Bank credit plays a very important role in the economy’s development. It is so critical a function that some European countries are now reluctant to leave credit entirely to market forces. In developing countries, directed credit programs have been used in order to conserve scarce resources for socially productive uses. There are generally five types of intervention: lending requirements and quotas on banks, refinance schemes, loans at preferential interest rates, credit guarantees, and direct lending by government agencies.

Directed credit is one of the ingredients that contributed to the strong economic growth of Korea, Japan and Taiwan. The directed credit paradigm was meant to overcome market imperfections. Finance flows had to be controlled in order to promote new technology, stimulate production, implement state plans and ultimately help the poor. The empirical evidence in these three countries reveal that industrialization and growth would not have been possible without government directed credit. At some point, however, the policy blunted the process of price discovery and limited the allocative efficiency of the financial system.

The more popular thinking today, as exemplified by policy advocated under the World Bank, champions the financial market paradigm which is demand responsive and allegedly more efficient. According to the market paradigm, the interest rate channel works best on the assumption that financial intermediaries like banks are neutral in their borrowing/lending activity. Hence competition for financial flows will lead to allocation of funds to its most useful and productive use.

Despite the conventional wisdom that market-based allocation of resources is superior in achieving growth and redistributive objectives, the debate rages on. A recent study in India showed that in a context in which pervasive credit market failures (due to information asymmetries) result in credit rationing, the macro-economic effects of India’s directed credit program, targeted to agriculture and small scale industry, are significant and positive.

The short term significance of directed credit is due to its positive impact, via the availability of working capital loans, on output of crucial wage goods, produced by household sectors (including agriculture). In the medium run, government-directed credit helps maintain private investment in sectors such as agriculture, with high social returns, without crowding out investment growth in the other sectors.

In the Philippines, government directed credit programs in the past have been criticized largely because a number of non-financial government agencies were tapped to do the lending function and the program suffered from poor collections. But because of many reforms initiated, today the credit programs are largely handled by government financial institutions or government-owned quasi banks which have responded positively to issues of sustainability.

However, one type of directed program is not fully appreciated. This is the mandatory lending allocation from private banks, notably the agri-agra law and the Magna Carta for SMEs. Unfortunately, both these laws have been spotty in the implementation side. The existence of numerous alternative compliance mechanisms as well as the puny penalty provisions have rendered assessment of their economic impact quite difficult. Note that India’s directed credit programs also have compliance provisions embedded. And while it is not by itself perfect, the observed positive macro-economic effects deserve attention.

The global financial crisis that started in the most developed country of the world, the USA, is also partly blamed on the so-called market failure. One of the initiatives of President Obama upon assuming control was to ask the Small Business Administration (SBA) to guarantee more loans and liberalize some of its operating rules. And the SBA, of course, received major funds infusion to cover potential losses out of increased risk taking.

Yes, even America is implementing various forms of government directed credit programs.

Isn’t it about time policy makers take a second look at how directed credit programs can be harnessed without the ills that confronted it in the past? We don’t have to reinvent the wheel. Let’s learn from over neighbors. With proper control, a resource scarce country like ours can benefit from a properly managed directed credit program insulated from the errors of past execution.
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This writer wishes to congratulate Far Eastern University President Lydia B. Echauz for having been named one of the Outstanding Filipinos (TOFIL) in education for 2009. I have had the chance to work under Lydia then when she was the Dean of the Graduate School of Business at the De La Salle University. I bear witness to the dedication, passion and innovativeness of Dean Echauz in improving both the quality of DLSU’s business education system, and its access to deserving and promising Filipino managers who can only afford to pursue their MBA aspirations as working students. I am positive she has brought this passion in the continuing transformation of the FEU system.

(Mr. Benel P. Lagua is the President/COO of the Small Business Corporation. He is likewise an active member of FINEX. Feedback and comments are welcome at benellagua@alumni.ksg.harvard.edu ).