What kind of banking and finance sector does the new nation of Timor Lorosae need? What actions are required on the part of the new government to ensure that the right kinds of institutions and markets emerge? What government policies are required in order to encourage appropriate behaviour by these institutions? These are the fundamental questions to be addressed in this chapter.

We begin by considering the basic question of whether it is necessary for the new government to implement policies designed to hasten the process of ‘financial development’ – that is, the proliferation of types of financial institution and of the products and services they offer, and the expansion of their activities. The early financial development literature (for example, Goldsmith 1969; Gurley and Shaw 1967; Patrick 1966) drew attention to the positive correlation between financial and economic development, in some cases implicitly favouring the active promotion of formal finance as developmental policy.

Building on this literature, McKinnon (1973) emphasized what he saw as a significant obstacle to development in the fact that many small businesses, including farmers, were ‘restricted to self-finance’ (p. 21). In McKinnon's view, being restricted to self-finance meant that promising entrepreneurs with good investment opportunities were forced to stick to old technologies with which they were already familiar. This followed from his assumption that the potentially rewarding new investment opportunities required outlays well in excess of the cash resources of the firms in question. On the other hand, if they had ready access to funding from banks, they would be able to carry out invest-ments that incorporated new or improved technology, with returns more than sufficient to enable repayment of the loan with interest.

AN ARGUMENT IN FAVOUR OF ACCELERATED FINANCIAL DEVELOPMENT?

Discussion of the role of finance in development often has much in common with the McKinnon view. The shortcomings of the banking system are portrayed in terms of market failure, whereby banks allegedly fail to lend optimal amounts to particular kinds of entities (such as farmers and other small businesses) and activities (such as exporting: ADB 1990).