External Finance for Private Sector Development

Most forms of foreign finance for private sector development (PSD) have gone through peaks and dips over the years. The objective of the chapter is to present not only a comprehensive picture of this pattern but also to describe its movement over the years and to provide likely explanations.While our explanations are at times based on findings reported in existing empirical literature, we also have recourse to some empirical tests, particularly in cases where previous studies have insufficiently reported on factors affecting cross-border flows of the types of finance under consideration.

In the minds of a large majority of development thinkers and agencies, there is no longer any doubt that the private sector is the real ‘engine of growth’, the motor that will lead to economic progress and thereby to poverty reduction. On the other hand, the lack of conceptualization and, certainly, operationalization of the poverty reduction objective is a major problem for the development cooperation policies of the donors.This is of particular importance when looking at those interventions and programmes which seem at best to be tackling only one dimension of poverty reduction, such as those falling under the rubric of private sector development (PSD).

In the 1980s, development thinking shifted from seeing the state as the conducive force behind economic activities to viewing it as the facilitator of an enabling environment for the private sector which, in turn, is increasingly recognized as the prime mover of economic activities.By the mid- 1980s and the early 1990s, the socialist systems were under strain and, indeed, crumbling. In 1991, the Soviet Union collapsed and market reforms progressed (Exeter and Fries 1998: 26). As if awakened by these events, the donor community, academics, policymakers and professionals in the aid business, increasingly focused attention on the effectiveness of previous aid efforts. It is worth noting that until very recently, virtually all recipients of official aid were governments and such aid was for public sector development (Van de Walle 1999: 345).

Recent years have witnessed important changes in the area of development finance, both internal and external. Regarding external development finance in particular, the volume of net official flows has been decreasing and the net private flows have been not only very volatile but also geographically concentrated in favour of just a few countries.External official support for private sector development (PSD) in these countries is a way of rectifying this situation and, arguably, this is better implemented within amultilateral framework than if donor countries do so individually. This realization has thus prompted a resurgence of specialized affiliates, units or windows of the existing global and regional multilateral development banks that provide direct support for PSD in these countries. Some multilateral development banks, particularly the European Bank for Reconstruction and Development (which exists solely for providing support for PSD in the transition economies), have also been established. There is a clear need to shed light on how these multilateral institutions have been performing, how they allocate their portfolio, how they accomplish their missions, and so on. This can be done by looking at a prototype or representative one, as a case study, although a substantial degree of variation may be expected among different multinational development banks (MDBs).

Over the last decade or so, we have observed a proliferation of microfinance institutions (MFIs) in developing and transitional economies as well as in some developed countries such as USA and Canada.Modelled on infamously ‘successful’ institutions such as the Grameen Bank of Bangladesh, the Badan Kredit Kecamatan (BKK) of Indonesia or BancoSol of Bolivia, new strands of ‘innovative’ microfinance institutions have been established specifically for reaching ‘the poor’, in the field of ‘micro-enterprise finance’ and ‘poverty lending’. Drawing lessons from the widely acknowledged failure of the earlier experiments with credit interventions such as the targeted rural credit programmes based on subsidized interest rates, new microcredit programmes lean heavily towards ‘market-based solutions’, with use of concepts such as group lending and joint liability contracts.

The developing countries of the world have in general been recipients of both official and private financial flows over the last four decades. Understandably so, since in most of these countries, the level of domestic savings is generally very low, the financial sector is widely underdeveloped and in most cases repressed, and therefore the capacity to harness domestic financial resources for sustainable development of the key sectors of the economy is quite limited.A wide body of literature has investigated the role that the flow of external financing could play in the development of recipient countries. The convergence of opinion seems to be that on the balance, there is a net positive relationship between external financial assistance and economic performance of countries, particularly if and when such assistance is accompanied by conducive policy environment (Burnside and Dollar 2000). This may have in some way informed the UN General Assembly, which after adopting the international development goals (IDG) in September 2000, also conceded that the mobilization of external financial resources is essential to the attainment of the goals. An important component of the IDG is the commitment of governments to reduce by one half, the incidence of absolute poverty, which is more pronounced in the developing countries of the world by 2015. According to UN (2002: 5),

Capital flight remains one of the enigmatic policy and academic issues of the day. Although from the end of the 1980s and early 1990s the debt crisis appeared to be contained and attention to the capital flight phenomenon waned, capital flight still remains a serious problem in a number of countries.The most pronounced concern among policymakers, researchers and the key stakeholders in economic development is that in most developing countries which are riddled with heavy debt burdens, foreign exchange shortages, transient and chronic poverty, capital flight amounts to a substantial proportion of the very resources which are essential for financing economic growth and reversing the perverse economic trends.¹