UNTIL the mid-1960s, the dominant view in economics profession was that accumulating physical capital (plants and machinery) is the key to prosperity. In the past thirty years, this view has changed to emphasise the role of creativity and innovation in creating value.

Specifically, the emerging consensus seems to be that certain institutions encourage creativity and innovation. Hence, prosperity is achieved if right institutions are in place.

Economic growth results from the realisation of opportunities that create value. At the core of every opportunity is an idea. Some ideas are brand new such as the invention of television or a personal computer.

Often, the opportunities are based on old ideas in a new context. As one example, Ahmed, who is skilled electronics repair work and working part-time in Lahore, may think of opening a repair shop in his home town.

People in his town have to travel over 40 kms to get their electronic items fixed. They would surely benefit if there is a repair shop practically next door to them. Even though it is an opportunity to create value, there is nothing fundamentally new about Ahmed’s idea of opening an electronic repairs shop. It is the context of his home town that makes it interesting and workable.

It is important to realise that at the core of most opportunities in a developing country like Pakistan are ideas like this. This is very different from what one would expect in a technologically advanced country like the US. If, in the US, Walmart wants to gain an edge over competitors like Sears of Target, it will have to innovate by, as one example, thinking of fundamentally new distribution mechanisms that have not been tried before.

The opportunities of the former kind (replicative opportunities) do not require much expenditure in resources for discovering them. People discover them as they go through life and gain experience. However, opportunities of the latter kind (innovative opportunities) are more challenging to discover and require th considerable resources devoted to the discovery process. The realisation that different types of ideas are at the core of opportunities in developing and developed countries has implications for what type of growth path developing countries are likely to take.

Replicative opportunities are the low hanging fruit of development, and it makes good sense to emphasise them in any growth strategy for Pakistan. We have failed in taking advantage of such opportunities because our institutions are hostile to such opportunity realisation. We need to change our institutions appropriately. That is, we need to change the ‘rules of the game’ in order to take advantage of such opportunities. Specifically, we need to revisit the typical credit mechanisms operating between the lenders and the borrowers.

People like Ahmed are everywhere. They understand their local context and spot opportunities that would create value if implemented.

However, why is that nobody seems interested in financing them? The answer is that traditional credit mechanisms between borrowers and lenders fall short when it comes to people like Ahmed. A standard debt contract is one in which a lender demands a fixed return on his loan from a borrower. Due to the nature of such a contract, a borrower’s debt capacity is determined by looking at the worst possible outcome. Of course, the worst possible outcome is his proposed project failing, so a borrower’s debt capacity (which is equal to how much he can pay back regardless of his project failing or succeeding) is his wealth if the proposed business fails. If he does not have enough wealth, he cannot qualify for a loan.

In general, lenders have two concerns:1) Borrowers can play unfair with their money 2) If the project fails, how will they get their money back?. Bankers solve both of these problems by requiring collateral. This ‘no-collateral-no-loan’ model excludes almost all ‘opportunity discoverers’ apart from the already wealthy.

Microfinance institutions also fail in this regard. They have taken the debt contract to the poor by investing in selection and monitoring network. The selection and monitoring network mitigates the first concern but does little to alleviate the second concern. Hence, microfinance institutions cannot afford to give out loans which are large enough to help people like Ahmed. Their loans remain small and typically fund consumption.

Microfinance institutions need to move beyond the standard debt contract if they want to have a significant impact. One possibility is to implement venture capital or modarba contract in which funding is provided on profit sharing basis. Typically, venture capital financing is reserved for highly innovative large projects. However, microfinance institutions are in a good position to bring the venture capital contract to people like Ahmed because their existing selection and monitoring network can be tweaked to mitigate the concern that borrowers may play unfair with their money.

As profit sharing allows the lender to share in the upside potential, more downside risk can be tolerated offsetting the second concern.

Microfinance lenders would be reaching fewer people under the venture capital contract when compared with the debt contract but it is a sacrifice in breadth in favour of depth.

To conclude, our failure to develop is our failure to take advantage of opportunities. And, we are failing miserably in taking advantage of the opportunities due to unfavorable ‘rules of the game’. We need to change the ‘rules of the game’ by designing more inclusive venture capital or modarba type contracts rather than the standard debt contracts which exclude almost everyone except the already wealthy.

The writer is Associate Professor of Economics at Lahore University of Management Sciences hammad@lums.edu.pk