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Industrial development – why invest in financial sector development?

Industrial development – why invest in financial sector development?

20 Oct 2016

Ashly Hope, tralac Research Advisor, comments on the importance of investment in financial sector development for successful industrialisation in the 21st century

Industrialisation conjures images of factories and workers, shifting from agriculture to manufacturing, from extraction to value-added production and moving up the value chain. Yet new factories and technologically enhanced production lines are only part of the industrialisation story. In the modern, globalised world, there are many more inputs to a competitive and diversified economy – surely the ultimate goal of any industrialisation plan.

Industrialisation in the 21st century is about complex economic linkages and relationships that transcend traditional policy, industry/sectoral and geo-political boundaries. African industrial development is occurring in a globalised environment and the inputs into that development will not be found solely inside the borders of any one country or continent.

Finance is one such globally integrated industry, and the global financial services sector plays a critical role in modern industrialisation both as a support service underpinning industrial development and trade-in-goods, and as an industrialising sector and tradeable service itself. As such, recognising the importance of, and facilitating financial services sector development is essential to any industrial development policy.

In other sectors where industrial development policies are pursued – manufacturing, mining – investment in and incentivising of particular businesses and infrastructure development are key tools for industrial development. Although this can also be important in services sectors like the financial sector, there is arguably more to be gained by ensuring the policy and regulatory settings are enabling of sector development.

Enabling industrial development

Financial services channel funds – both domestic and international – through bank lending, market-based lending and equity fundraising that can support industrial development. In particular, the investment in plant and equipment, research and development, and the expansion of businesses; as well as investment and/or development of other supportive infrastructure for industrial development.

Banks and financial markets are considered to be more effective and efficient at allocating funding to the most productive areas of the economy than the public sector. As such by encouraging the development of functional, efficient and well-regulated financial institutions and financial markets, we can expect to see money flow to those areas of the economy most likely to generate profits.

Non‑traditional financial services businesses can also provide much needed financial services and products to businesses that traditional banking, insurance or financial markets do not or will not support. Encouraging new financial businesses and new kinds of financial products and services as part of a broader innovation eco-system means that a diverse financial sector will contribute to more diverse industrial development.

Furthermore, fiscal constraints mean that even if they wanted to, governments could not fund industrial development alone. The participation of private funding sources, including though the crucial FDI channel, is therefore essential to realise the full possibilities of industrial development.

Financial sector development also means that the mechanisms and skills become available to channel and leverage public funds – via development banks, public-private partnerships and government bonds. Skills such as credit and risk analysis, and mechanisms such as the payments systems are created within and by the financial sector. These public mechanisms will not function effectively without a robust financial system in which to operate.

Payments systems are a particularly important part of the financial sector infrastructure, being crucial to enable the transfer of funds right across the supply chain, from manufacturers to suppliers and from consumers to distributors, as well as from employers to employees.

A stable, well-regulated financial system is also important in creating a favourable investment environment generally, and therefore in attracting foreign direct investment into the manufacturing and other priority sectors.

Graduating businesses

Financial services play an important role in graduating businesses from small and micro enterprises to bigger businesses that generate more economic activity, including by employing others. Without the credit, insurance or intermediation of investment funds that financial services offer, this graduation could take much longer, or not occur at all.

For example, by minimising the risk from crop failure, weather insurance has encouraged smaller farmers to invest more in improving the productivity of their core businesses, rather than spending money on alternative sources of income or food.

Micro-credit loans can enable small businesses to grow – for example through investing in new capital equipment, opening new locations, diversifying offerings or entering new markets. These loans can also provide a pathway to further financial products and services, as well as assist in effective business management.

Facilitating international trade

Financial services are essential to trade in both goods and services. Trade can only occur if the seller and buyer both have confidence that the exchange of money for goods or services will occur – when the exchange does not occur contemporaneously, as is the case with international trade, specialised financial services such as letters of credit, and export insurance as well as foreign exchange services enable the necessary level of trust for the transaction to occur.

A lack of finance is a significant barrier to trade growth globally and an acute problem on the continent. A recent survey from the International Chamber of Commerce found that 66% of businesses find access to finance a significant obstacle to trade in Africa. The ICC estimates that the trade financing gap in Africa is between US$110-120 billion.

Improving manufacturing productivity

There is evidence that services sector reforms, including reform of the financial sector can not only support industrialisation, but actually improve manufacturing productivity. Studies have found financial sector reforms are associated with both improved manufacturing productivity and better export performance.[1] In a specific study on India, the authors find that liberalisation in the banking sector has improved capital allocation and allowed investment in higher return projects[2] – demonstrating that an open and competitive sector supports overall resource allocation across the economy – including to new activities.

Financial sector industrialisation

The shift towards new production methods – using technology such as 3D printing and sophisticated robotics – leading to ‘localisation’ of production in developed economies – and increased automation generally means manufacturing may not drive development in African economies in the same way it has done for other countries. This means it is even more important to have robust and effective underpinning services – services that can provide both demand and supply side support to all areas of the economy, not just manufacturing. Financial services, by way of their role in facilitating and enabling both individual and household wealth creation and consumption, and productive investment are such a service.

Similarly, with the industrial sector becoming less labour intensive, globally services are increasingly the most important source of employment. For example, the UK’s latest employment figures show that since the late 1970s, the proportion of jobs accounted for by the manufacturing, and mining and quarrying sectors fell from 26.3% to 8.0%, while the proportion of jobs accounted for by the services sector increased from 63.2% to 83.2%.[3]

Recognising that, in a world where a traditional, linear industrialisation path is not necessarily possible, nor guaranteed to offer broader growth and development, the industrialisation of the financial sector itself can provide a potential source of growth and development and contribute to a diversified economy.

If industrialisation can be considered as a rapid increase in productivity enabled by technological and management advances, for the financial sector, industrialisation comes in the form of the ‘billions of people connected by mobile devices, with unprecedented processing power, storage capacity, and access to knowledge…’ and the increasing possibilities of artificial intelligence described by Klaus Schwab as the “Fourth Industrial Revolution”.[4] The ability of the financial sector to take advantage of these technological advances will significantly impact the development and growth in financial eco-systems in Africa where fintech developments are disrupting and even substituting for traditional financial services. For example, the vast increases in information that are accessible as a result of technological advances means that financial services can be better targeted or more suitable products can be designed, but the ability for financial services businesses to process, interpret and use the information appropriately is not guaranteed.

What does this mean for financial sector policy and regulation?

For many African countries, broad-based financial sector development and growth is desirable. While oversized financial sectors are associated with economic and fiscal risks, the size and depth of financial sectors on the continent are generally not close to this threshold.

To enable this growth, and therefore to enable the financial sector to support other sectors, appropriate financial sector policies and regulation need to be in place.

If poorly regulated, financial products and services can do more harm than good, and importantly can erode trust in the broader financial sector. For consumers, financial products and services can be particularly harmful to wellbeing. This, combined with the difficulty for consumers to make optimal decisions about the purchase of financial products and services[5] means that regulation is both justified and desirable to protect consumers. In addition, the use and sharing of personal information must be regulated for appropriate privacy and data protection, but be balanced with the possibilities for the use of information to offer better and new services. And of course, the financial sector has a unique role in an economy, so regulation to ensure stability is also essential.

However, regulation, if poorly designed or implemented can stifle innovation and create barriers to participation both from the consumer and the provider perspective. That is, both little or no regulation, and too much or inappropriate regulation, will hold back the growth and development of the sector and its ability to provide the support needed for industrial development. The regulatory framework – internationally, domestically and how these interact – has an important impact on the development and competitiveness of the sector.

More generally, a strong supervisory framework and actual supervision and enforcement of regulation is essential. Consistency with international standards, including having a regulatory structure that facilitates entry and exit will encourage sectoral competitiveness. Increased openness and engagement with the private sector – big and small providers, and big and small consumers of financial products and services – will enable the regulatory regime to work for the businesses and people it is intended for. Cooperation with other regulators – domestically and internationally – is necessary given the global nature of finance. Perhaps most importantly, however, is regulatory transparency, flexibility and responsiveness. The flip side to this is that regulators must be accountable and regulation must be transparent. This will enable all stakeholders to understand the environment, to accommodate innovation and to respond to new challenges and threats to consumers and financial stability.

Financial sector policy should not be directed primarily at trade, but it should consider the trade implications, because ultimately these will affect the competitiveness of the sector, as well as have a direct impact on consumers. Similarly, financial sector development policies need not specifically focus on the role of the financial sector in industrial development in order to support it, but consideration of where the gaps are and where adjustments might be made to enable finance to do play its key role industrial development – channelling investment to create new, diversified productive capacity, expanding existing capacity and enhancing competitiveness.

Industrial development does not occur in isolation from the development of its supporting sectors. Finance is an essential part of this puzzle. Investment in enhancing the regulatory framework, expanding the capacity and responsiveness of regulators and encouraging competition and innovation in the sector can provide a significant contribution to industrial development goals – both through the support of industry, and as an important employer and potential export service itself.

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[1] See, for example: Bernard Hoekman and Ben Shepherd ‘Services Productivity, Trade Policy, and Manufacturing Exports’ EUI Working Paper RSCAS 2015/07.

[2] Jens Matthias Arnold, Beata Javorcik, Molly Lipscomb, Aaditya Mattoo ‘Services Reform and Manufacturing Performance: Evidence from India’ The Economic Journal Volume 126, Issue 590 February 2016: 1–39. Available at: http://onlinelibrary.wiley.com/doi/10.1111/ecoj.12206/full

[3] ONS Statistical bulletin: UK Labour Market: September 2016

[4] Klaus Schwab 2015 ‘The Fourth Industrial Revolution What It Means and How to Respond’ Foreign Affairs https://www.foreignaffairs.com/articles/2015-12-12/fourth-industrial-revolution

[5] Due to market failures such as information asymmetry, systematic decision-making biases exhibited by financial consumers, agency problems associated with sales incentives.