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Multi-Page.Pdf POLICY RESEARCH WORKING PAPER 1458 Public Disclosure Authorized Credit Policies Directed credit programs should be small, narrowly focused, and of limited Lessons from East Asia duration fwith clear sunset provisions).They should be Public Disclosure Authorized Dimitri Vittas financedby long-term funds Yoon Je Cho to preventinflation and macroeconomic instability. Public Disclosure Authorized Public Disclosure Authorized The World Bank FinancialSector Development Department May 1995 POLICY RESEARCH WORKING PAPER 1458 Summary findings Directed credit programs were a major tool of * Credit programs must be financed by long-term development in the 1960s and 1970s. In the 1980s, their funds to prevent inflation and macroeconomic instabilitv. usefulness was reconsidered. Experience in most Recourse to central bank credit should be avoided except countries showed that they stimulated capital-intensive in the very early stages of development when the central projects, that preferential funds were often (mis)used for bank's assistance can help jump-start economic growth. nonpriority purposes, that a decline in financial * They should aim at achieving positive externalities discipline led to low repayment rates, and that budget (or avoiding negative ones). Any help to declining deficits swelled. Moreover, the programs were hard to industries should include plans for their timely phaseour. remove. * They should promote industrialization and export But Japan and other East Asian countries have long orientation in a competitive private sector with touted the merits of focused, well-managed directed internationally competitive operations. credit programs, saying they are warranted when there is * They should be part of a credible vision of economic a significant discrepancy between private and social development that promotes growth with equity and benefits, when investment risk is too high on certain should involve a long-term strategy to develop a sound projects, and when information problems discourage financial system. lending to small and medium-size firms. The assumption * Policy-based loans should be channeled through underlying policy-based assistance and other forms of well-capitalized, administratively capable financial industrial assistance (such as lower taxes) is that the main institutions, professionally managed by autonomous constraint on new or expanding enterprises is limited managers. access to credit. - They should be based on clear, objective, easily Vittas and Cho give an overview of credit policies in monitorable criteria. East Asian countries (China, Japan, and the Republic of - Programs should aim for a good repayment record Korea) as well as India, and summarize what these and few losses. countries have learned about directed credit programs. - They should be supported by effective mechanisms Among the lessons: for communication and consultation between the public * Credit programs must be small, narrowly focused, and private sectors, including the collection and and of limited duration (with clear sunset provisions). dissemination of basic market information. * Subsidies must be low to minimize distortion of incentives as well as the tax on financial intermediation that all such programs entail. This paper - a product of the FinancialSector Development Department - is part of a larger effort in the department to study the effectivenessof policy-basedfinance in East Asia. Copies of the paper are availablefree from the World Bank, 1818 H Street NW, Washington, DC 20433. Pleasecontact PriscillaInfante, room G8-118, extension 37642 (36 pages). May 1995. The Policy Research Working Paper Series disseminates the findings of work in progressto encourage the exchange of ideas about development issues. An objective of the series is to get the findingsout quickly,even if the presentationsare less than fully polished. The papers carry the names of the authors and should be used and cited accordingly. The findings, interpretations, and conclusions are the authors own and should not be attributed to the World Bank, its Executive Board of Directors, or any of its member countries. Produced by the Policy Research Dissemination Center Financial Sector Develbpment Department The World Bank CREDIT POLICIES: LESSONS FROM EAST ASIA Dimitri Vittas and Yoon Je Cho I. INTRODUCTION Directed credit programs involvingloans on preferentialterms and conditionsto priority sectors were a major tool of developmentpolicy in both developedand developingcountries in the 1960s and 1970s. During the 1980s, the realizationthat most of theseprograms had resulted in distorted incentives among both lenders and borrowers led to a reconsiderationof their rationale and effectiveness. The experience of most countries around the world showed that directed credit programs stimulated capital intensive projects, suffered from abuse and misuse of preferential funds for nonpriority purposes, increasedthe cost of funds to nonpreferentialborrowers, involved a decline in financial discipline that resulted in low repayment rates, and contributed to a swelling of budget deficits. Moreover, once introduced, directed credit programsproved difficult to remove. This general assessmentof the adverseeffects of directed credit programshas contrastedwith the experience and views of governmentofficials in Japan and other East Asian countries who have long advocated the merits of well managed and focused directed credit programs. According to this view, governmentinvolvement in directing credit is warrantedwhen there is a significantdiscrepancy between private and social benefits, when the investment risk of particular projects is too high, and when informationproblems discouragelending to small and mediumsize firms. Use of policy-basedlending, in addition to other forms of industrial assistance (e.g. lower taxes, grants, etc), is premised on the argumentthat the main constraintfacing new or expandingenterprises is their limited access to external financeat reasonableterms and conditions. Directedcredit programs involving small subsidiesovercome this constraint, but to avoid the misuse of funds and abuse of credit programs, a strong emphasis must be placed on the maintenanceof macroeconomicstability to minimize distortions in incentives and on effective monitoringto ensure the timely repaymentof loans. This paper providesa brief overviewof credit policiesin East Asian countries (Japan, Korea and China)' as well as India and attemptsto pull togethersome lessonsfrom the experienceof these countries. It draws on the findingsof a World Bank researchproject on the "Effectivenessof Credit Policies in East Asian Countries",2 I But the paper's main focus is on Japan and Korea. 2 The project consists of four parts: this overview paper; two conceptualpapers on the case for credit policiesand the role of governmentin overcomingmarket imperfections;a series of country papers on policy-basedlending, financialsector developmentand industrializationincluding very detailed studies of policy-basedfinance in postwar Japan and Korea; and empirical work using a large sample of firm- level data on the effectivenessof credit policies in Japan. I This project is part of the responseof the World Bankto the issues raised by Japanese and other East Asian officials regarding the appropriateness of government intervention in stimulating industrializationand economicdevelopment 3. It focuses on the role of governmentin the financial sector and seeks to establish under what conditions can government interventions make a positive contribution to economic growth and development. It also discusses the replicabilityof East Asian experiencein other developingcountries. The second section discusses the theoretical underpinnings of policy-based finance and suggests a framework in which this study attempts to inyestigate the role of government. The third section introduces the main findings of individualcountry studies (Japan, Korea, China and India), while the fourth section analyzesthe similaritiesand differencesin the credit polices among these countries in a comparativeperspective. The final section briefly summarizesand concludesthe paper. -' This project is complementaryto the "East Asian Miracle" project (World Bank 1993) and, in a less direct way, to the project on the "Main Bank System of Japan", sponsored by the Economic DevelopmentInstitute. All three projects have receivedgenerous support from the Governmentof Japan and have relied extensively on inputs and contributionsform Japanese and other East Asian officials, economists and practitioners. The paper also draws on the 1989 World Development Report on "Financial SystemsanJ Development"(World Bank 1989). 2 II. THEORETICAL UNDERPINNINGS OF POLICY-BASED LENDING 4 In a world of "perfect and costless" information, the role of the financial system is passive: finance is provided to the projects that yield the highest returns. There is little scope for activist involvement by either governments or financial institutions for improving the allocation of credit. In the real world, however, information is highly "imperfect" and costly. The allocation of credit suffers from the existence of informational asymmetries, from the costs of monitoring and verification, and from the costs of contract enforcement. Under these conditions, credit is not necessarily allocated to its best use. Informational asymmetries give rise to problems of adverse selection, moral hazard, free riding and incentive incompatibility. Asymmetric information problems are further compounded
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