The role of national development banks in industrial policy

The views expressed in the Let’s Talk Development blog are solely those of the author(s).
 

Industrial policies seek to transform the productive structure of economies. This blog explores the role of National Development Banks (NDBs) in addressing market failures to provide long-term capital to finance the investments needed to implement industrial policies.

Industrial policies often use tariffs and fiscal subsidies to make investments more attractive. However, long-term investments need long-term capital, which is often provided by government-sponsored financial services.  According to Juhasz et al. (2023), 69% of industrial policy actions by high-income countries involve financial state loans, trade finance, loan guarantees, or equity investments. This share is 61% for middle-income countries and 48% for low-income countries, through their dataset has limited coverage of low- and middle-income countries

National Development Banks (NDBs) are key actors in the provision of finance for economic transformation often contributing to policy formulation given their industry expertise. NDBs are financial institutions with a policy mandate, typically owned or controlled by the government. Lending is their core activity, but they provide a variety of financial services (e.g. guarantees, equity investments) as well as advisory services. Examples include KDB in Korea, Brazilian BNDEs or KFW in Germany.

Contrary to the believe that NDBs are mostly active in countries with underdeveloped financial markets, recent data shows that NDBs are mostly present in high and upper middle-income countries and are prevalent in all continents. During the 1980s and 1990s, poor performance and fiscal constraints led to privatization and institutional reforms. In recent years, NDBs have experienced a revival due to their countercyclical role and their role in financing Sustainable Development Goals (SDGs). SDGs such as quality jobs and climate transition are common industrial policy objectives. Following the global financial crisis, the EU issued guidelines for EU countries to set up NDBs in case they did not have one and several new NDBs have been created in Europe and elsewhere.

Underlaying Rationale

NDBs are well placed to address market failures such as asymmetric information, externalities, and coordination failures. They have higher risk tolerance and can provide long-term capital at favorable rates thanks to government backing and donor funding. However, NDBs can face political interference and capacity constraints that may hinder their effectiveness.

There is no empirical cross-country evidence on NDB performance. Some studies on the effects of individual NDB activities show positive impacts on firm sales, exports, and employment, but not on productivity. For instance, guarantees provided by the Korean Development Bank on foreign loans to firms investing in heavy industries and metal sector during the 1970s increased firm sales as much as 30 years after the credit stopped (Choi and Levchenko 2021). Loans also supported export and employment growth in beneficiary firms, doubling real output in targeted industries. However, evidence on the impact of Brazil BNDES investment loans during 2009-2015 is mixed. Listed large firms receiving the loans did not increase investment but used those loans to replace private credit (Lazzarini et al 2015). Exports and employment grew, particularly for credit constrained firms (De Negri et al. (2011), Machado et al (2011) ) but productivity did not increase (Souza and Ottaviano (2007), De Negri et al (2011), Souza and Ottaviano (2014)).

In the presence of coordination failures, non-subsidized co- lending and guarantees and equity investments by an anchor investor/coordinator agent are the first best solution. For other market failures there are alternative measures to government-sponsored investments and NDBs, but they are not always feasible or effective for all types of investments

• Pigouvian taxes (creating an additional cost borne by individuals not directly involved in the transaction, e.g. carbon taxes) and investment subsidies can be more efficient in case of externalities but have high budgetary costs and may not be politically feasible. Furthermore, investment subsidies may create a culture of subsidy that subdues credit demand reducing investment.
• Reforms in credit information systems and collateral reforms can address information asymmetries, particularly for SMEs. However, the UK and France created SME NDBs in the mid 2010’s despite well-developed financial infrastructure and the US continues to provide government loans and guarantees through the Small Business Administration (SBA).
• When NDBs are not efficiently run, it may be better to use interest loan subsidies and public guarantee funds. These interventions outsource credit decisions to private financial institutions and mobilize private capital. However, this requires a well-developed financial system with institutions funding long-term projects and high-risk investors.
   

Lessons Learnt from Efficient NDBs

Successful NDBs focus on addressing market gaps and crowding in private finance to ensure additionally. Subsidized loans are appropriately funded not to compromise solvency, well targeted and at a scale that does not distort credit markets. Effective development banks are well managed (through corporate governance and risk management), and incentives are aligned throughout the institution (through remuneration policies, supervision, and impact evaluation). Lending through financial intermediaries for on-lending or providing guarantees can be an effective way to improve NDB performance in countries with poor governance culture.
 

Conclusion

Government loans and guarantees are widely used industrial policy tools to increase investment in new industries/activities. NDBs play a key role in implementing industrial policy, addressing market failures to provide the necessary long-term capital. By learning from successful NDBs and considering alternative measures, we can enhance their effectiveness and ensure they contribute positively to economic transformation.