World Bank Reprint Series: Number Twenty-one REP21 December 1974 Public Disclosure Authorized V.V. Bhatt Some Aspects of Financial Policies and Central Banking in Developing Countries Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Reprinted from World Development 2 (October-December 1974) World Development Vol.2, No.10-12, October-Deceinber 1974, pp. 59-67 59 Some Aspects of Financial Policies and Central Banking in Developing Countries V. V. BHATT Economic Development Institute of the International Bank for Reconstruction and Development mechanism and agency as provided by the existence of a Central Bank. What needs special emphasis at an international level is the rationale and urgency of evolving a sound financial structure through the efficient performance of the twin interrelated functions-as promoters and as regulators of the financial system-by Central Banks. 1. SOME ASPECTS OF FINANCIAL POLICIES .. ~~~The main object of this Section is to show the Economic development is not only facilitated but its . pace is quickened by the appropriate development of the significance of saving and flow-of-funds analysis as an financial system--structure of financial institutions, indicator of a set of financial policies-policies relating instruments and interest rates.1 to the structure of financial institutions, instruments and Instrumentsand interest rates.r interest rates-essential for resource mobilization and In any strategy of development, therefore, it is allocation consistent with a country's development essential to emphasize the evolution of a sound and . 6 c well-integrated financial system from the point of view objectives. In a large number of developing countries, the only both of resource mobilization and efficient allocation.2 reliable data available for understanding the trends in the In Section I of this paper, an attempt is made to economy and for policy purposes relate to monetary delineate the broad contours of a set of financial policies flows and the balance of payments. These data thus that seems to be consistent with any sound strategy of assume critical significance. Flow-of-funds data are not development. In Section 11, the role of Central Banks is available for a large number of countries but are such as emphasized, not only as promoters but also as regulators of sound integrated financial systems. These two functions are interrelated: the function of Central Banks functins is intefeactedrheinocdb functionhioCetaBans 1 See Raymond W. Goldsmith, Financial Structure and as regulators is m fact remforced by their function as Development (Vale University Press, 1969). promoters. 4 In spite of the dynamic catalytic role of the banking 2. See Ronald l.McKinnon, Money and Capital in Economic 5 system in promoting economic development, it is some- Development (The Brookings Institution, 1973) what strange that, at an international level, this role is 3. See R. S. Sayers, Ceitral Banking in Underdeveloped not sufficiently stressed in providing technical and Countries (Cairo, 1956). financial assistance to the developing countries for the purpose of promoting the evolution of sound financial 4. See John I-licks, Capital and Growth (Oxford, 1965) systems. The International Monetary Fund emphasizes Chapter XXIII, p. 292. Hicks writes: 'There is a place for monetary policy .... It can perform its function more satisfac- the regulatory role of Central Banks only, while the torily ... if it is backed by an efficient system of financial International Bank for Reconstruction and Development intermediaries.' See also pp. 290-2 lays stress on the development of specialized financial intermediaries only. The result is that a large number of 5. See Joseph A. Schumpeter, Business Cycles (New York, central banks have not been appropriately oriented 1939) Volume 1, pp. 109-29. See also Alexander Gerschenkron, Economic Backwardness in Histoncal Perspective (Cambridge, towards development objectives in general, and to the Massachusetts, 1962) pp. 10-15 and Rondo Cameron et al. development of sound financial systems in particular. (eds.), Banking in the Larly Stages of Industrualization A Study Further, the evolution of specific financial inter- in Comparative Economic History (Oxford, 1967) mediaries takes place in such a way as to promote 6. For a discussion of saving and flow-of-funds analysis as a further fragmentation of the capital market; or at any technique for financial planniing, see V. V. Bhatt, 'Saving and rate the policy of merely promoting specific financial flow-of-funds analysis: A tool for financial planning in India', intermediaries does not stress the need for an integrative The Review of Income and WVealth (March 1971). 60 WORLD DEVELOPMENT Table 1. Sectoral surpluses and deficits (-): 1950-59 Percent of Gross Domestic Product Developed Less developed All countries countries countries 1. Households 6.1 3.5 4.8 2. Enterprises' -7.6 -4.9 -6.3 3. Government 1.3 -0.7 0.3 4. Rest of the World -0.1 2.1 1.0 Source. R. W. Goldsmith, FinancialStructure and Development (Yale, 1969) p. 441. * Includes government enterprises. Table 2. Pattern of household saving India USA (1963-4) 1909-14 1960-4 Form of Saving % % % 1. Financial assets 66.7 98 123 (5.5) (8.83) (10.09) 2. Financial liabilities -16.7 -46 -86 (-1.4) (-4.17) (-7.06) 3. Physical assets 50 48 63 (4.1) (4.35) (5.17) 4. Total (1+2+3) 100 100 100 (8.2) (9.01) (8.20) 5. Percentage share of household saving in national saving 67.2 - 61 Figures in brackets indicate proportion of personal disposable income. Sources. V.V. Bhatt, 'Saving and flow of funds analysis: A tool for financial planning in India', The Review of Income and Wealth (March 1971). R. W. Goldsmith, 'Changes in the structure of personal saving', Saving in Contemporary Economic Research (Congress Palace, Brussels, 1965). can be reliably compiled and presented. The data the projected volume and pattern of investment. relating to corporate enterprises and financial inter- Further, various policy instruments can be rationally mediaries are available and can be consolidated in the used for attaining financial balance only when the degree required form with some effort. Similarly, data relating and nature of imbalances are clearly known through to the, government sector and the balance of payments flow-of-funds analysis. are available and can be presented in flow-of-funds form along with the data for corporate enterprises and A. Characteristicfeatures of saving and flow of funds financial intermediaries. The data relating to the govern- Saving and flow-of-funds analysis brings out the ment sector, corporate enterprises and financial inter- crucial importance of household sector saving for mediaries can provide the necessary information relating financing the saving deficits of the government sector to the transactions of these sectors with the household and the private corporate sector. Generally, the latter sector-an omnibus term for the sector comprising all two are deficit sectors and the only surplus sector is the unincorporated enterprises and households. Thus, pro- household sector which finances directly and indirectly, vided the usefulness of flow-of-funds analysis is through the financial institutions, a part of the deficits recognized, it may not be difficult to collect and process of the other two sectors. The external sector finances data in this form. the residual deficits. Whatever the development objectives and whatever Table 1, on Sectoral Surpluses and Deficits during the nature of planning or programming, it is essential to 1950-59 in 14 developed countries and 10 developing aim at financial balance. This balance indicates that the countries, brings out this fact clearly. In the developing investment demand for resources of the deficit sectors is countries, both the government and business sectors met by the supply of required resources from the surplus have deficits-that is, their total expenditures exceed sectors. In most of the developing countries, and in the their incomes, while the household sector shows a developed countries, the surplus sector is the household surplus and finances, along with the external sector, the sector which provides resources directly, or indirectly deficits of the government and business sectors. In the through the financial intermediaries, to the government ueveloped countries, the government sector shows a sector as well as to the corporate sector. The other surplus. However, in the data available, government sector which provides resources to these deficit sectors enterprises are included in the business sector; if these in the developing countries is the external sector through enterprises were shown in the government sector, it is official external assistance and private foreign invest- likely that the government sector too would have been a ment. For the viability of a development program, it is deficit sector. essential that these resource-flows are consistent with The second significant implication of the saving and FINANCIAL POLICIES AND CENTRAL BANKING IN DEVELOPING COUNTRIES 61 flow-of-funds data is that the saving surplus of the these rates. And secondly, these high rates induce household sector that can be potentially transferred to speculative investment-investment in land, real the other two sectors is represented by the household estate, scarce commodities, gold and the like. Thus, saving in the form of financial assets. Of course, a part of on the one hand, potential productive investment is this surplus returns to the household sector via its not taken up and, on the other, resources are diverted borrowing from the financial institutions. toward undesirable forms of investment. Household sector saving is partly in the form of (iii) Because of the existence of this unorganized physical assets like residential housing, equipment, and market, government economic policies-credit as well inventories of goods, and partly in the form of financial as fiscal policies-are not very effective in influencing assets. Saving in the form of physical assets represents the magnitude or the pattern of investment in the household sector investment, which is financed partly by household sector.