Financial Intermediation & Policy Issues

Contrast the ways in which financial savings were mobilised, and were allocated to investment projects, in any two countries of your choice. Mobilising financial savings is obviously of great importance for the economic development of an economy as it allows the expansion of investment throughout the economy. Unless savings can be mobilised it is very difficult for entrepreneurs and firms to obtain the funds required so that investment projects can be financed.

Without the efficient mobilisation of savings entrepreneurs have to rely on past profits as the source of finance and hence many good investment projects, especially those in potentially prosperous infant industries are unable to be undertaken. This essay aims to analyse how these savings can be mobilised and the investment projects to which these were channelled hence helping development in light of the differing experience of Germany and India.

The role of a credit market in a developing economy is of upmost importance in order that entrepreneurs and firms are able to allocate resources to investment projects without having a detrimental effect on consumption patterns. The whole principle of a credit market relies upon the fact the economic agents who are advanced loans will be able to repay the loan at some point in the future, as well as the interest rate payments that are due in the interim.

There are two main problems with the distribution of credit, which arise from the fear that a loan will not be repaid i. e. the borrower will default upon the loan. The first problem is that of asymmetric information, in that it is very difficult for the lender to monitor / regulate what the borrower uses a loan for. For example a loan may be used to finance present consumption and hence will not have the resources in the future and must default. This type of default is known as involuntary default.

The second problem is that if there is not a comprehensive and powerful legal system then lenders may find it very hard to enforce the repayment of a loan with borrowers voluntarily / strategically defaulting. Insurance markets are also important in helping to mobilise savings by helping to smooth streams of income so that savings do not have to be used to compensate for any risk of disruption to future income, but can be allocated to more productive purposes. The Insurance market is, however, also subject to the same or at least similar problems to those that have been stated above.

It is important to note that rural communities are of particular importance when considering issues of economic development and hence it is now necessary to analyse the credit and insurance markets given this context. Although the role of formal or institutional lender's is often stressed and certainly much praise has been given to the universal banks for their role in the development of Germany, the role of informal lenders in rural areas is also of great importance and is often unwisely ignored and underestimated.

Indeed despite the creation of rural cooperatives in India during the 1950's and the expansion of branch banking into rural areas in the 1970's there is contemporary literature that recognises the importance of informal lenders as illustrated by the following quote based upon the All Indian Rural Credit Survey. "The thesis that the moneylender remains powerful and that his dealings are an obstacle to progressive changes in rural economic life has been developed forcefully and at length by Bhaduri and his school . . .

the analysis has not gone unchallenged, but both theoretically and empirically it seems fair to say that they have provided the clearest formal statement"1. Many would argue that the cooperative movement in India and the extension of commercial branch banking has meant that the private lender has become overshadowed as a result of the competition in the form of institutional credit. Data from the International Crop Research Institute for the Semi-Arid Tropices (ICRISAT) in Hyderabad, India, suggests contrary to official reports that the fall and demise of the private lender has not been as significant as it is often made to seem.

Before beginning to analyse this proposition that results from the ICRISAT data, it is first necessary to understand a little more about the workings of an informal credit market uncovering why the informal moneylender is an obstacle to development. As a result of the fact that a lender does not have perfect knowledge of its potential clients and is unable to monitor his / her use of any agreed loan, the threat of a possible default means that the lender not only charges very high rates of interest, but is also keen to insure himself / herself against this risk.

Even the most established and developed financial institutions, therefore, ask for some form of collateral in order for a loan to be issued. A major problem is that in a developing economy not only is the risk of a potential default greater, but also the potential borrowers often do not have any form of collateral that interests such institutions. It is, therefore, the case that the rural, informal moneylenders have found other ways to 'insure' themselves against the risk.

Examples of this can be found in India where "Kurup's (1976) study of Kerala, India, showed that ration cards (which are used to purchase subsidised food from the public distribution system) are often handed over to the lender for the duration of the loan. This type of collateral is often, however, one-sided in that it is often still really only valuable to the potential borrower and doesn't really protect the moneylender from involuntary default.