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UNITED NATIONS CAPITAL DEVELOPMENT FUND Microfinance |
Issue 4 / July - August 2004 |
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News | Donor Recommendations and Government Constraints: The Case for Some Restraint By Marc Jacquand The recent emphasis on integrating microfinance into country’s financial landscape has increased the focus on how governments should support the development of the sector and its formalization. A few years ago, the donor community touted microcredit as an instrument to directly support local entrepreneurship without having to work through or with public authorities. Now, the shift to microfinance as a broader concept of integrated financial services for the majority has in a way rehabilitated governments and their role in the process. As a result, governments around the world are now the focus of the donor community. Based on the experience of markets that have reached microfinance maturity, donors are consolidating knowledge on how national and local governments can support the industry’s development and its integration into the country’s financial sector. With the aim of transferring the lessons learned to less developed markets, advice on policy reform for microfinance is now plentiful. Donor training courses now include specific sessions on government policies. Many donors now support the drafting of national policies that spell out the responsibilities of the state in promoting the growth of the industry. Lists of best practices for governments are being compiled. The history of any industry includes a chapter on government intervention. So it is only natural and healthy for the microfinance community to envision, explore and define how public authorities can contribute to the development of the industry. As donors move forward with their policy advice, it is necessary to look at historical track records and political realities. In some countries, government’s contribution is long overdue given the market’s maturity; in others the rush to engage governments may be premature. From isolation to engagement, has the pendulum swung too far? Any list of constraints and appropriate policy responses should pass two tests. Do we understand financial sector development? It is important that policy recommendations make sense, in terms of the country’s economic situation and its capacity to enact reforms. One challenge is to determine whether recommendations that pertain solely to microfinance will have the desired effects or whether microfinance development derives from broader economic measures and financial sector reforms. Under the latter hypothesis, the development of the financial sector is linked with issues such as budget deficits, monetary policy, legal frameworks, distribution channels and market infra-structures. Hence, any recommendation that strives be practical and cement concrete results should fit with other financial sector development policies. A clear understanding of a policy’s consequences and implications is required to avoid potential incompatibilities. In some cases, policies intended to support the growth of a microfinance sector may conflict with other economic policies designed to root out corruption, enhance market competition, increase the national savings rate or increase the state’s revenue base. Given its complexity, the history of financial sector reform is strewn with ill-advised and ill-fated initiatives. The stark contrast between the reality in the field and the academic research and policy papers on the issue attests to its inherent complexity. Even a succinct review of recent discussions reveals unresolved debates and the lack of clarity on potential solutions. Experience from one country can hardly be transferred to another as text-book – or ideological – assumptions are often challenged by results on the ground. For example, studies on the Philippines have shown that the removal of restrictions can sometimes lead to a higher concentration of service providers, and less competition. In some cases, rigid adherence to “best practices” may act as barriers to entry or facilitate takeovers by large institutions of weaker, yet promising competitors. This is particularly true when best practices are narrowly defined, forcing institutions into an operational straightjacket stunting their growth. Can we ensure that our list of best practices will lead to greater competition and choice for the poor? Donors should be aware that since the elasticity of substitution between alternative financial instruments is usually high (especially in developing economies), deliberate proliferation of financial instruments could reach the point of zero marginal return. Hence, optimal financial development may involve only modest innovation of financial instruments. This will of course depend in part on the level of economic activity that can absorb financial innovation. Yet this issue serves as a reminder that resources can be wasted on attempts to force-feed innovation in an immature market. What tools do we currently have and propose to gauge the market’s receptivity and absorptive capacity for new financial products? Government ownership is often positively linked to underdevelopment and inefficiency of the financial sector. As a result, donors emphasize the need to privatize microfinance while frowning with suspicion upon government owned institutions. Government ownership often translates into inappropriate meddling and poor oversight though private ownership is not always exempt from these malpractices. Political interference comes in many guises, even under the cloak of private ownership. The public versus private divide is not as important as the adherence to sound and transparent business practices. History, in countries such as France, Italy, and Taiwan, suggests that government institutions can drive market development, including the financial sector. France actually offers a vivid example of the good, the bad and the ugly of government participation in financial services. The bad and the ugly usually eclipse the good when the government, after playing the useful midwife role, does not know how to let go, and transfers ownership to private hands with no strings attached. Do we want to simply and unequivocally advocate for private ownership of the microfinance industry? Finally, one issue that has received little attention is the integration of MFIs into the interbank market as a source of capital. What are the pre-existing conditions required to set up simple and efficient interbank markets, in which MFIs could access liquidity from other financial institutions, including other MFIs? The list of technical challenges, where consensus is scarce, is endless. Numerous conflicting studies and policy papers show that the links between reserve requirements and deposit levels remain obscure and poorly understood. In our recommendations on the development of direct markets, will we take into consideration the numerous tax implications (taxing dividend income versus deposit income, and the problems of double taxation)? And then, there is the political test. Microfinance ideals and political realities In general, the microfinance community is often unaware of the constraints that their government counterparts face. They offer policy recommendations with the expectation that they be implemented as a matter of priority while in fact, local realities may require that these measures take a back seat to more pressing matters. In fact, policy recommendations usually clash with political realities on two levels: timing and the political and social context. The development of the microfinance sector may not always be a priority and more pressing issues such as rebuilding the infrastructure or stemming a health endemic may bump microfinance off the to-do list. In a context of limited institutional capacity, we should sharpen our understanding not only of what a country needs, but also of what a government can realistically achieve. Policy recommendations will only be useful if they come with the appreciation of such constraints. While policy notes and best practice books are the realm of the ideal, politics is the realm of the possible. Furthermore, governments in many countries are faced not just with a set of choices, but a set of theoretically bad choices. In this context, the donor community should recognize that what it calls “bad practice” measures are often chosen and implemented for the right reasons. For example, many post conflict governments are formed to ensure an immediate cessation of violence. After achieving this goal, the priority for such governments is to maintain the peace by ensuring that the people quickly see concrete action that is beneficial to all segments of the population. As a result, national and local officials may be hard pressed to engage in “bad practices”. Donors often frown upon certain practices that risk undermining the long-term development of a vibrant financial sector. Yet, in a post conflict situation where tensions linger, these concerns need to be balanced with the need for responsiveness to local suffering, necessary for maintaining social peace and political stability. Political constraints are usually more time sensitive. A list of policy recommendations should therefore recognize what is politically feasible and what is not. Since there is a world beyond microfinance, governments may sometimes dismiss good advice for the right reasons. While policy notes and best practice books are the realm of the ideal, politics is the realm of the possible. In fact, these political constraints may call for greater caution when engaging national and local authorities. Since the microfinance industry can initially flourish without government intervention, donors should think twice about putting it on the political radar screen. In many cases, where politicians, despite good intentions, will use microfinance in less than optimal ways it may need to be isolates from the political focus. Lack of government knowledge and intervention is often the most propitious environment a government can create. So should donors support national
policies? Many mature microfinance markets grew initially without a national
policy and strategy. Perhaps a detailed policy is useful at latter stages of
development, when the industry has reached a size that extends beyond any politician’s
ability to inflict irreparable harm, when the policy recommendations can claim
to have passed both the technical and the political tests.
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