Credit Policies: Lessons from East Asia

This paper explains that directed credit programs were a major development tool in the 1960s and 1970s. Yet in the 1980s, their usefulness was reconsidered as experience in most countries showed that they stimulated capital-intensive projects, that preferential funds were often (mis)used for nonpriority purposes, that a decline in financial discipline led to low repayment rates, and that budget deficits swelled. Moreover, the programs were hard to remove.

However, Japan and other East Asian countries have long touted the merits of focused, well-managed directed credit programs, saying they are warranted when there is a significant discrepancy between private and social benefits, when investment risk is too high on certain projects, and when information problems discourage lending to small and medium-size firms.

It overviews credit policies in East Asian countries (China, Japan, and the Republic of Korea) as well as India, and summarizes what these countries have learned about direct credit programs:

• Credit programs must be small, narrowly focused, and of limited duration (with clear sunset provisions);
• Subsidies must be low to minimize distortion of incentives as well as the tax on financial intermediation that all such programs entail;
• Credit programs must be financed by long-term funds to prevent inflation and macroeconomic instability, and recourse to central bank credit should be avoided except in the very early stages of development when the central bank's assistance can help jump-start economic growth;
• They should aim at achieving positive externalities (or avoiding negative ones), and any help to declining industries should include plans for a timely phaseout.