Book Description

May 1995 Directed credit programs should be small, narrowly focused, and of limited duration (with clear sunset provisions). They should be financed by long-term funds to prevent inflation and macroeconomic instability. Directed credit programs were a major tool of development in the 1960s and 1970s. In the 1980s, their usefulness was reconsidered. Experience in most countries showed that they stimulated capital-intensive projects, that preferential funds were often (mis)used for nonpriority purposes, that a decline in financial discipline led to low repayment rates, and that budget deficits swelled. Moreover, the programs were hard to remove. But Japan and other East Asian countries have long touted the merits of focused, well-managed directed credit programs, saying they are warranted when there is a significant discrepancy between private and social benefits, when investment risk is too high on certain projects, and when information problems discourage lending to small and medium-size firms. The assumption underlying policy-based assistance and other forms of industrial assistance (such as lower taxes) is that the main constraint on new or expanding enterprises is limited access to credit. Vittas and Cho give an overview of credit policies in East Asian countries (China, Japan, and the Republic of Korea) as well as India, and summarize what these countries have learned about directed credit programs. Among the lessons: * Credit programs must be small, narrowly focused, and of limited duration (with clear sunset provisions). * Subsidies must be low to minimize distortion of incentives as well as the tax on financial intermediation that all such programs entail. * Credit programs must be financed by long-term funds to prevent inflation and macroeconomic instability. Recourse to central bank credit should be avoided except in the very early stages of development when the central bank's assistance can help jump-start economic growth. * They should aim at achieving positive externalities (or avoiding negative ones). Any help to declining industries should include plans for their timely phaseout. * They should promote industrialization and export orientation in a competitive private sector with internationally competitive operations. * They should be part of a credible vision of economic development that promotes growth with equity and should involve a long-term strategy to develop a sound financial system. * Policy-based loans should be channeled through well-capitalized, administratively capable financial institutions, professionally managed by autonomous managers. * They should be based on clear, objective, easily monitorable criteria. * Programs should aim for a good repayment record and few losses. * They should be supported by effective mechanisms for communication and consultation between the public and private sectors, including the collection and dissemination of basic market information. This paper -- a product of the Financial Sector Development Department -- is part of a larger effort in the department to study the effectiveness of policy-based finance in East Asia.