Old problem, older solution

State-controlled DFIS will have the same problems as PSBS

One of the moves that the government is reportedly taking to increase investment in the upcoming Union Budget is to announce the formation of one or more new development finance institutions (DFIS) to focus on long-term capital financing. Such DFIS would not be a new feature of the Indian landscape, though most of the large institutions set up in the post-independence decades were transitioned into regular banking in the 1990s. Why is the government considering returning to a financing model that it was once thought India had outgrown? Several reasons could be stated in its defence. For one, the hope that a deep and liquid corporate bond market would grow in India has been belied. Various reasons — including heavy government borrowing — have ensured that the corporate bond market in India has remained stunted. For another, commercial banks in the pre-2008 crisis era were much more comfortable with taking on the maturity mismatch involved in funding long-term projects in spaces like infrastructure. In today’s India, the need to ensure sufficient infrastructure finance — particularly given the weakness of the non-banking financial sector — and the revenue crunch faced by the government mean that there is an understandable desire to find other ways to channel long-tenure capital.

Yet it is far from certain that new DFIS will be good at the job that they will be set up to do. The basic problem with state-controlled banks will apply also to state-controlled DFIS. They will be subject to political interference. In the worst case, this will take the form of cronyism and favouritism towards particular borrowers. But even otherwise, state-controlled DFIS would inevitably become one of the instruments used by the Union government to manage the economy and achieve its ends. State-controlled banks are weighed down by multiple policy priorities and directives issued by their primary owner. State-controlled DFIS will similarly find their room to manoeuvre as well as risk appetite determined by politicians and bureaucrats. They will find themselves told to focus on particular sectors or solve particular problems. For example, a government with coal-fired power plants facing closure due to new regulations might force a DFI to provide project finance to that sector. The government has already come out with various lists of “champion sectors”, and it is likely any new DFI would be forced by bureaucratic diktat to prioritise them.

Further, the government’s push for DFIS is a shortcut of the real work that needs to be done to de-risk long-term investment in India. And that is, after all, what DFIS are really for — claims that it should instead focus on, say, equity financing, are woefully misguided as to the actual gap in the market these are intended to fill. Any ambition in the direction of DFIS should be carefully circumscribed. Sector-specific institutions in which the government has a minority stake and no control, but in which its stake exists purely to provide de-risking comfort to other investors, would be far more effective. Such initiatives should come alongside longer-term effects to deepen the corporate bond market — for example by reducing banks’ dependence on holding government securities — and improving policy and legal certainty for long-term finance, including through protection against arbitrary judicial action.