Financial Liberalization, Financial Restraint, and Entrepreneurial Development

Abstract

This paper argues that there is a fundamental conflict between financial liberalization and private sector led development strategy in developing countries. Using a simple model of occupational choice with moral hazard, it shows that under financial liberalization banks may (i) fail to finance new entrepreneurs because of poaching externality, and (ii) systematically favor projects with front-loaded returns at the expense of projects with strong learning effects. We identify two types of policies that are helpful in escaping from a 'no entrepreneurial experimentation equilibrium': intersectoral and intertemporal policies. Among intersectoral policies, a deposit rate ceiling, or a tax on the deposits coupled with a 'contingent subsidy' to the new industrial financing (but not interest rate subsidy) may be helpful for entrepreneurial discovery. The intersectoral policies are, however, not effective in weeding out short-termism in project choice. Among intertemporal policies, a dual track policy where competition is preserved in the lending to competing activities (agriculture) but limited duration monopoly is awarded to industrial lending is shown to be effective for both the discovery of new industrial entrepreneurs and tackling short-termism in project choices.

Keywords: Financial Liberalization, Financial Restraint, Entrepreneurail Discovery, Learning, Dual Track Policy

JEL Classification: O16, G2, E4, L26