Renationalising finance after the 2008 crisis: External and domestic obstacles to financial reform in emerging markets

Natalya Naqvi - Assistant Professor in International Political Economy, Department of International Relations, London School of Economics

These so-called ‘activist’ or ‘developmentalist’ policies to direct credit are often supported by labour unions concerned with job creation and industrialists concerned with access to investment credit. However, it remains unclear how much policy space previously liberalized developing countries still have to renationalize their financial sectors, following over three decades of financial globalization. Policymakers facing pressures to reign in private finance from domestic constituents operate under both domestic and external constraints. The domestic private financial sector is likely to be opposed to large-scale public banking funded through fiscal transfers if it fears this will erode its profitability due either to direct competitive threats, or indirect fiscal costs which are perceived to result in higher inflation, sovereign default risk, and tax burdens. In addition to being well connected to policymakers and political parties, the domestic financial sector also has influence over policymaking due to its central economic position, or ‘structural power’. This stems from its role in providing short term liquidity, investment finance, and trade finance, to real economy firms, consumer finance, which boosts demand in highly unequal low-wage economies, and financing government deficits through issuing and holding government bonds. If developmentalist financial policy threatens its profitability, it can threaten both capital flight and domestic disinvestment: a reduction of lending to the real economy, and unwillingness to hold government bonds.

Foreign financial investors can also respond negatively to financial activism, not necessarily because they are directly affected by developmentalist financial policies, but because the fiscal transfers and increased risk-taking associated with such policies can result in ratings downgrades to the sovereign or domestic financial system. If foreign investors exit or domestic capital flees, this results not only in domestic disinvestment, but can also leave governments unable to defend their currencies or finance their current account deficits. This can lead to sharp currency depreciation, higher inflation, and unsustainable increases in the value of external debt. In extreme situations, this results in balance of payments crisis and bailouts from traditional external creditors such as the IMF, which can enforce fresh cycles of liberalization and fiscal austerity conditionalities.

This alignment of interests between domestic and international private and official creditors further increases the influence of the domestic financial sector, because it can exploit policymakers’ fears of capital flight and an ensuing crisis to its advantage. Yet this form of influence is not constant. It becomes more important when risks of capital outflow are pronounced during periods of dollar scarcity, and ratings agencies, which tend to be pro-cyclical, are more likely to downgrade risky emerging market securities. It diminishes during periods of excess global liquidity, when threats of capital flight are mitigated by ratings upgrades and strong foreign inflows, and the threat of balance of payments crisis is minimized as external deficits can be financed freely through foreign borrowing. Changes over the course of the international financial cycle alter the balance of power between domestic and international finance and countervailing groups, opening up or closing off possibilities for reform. Furthermore, periods of dramatic crisis can reshape economic structures and corresponding distributions of political power, creating the conditions for equally dramatic policy change.

My research investigates the conditions under which financially integrated emerging market economies overcome these domestic and external constraints to implement developmentalist financial policies. This is done through comparing public development banking policies in Brazil and South Africa, two key emerging economies where purportedly developmentalist governments were in power during the post-crisis period, but where public banking responses diverged sharply.  

From the early 2000s, both countries faced intensifying calls for developmentalist financial policies from labour unions and manufacturing associations. The 2008 crisis and events that followed loosened structural constraints on policymakers and opened up a reform window. Domestic banks’ economic position was temporarily weakened in the immediate aftermath of the crisis as they were forced to retrench.  The core economy quantitative easing (QE) and low interest rates that followed created an environment of excess global liquidity, mitigating threats of capital flight and balance of payments (BOP) crises in emerging markets. After 2008, Lula’s PT government in Brazil scaled up the National Bank for Economic and Social Development’s (BNDES) activities to unprecedented levels through fiscal transfers, and went far beyond countercyclical crisis response to give it a strategic industrial policy role, until 2014, when public banks began to be scaled back again. In South Africa on the other hand, similar demands for reform of NDBs were repeatedly blocked during the 2008-18 period. The Industrial Development Corporation (IDC) and Development Bank of Southern Africa (DBSA) were denied significant additional resources, and continued to play a passive role under Zuma’s ANC government.

Why did Brazilian policymakers take advantage of permissive international conditions to push through interventionist financial reform, while South African policymakers hid behind alleged IMF pressure and WTO rules to block similar attempts, despite an important part of the ANC support base pushing for increased public financial control? My research argues that domestic banks disinvestment threats were more credible in South Africa than Brazil, not because of stark differences in the domestic role of the private financial sector, but because of South Africa’s comparatively higher vulnerability to capital flight. Lower foreign exchange reserves, a wider current account deficit, and greater dependence on portfolio inflows allowed the private financial sector to successfully exploit policymakers’ sensitivity to threats of ratings downgrades and ensuing capital flight in response to increased fiscal transfers to NDBs. On the other hand, Brazil’s more comfortable external position from 2006 onwards, insulated policymakers from similar threats, and allowed them to sustain massive fiscal transfers to the BNDES. After 2013, when the external environment turned unfavourable as the US began to end QE, the threat of sharp currency depreciation, and ensuing inflation increased the perceived costs of fiscal transfers to public banks, and increased the credibility of threats by private banks to stop financing government deficits in both countries.

My research highlights how developmental policy space varies with the international financial cycle. Although it is possible for emerging economies to reassert public control over their financial sector in order to make it support industrial policy objectives, volatile capital flows and an anti-developmental international financial architecture increase the costs of doing so, especially during periods where international liquidity is scarce. In order to foster industrial development, pro-development financial reform is necessary not only at the domestic, but also the international level.