The Perils and Promise of Financial Markets for Development

In the first two editions of the CGD/Gui2de Future of Development seminar series, our look at the big ideas that have the potential to reshape the face of development over the next decades, we examined how the adoption of digital technologies could change the way farmers receive and engage with information, and in turn their agricultural and marketing practices; and the importance of large government investments in public health for the pursuit of better health outcomes. The third edition, featuring Atif Mian and Jing Cai, was a little different: it started with Atif providing a stark warning on what not to do, before he and Jing made the case for how financial markets can be effectively marshalled in support of the productivity-enhancing investments that are crucial for economic development.

It is almost an article of faith that in the face of a substantial financing gaps and credit constraints, larger global capital inflows will accelerate development. Atif challenged this belief with a simple but powerful empirical observation: that developing countries with larger global capital inflows tend to have lower productivity growth.

Atif argued that a productive relationship with global capital requires distinguishing between healthy and unhealthy capital—which is in turn derived from what it finances. The junk food of the global financial market is the money that enters and exits at high volume with minimal productive impact: portfolio flows and short-term loans. Similarly, capital that finances non-tradable sectors like real estate will inflate the waistline without much impact on the productive potential of the economy. Such flows cause real exchange rate appreciation and possibly macroeconomic disruptions.

Instead, he argued, finance that focuses on the tradable sector, and generates improvements in productivity of traded goods are what should be encouraged. He suggested that in many ways, finance itself is a secondary concern in accessing global finance. Rather, the knowledge transfer and learning in sectors of the economy which have the space to expand and compete globally are what should be most deeply prized. The role of the financial aspect of the relationship is to create an incentive on the part of the investor to successfully transfer the knowledge and induce productivity upgrading.

Atif pointed to China as a successful example of this strategy, and Jing’s discussion used China as a setting for a microeconomic complement to Atif’s birds-eye view. She discussed the firm-level dynamics of how credit (domestic in her case) is used to change production operations, and the market-level effects expanding access to credit. Though using a different approach from Atif’s, her conclusion was similar: it is how the firm uses the credit that determines its effects. Most firms were using credit to increase their quality/price ratio and expanding their market share; this generated large welfare gains to consumers and changed the overall shape of the market, tilting it more towards higher-quality producers. She too pointed to research which suggested that there was something special about credit to the tradable sector, where such crowding out was more muted, but positive effects still observed.

The discussion was rich and varied. Most provocatively, they discussed whether the credit provided by the multilateral development banks falls under the ‘healthy’ or ‘unhealthy’ side of the ledger. Atif argued that the lender needs an incentive to transfer both finance and technology to the borrower, and consequently that equity, rather than concessional lending, is the optimal form of global capital transfer. Shanta pointed out that in many ways, technical expertise, rather than concessional finance, is the central aspect of the World Bank’s offer.

The example of China’s approach to global capital and domestic credit came up repeatedly in the session, providing a neat segue to the next Future of Development seminar on June 24 from 9:00 to 10:15am EST, at which Yuen Yuen Ang and Shang-Jin Wei will discuss China’s rapid development and the lessons it bears for developing countries today.

The discussion of Atif’s paper here draws extensively on his superb Twitter thread of his talk.