of public sector banks and development financial institutions, along with private lenders and venture capital, could be the optimal partner for the region. Applying lessons learned from India’s experience would avoid repeating mistakes or reinventing the wheel.

In addressing the issue of finance, one needs to view both the supply side and the demand side. Financial intermediaries seek to bridge demand and supply for finance, while benefiting savers and investors. Absent trusted financial intermediaries, potential savers in an emerging economy are compelled to hold their savings either in cash or in the form of real assets like gold, jewelry and occasionally land (if clear titles can be established). And if they reside in areas of poor security, they are understandably inclined to spend immediately rather than hold physical savings under a pillow or in a cupboard that might attract violent theft.

Financial intermediaries could provide a safer and more reliable avenue for savings. Japan’s experience after the Second World War is instructive. With its infrastructure and manufacturing in ruins, and transport systems destroyed, it established the Reconstruction Finance Bank in 1947 to lend to key industries such as coal. Most of the funding was drawn from the Japanese central bank. The good work of this institution was carried forward by the Japan Development Bank, and later the Long-Term Credit Bank of Japan, the Industrial Bank of Japan and still later the Exim Bank of Japan. In Korea, institutions like the Korea Development Bank led the way.

Development Financing Landscape in India and the Indo-Pacific

India sits in the middle between developing and developed countries, and hence is a good example of the problems and opportunities of both.

India’s strategic approach proceeded on two parallel lines. In July 1969, 14 major Indian Scheduled Commercial Banks with deposits of over INR 50 crore were nationalized “to serve better the needs of development of the economy in conformity with national policy objectives” (the Imperial Bank had earlier been nationalized as the State Bank of India in 1955). This ensured a devolution of banking to serve the less well-off; bank branches could be found in large numbers in semi-urban, second and third-tier cities and even in rural areas and villages, enabling the savings of a vastly larger number of people to be mobilized and aggregated for lending. In addition, large Development Finance Institutions (DFIs) were established to provide long-term finance at competitive terms to industry, supplementing the short-term working capital lending by the banks. The Industrial Finance Corporation of India (IFCI) was incorporated in 1948, the Industrial Credit & Investment Corporation of India Ltd. (ICICI) in 1955, and the Industrial Development Bank of India (IDBI) as a subsidiary of the Reserve Bank of India in 1964. The DFIs, along smaller agencies at national and state level, enabled a big push toward industrialization. Many storied names of Indian business today owe their initial launch and support to loans from the DFIs. Increasing politicization and functional capture by unsavory elements led to the winding down of the DFIs, and public sector banks (PSBs) steadily lost ground to their private sector counterparts. However, the institutions did create an infrastructure for the financialization of savings, collation from small savers and deployment into productive uses that arguably no other poverty-stricken developing country has managed.

What does this experience suggest concerning the financial needs of the Indo-Pacific? The majority of the countries in the Indo-Pacific are lower-income countries and are yet to progress down the classical road to economic development. Countries like Mozambique in Africa and to some extent Sri Lanka and Nepal in Asia face many challenges including lack of skilled labor and appropriate levels of technology, poor absorption of technology, imports that have a strong political constituency and, in some cases, inverted duty structures. Many have small populations, and thus lack potential demand, making economies of scale difficult to achieve from domestic operations alone – advantages that India and China have enjoyed. Currently such countries finance development with:

  • Concessional borrowings from the multilateral development banks (the International Bank for Reconstruction & Development and the International Development Association; the Asian Development Bank, the African Development Bank) and regional institutions such as the ECOWAS (Economic Community of West African States) Bank for Economic Bank for Investment & Development and the East African Development Bank.
  • Bilateral and mixed aid from friendly or interested governments.
  • Long term credits from national Exim banks.
  • Occasionally, recourse to capital markets by way of bonds and syndicated loans. A growing trend is discernible towards green finance or ESG (economic, social and governance) loans.

Relying on external capital for development is risky because the supply can shrink or dry up at critical times. It also is inadequate because it creates crutches instead of self-sufficiency. Much of the multilateral and bilateral developmental attention of the outside world to the Indo-Pacific has focused on development projects, usually executed by companies of donor countries. Such marquee projects have done a good job in a few cases, but in others, like Sri Lanka, the landscape is studded with white elephant projects that benefit the donors more than the beneficiaries. The China-Pakistan Economic Corridor (CPEC) under the Chinese Belt & Road Initiative has given China access to the Gwadar port proximate to the Gulf of Oman; the benefit to Pakistan is distant. Reliance on external financing leaves locals with little say on the projects, with the result that post-completion maintenance, operations and management are neglected, and projects may even be abandoned. Borrowings in non-home currency can give rise to open exchange position that could be dangerous. In the case of the BRI, the imbalance has been grossly exacerbated by the huge amount of Chinese lending that is opaque and sometimes unstated in the books, as non-Chinese lenders have found to their dismay.

The Quad and Development Financing in the Indo-Pacific

In these circumstances, the Quad nations and others need to hit the pause button on new project financing, and instead leverage their financial strengths and their experience in financial sector development. Instead of supporting one-off projects, they can have a more lasting impact by investing in widening and deepening the financial architecture in these countries through investments in banks, national or more likely regional, that could mobilize domestic savings. India’s experience has shown that the involvement of national government gives a flavor of solidity and safety to invested moneys, thus helping new financial institutions gain time to reach viability. In addition, the Indian experience with small finance banks could provide helpful technical support, facilitating a network of branches that use telecommunications and financial technology.

In parallel, the Quad nations would do well to support either existing or new DFIs in the region with equity investment and term debt. Multilaterals like the Asian Development Bank and the African Development Bank are already doing a salutary job, as are various Exim banks. But the challenge is so huge and there is plenty of room for additional players. One possibility is for the Quad governments or their selected DFIs or Exim Banks to join hands to create a new regional DFI by contributing both financial support as well as technical and skill support.

Specifically, Quad countries should consider:

  • Increasing the equity shareholding of the Quad countries in the multilateral institutions. The U.S. and Japan feature among the top ten shareholders of the African Development Bank at 6.6% and 5.5% respectively. The four Quad countries are among the top ten shareholders in the Asian Development Bank (15.6% each for the U.S. and Japan, 6.3% for India and 5.8% for Australia). While attempts can be made to increase these contributions, the focus needs to be more on the second-tier regionals like the East African Development Bank (EADB) and the PTA, which otherwise stay below the radar, but which have better investments with better outcomes.
  • Establishing a new DFI to rival the New Development Bank or the Asian Infrastructure Investment Bank and would enable better control and targeting of finance. India has the expertise to set up such an institution. Capitalization by way of callable capital would not be difficult for the Quad countries; the parentage of the DFI would enable the institution to leverage funds from the capital markets at a very competitive cost. A model is the Corporacion Andina de Fomento (the Andean Development Corporation) in Latin America.
  • Encourage their banks to expand their branch networks in the region by setting up overseas branches or subsidiaries or by taking equity stakes in good local banks. India and Japan, in particular, may find their banks amenable to governmental encouragement.
  • Providing technical assistance, handholding and personnel training to banks and DFIs in the region.
  • Providing technical assistance and, if possible, some equity shareholding to encourage establishment of regional or national Exim Banks order to help small Indo-Pacific countries increase exports so as to enable scale production.
  • Boosting Trade Facilitation Facilities. India can offer much help with this.

With such support for improved financial intermediation, Indo-Pacific states that lag economically can bolster domestic savings and, in turn, domestic investment – and thereby make the developmental leap that countries like Japan, Korea and India have proven. All the while, they will be able to maintain direction, ownership and control over the development process.

David Rasquinha is former Managing Director, Exim Bank India.

This paper has been published by Gateway House, with the support of the United States Embassy, New Delhi. Read the full compendium ‘India in the Indo-Pacific: Pursuing Prosperity and Security’ here.

The views and opinions expressed in this paper are solely those of the authors. The views expressed in the paper do not necessarily reflect those of the United States Embassy, New Delhi.

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