Mobilization of Savings through Increased Monetization of African Economies by Jean K. Thisen ESPD – UNECA 1 Contents I. Introduction: An Overview II. Financial Intermediaries and Degree of Monetization in Africa III. Increasing Monetization through Bank Credit Creation IV Applications to the Poor: Micro-Finance V. Framework of Monetization and Savings Link VI. Monetary, Fiscal and Exchange Rate Policy VII Conclusion 2 I. Introduction: An Overview SSA Africa’s savings rates vary widely between countries, but remain comparatively low averaging around 15 per cent of GDP during the 1990s. This is not commensurable with the investment needs of 25 per cent of GDP required to reduce the poverty by 2015 One way to increase the new opportunities and incentives for poor households and business firms to save a greater part of their income for the future in the forms of financial assets is to increase the monetization of the African economies through bank credit. 3 II. Financial Intermediation and Degree of Monetization Banking institutions. The African banking intermediary is weak and underdeveloped and is characterized as “shallow, narrow, and undiversified.” (Ayeerty, 1994) Table 1 in Annex I and figure 1 show that the average ratio of M2 to GDP has remained constantly at the rate of 27.3 per cent for Africa as a whole, against 40 per cent for East Asia, 50 per cent for South Asia, 67 per cent for Latin America, 87 per cent for Europe and 91 per cent for North America. 4 Table 1: Comparison of the Level of Savings and (Percent) Monetization 1980 1990 2000 2002 Region S/Y M2/Y S/Y M2/Y S/Y M2/Y S/Y M2/ Y Sub- 20.8 30.8 14.1 32.9 13.9 35.3 15.9 37.9 Saharan Africa East 30.8 28.8 34.1 59.2 33.0 122.3 37.9 129.8 Asia South Asia 15.8 31.8 19.4 37.9 21.8 49.3 25.8 55.8 Latin 20.0 19.2 18.9 15.8 17.4 27.6 18.9 34.7 America Middle 37.8 34.4 23.4 55.6 28.5 54.4 34.7 58.7 East Source: World Bank: CD ROM 2003: World Economic Indicators 5 Low deposits may also be due to low rate of returns on savings with financial institutions. The average rate of returns or the average deposit rates offered by financial institutions range between 12 and 18 per cent while the average rate of return on commercial banks time deposits was 6-8 per cent. The financial institutions are also to blame that they did not create savings culture in the continent commensurable with its huge investment needs. Traditional culture of large extended family reduces the incentive of households to save. Likewise the huge capital flight that occurred after CFA devaluation has severely curtailed the saving deposits in the financial institutions. The financial systems with slow speed of business transactions and a low level of intermediations will not be able to attract substantial savings into institutions so as to allow them to provide substantial loans to the private sector. 6 FIGURE 1: Comparison of the Level of Savings and Monetization (Percent) 8 7 6 Series5 Series4 5 Series3 4 Series2 3 Series1 2 1 0 20 40 60 80 100 120 140 Series 1: Sub-Saharan Africa (Bleu); Series 2: East Asia (Red); Series 3:South A sia (Yellow); Series 4: Latin America (Green); and Series 5: Middle East (Black). 7 The financial services to low income households and entrepreneurs in the remote urban and rural areas may be the most effective way to increase monetization and savings and reduce poverty and achieve broad-based economic growth. Yet in Africa fewer than 2 per cent of low income producers have access to financial services from the moneylenders. Therefore, financial intermediaries need to adopt new paradigms and take on new and aggressive roles in building financial infrastructure that serves the majority of people and enable the poor to share economic growth. For example, if 10 per cent of all low income entrepreneurs are to be served by financial institutions by the year 2005 and 30 per cent by the year 2025, the total amount of portfolios in micro-loans will need to increase from US$2,5 billion to about m, US$12.5 billion by 2005 and about US$90 billion by 2025, servicing about 180 million of low income entrepreneurs. 8 The financial services to low income households and entrepreneurs in the remote urban and rural areas may be the most effective way to increase monetization and savings and reduce poverty and achieve broad-based economic growth. Yet in Africa fewer than 2 per cent of low income producers have access to financial services from the moneylenders. Therefore, financial intermediaries need to adopt new paradigms and take on new and aggressive roles in building financial infrastructure that serves the majority of people and enable the poor to share economic growth. 9 For example, if 10 per cent of all low income entrepreneurs are to be served by financial institutions by the year 2005 and 30 per cent by the year 2025, the total amount of portfolios in micro-loans will need to increase from US$2,5 billion to about m, US$12.5 billion by 2005 and about US$90 billion by 2025, servicing about 180 million of low income entrepreneurs. The main challenges of this increase in lending levels will be in expanding the capacity and resources of those retail intermediaries committed to providing financial services to low income entrepreneurs. 10 The underdevelopment of African Banks is rooted in historical failure of indigenous privately owned banks to emerge in most African countries. Commercial banks were initially created in colonies to finance the export of the raw material proceeds (cotton, coffee, tea, cocoa, etc) back to Metropolis. The legacy of colonialism has largely developed the current state of financial infrastructure in Africa. In post-independence period, many governments tried to remedy to this situation by nationalizing the commercial banks. (Like the case in Tanzania, Guinea, Ethiopia, etc.). The State owned a majority stake in more than half of the banks in Africa. But the State did rather liit the credit allocation to the private sector for sectoral development. 11 12 Usually, some governments are not ideal credit instruments. State banks were not interested in granting credit neither to the poor urban classes nor to the rural sectors, as these were not more often able to provide collateral guarantee. Small stakeholders continued to be served by the informal sector or the non-government organizations (NGOs). Central Banks could increase lending by the banks by reducing the statutory reserve requirements. But their independence to do so is scrutinized by the government. 13 Small stakeholders continued to be served by the informal sector or the non-government organizations (NGOs). Central Banks could increase lending by the banks by reducing the statutory reserve requirements. But their independence to do so is scrutinized by the government. Deposit mobilization is one of the most effective means for intermediaries to mobilize resources. Savings mobilization makes financial institutions accountable to local shareholders. Thus all financial intermediaries should be encouraged to build savings mobilization arrangements for their clients, either by providing these services directly or by making arrangements with non-governmental institutions (NGOs). Banking regulations need to be adapted to encourage those micro-financing institutions with the capacities to legally mobilize savings from clients or the general public. 14 Financial markets with the aim to attracting more private financial resources to complement public funds have emerged. Hence, in addition to the banking systems, a number of initiatives were undertaken to assist the African countries enhance their capacity in financial intermediation and development of bonds, stock, and money markets. 15 III. Increasing Monetization through Bank Credit Creation The establishment and extension of banking systems can create new opportunities and incentives for households and firms to save part of their income for the future. The extension of a bank network can have an effecting attracting new money into system. It is not a level playing field when industry in developing countries operates at lower cost, not because of cheaper labour, but because it can get access to finance, the lifeblood of the economy, at low (2-3%) interest rates 16 College economics textbooks provide descriptions of money creation by the banking system via the "money multiplier" mechanism, and even of "fractional reserve deposit expansion.” It states unequivocally that the commercial banks create more than 90 per cent of M2 or M3. Credit that can be accessed by credit card, overdraft check or bank loan represents nothing more than a bank's promise to pay. Exactly this can be done for African bankers by increasing savings mobilization through increased monetization; that is, through creation of bank credit that increases deposits for households and business community while respecting the anti- inflation rules. - Money must chest the production of goods and services - that is, the volume of money credits created and put in circulation should correspond to the volume of goods and services in the economy or the velocity of money should be stable or declining. 17 Africa did not lack industrial capacity, fertile farmland, or skilled, industrious, and willing workers, residing in both the city and countryside. Already, extensive systems of reasonably efficient transport and communications are in place in some countries. There remained plenty of development work to be done in Africa. The one thing that industry and commerce lacked was a sufficient supply of money. Bankers, who were the only source of new money credit, deliberately refused loans to industry, commerce, and agriculture. 18 Several African countries approved the Micro-finance Development Strategy to expand financial services to the poor and low-income households and their micro-enterprises. Despite the high level of the domestic banking penetration, the banks in Africa find it difficult to render full banking services to the remote areas of urban and rural sectors The range of micro-financial services, which enable cash flow smoothening for poor, should be wide enough to cater for short, medium and long-term needs, and they must be delivered in ways, which are: convenient, appropriate and accessible, safe and affordable. Providing poor people with effective financial services helps them deal with vulnerability and thereby helps reduce poverty. The relationship between poverty and access to financial services is driven by complex livelihood imperatives and is not simple. 19 “Banking with the Poor” is an attempt to explore, demonstrate and publicize the scope for increase access to credit for the poor on a sound commercial basis through increased monetization of African economies. Banks need to study how to target their credit to the poor, how to reduce the transaction costs on the very small loans to the poor, how to find substitutes for collateral on such loans, and whether the poor can pay market rate of interest to enable loan schemes to recover their costs.  G.B. Thapa, Jennifer Chalmers,K.W. Taylor and John Conroy , Banking with the Poor , http://www.bwtp.org/publications/pub/bwtp.html. 20 In Europe and Asian countries, the banking sector has led in providing both short-term and long-term credit to the private sector for growth and poverty alleviation Some Success Stories from History: the Saracen Empire forbade interest on money 1,000 years ago to its poor population and at that time its wealth outshone even Saxon Europe; Mandarin China issued its own money, interest and debt free, and historians and collectors of art today consider those centuries to be China's time of greatest wealth, culture, and peace; Germany financed its entire government and war operation from 1935 to 1945 without gold and without debt, 21 American colonies issued debt-free and interest-free money as colonial script in the 1700's and their wealth soon rivaled that of England, provoking restrictions from Parliament, which in turn led to the Revolutionary War. The basic cause of the revolt of the American colonies against the British Government was the fact that the colonists were creating their own money and enjoying comparative prosperity compared with conditions in Britain. American Banks printed 400 million dollars worth of interest and debt free Greenbacks in 1863 to successfully finance the Civil War, only after being asked to pay 24% to 36% interest by the banks. 22 V. Framework of Monetization and Savings Link A simple model is used to find out the effect of monetization on savings applying the following simultaneous equations: (1) S/Y = ao + a1M2/Y a1 > 0 (2a) M2/Y = bo + b1Y + b2r or b1>0 b2>0 (2b) M2/Y = co + c1Y + c2 Π Π>0 (3) Y = C + If + (X – M) 23 – Table 2 Adj SD F- N R2. Test Savings = -1.43 + 0.33 M2/Y 0.026 75. 13.9 316 S/Y (-.46) (3..7)* 8 Monetization = 29.1 + 0.22 Y + 0.26 R 0.262 98. 57.4 320 M2/Y (29.2)* (9.8)* (3.0)* 1 Monetization = 30.8 + 0.22Y - 0.09 Π 0.257 0.34 320 M2/Y (27.4) (9.6) (-4.3) Data Source: WDI CD ROM, 2004. *t significant at 5 24 per cent VI. Monetary, Fiscal, and Exchange Rate Policy (a) Monetary Policy. In several African countries, there is a limited room for an independent monetary policy to expand money supply for development purposes, particularly in the currency zone countries (i.e. CFA zone). The credit policy was primarily designed to maintaining an appropriate level of foreign reserves. The main policy instruments used were: National and bank- by-bank credit targets; a ceiling on access to central bank financing to maintain aggregate demand at all level consistent with balance of payments and domestic growth objectives; a rediscount rate; the inter-bank money markets, and a liquidity ratio. 25 Other monetary policy instruments for the poor: 1. Government Issuing Debt Free Credit 2. Nationalizing private Banks to create “People Banks” so that poor people will share bank profits: 3. Islamic Banking: Use of paper money is illegal according to Islamic law; so another Islamic initiative is a return to the use of coins made of precious metal. 4. Income Velocity of Money. The role of income velocity of money in monetary expansion is crucial, because the capacity of financial institutions to issue money to finance development (without fear of inflation) is greater when velocity is falling than when it is constant or rising 26 (b) Fiscal Policy. Many African countries have continued to make gradual progress in public financial management reform via the adoption and improved implementation of medium-term fiscal frameworks to improve fiscal accountability and transparency. This has allowed the linkage between fiscal resources and development and poverty reduction goals to be strengthened. 27 Tobin proposed a currency transactions tax to combat financial volatility. The potential of the currency transactions tax as a generator of revenue for development is well known and it is referred to as “Tobin Tax”. It can be raised to as high as 0.25 per cent on a transaction to discourage excess currency speculation. The issue is around the technical feasibility of this currency transactions tax as the financial markets are continuously developing, with new financial instruments being devised. The market structure is evolving with technological progress and in response to competitive pressures and regulation. Even at low rates of, say, 0.01 or 0.02 per cent, the tax may shift financial activity and encourage banking consolidation. 28 Tobin proposed a currency transactions tax to combat financial volatility. The potential of the currency transactions tax as a generator of revenue for development is well known and it is referred to as “Tobin Tax”. It can be raised to as high as 0.25 per cent on a transaction to discourage excess currency speculation. The issue is around the technical feasibility of this currency transactions tax as the financial markets are continuously developing, with new financial instruments being devised. The market structure is evolving with technological progress and in response to competitive pressures and regulation. Even at low rates of, say, 0.01 or 0.02 per cent, the tax may shift financial activity and encourage banking consolidation. 29 (c) Exchange Rate Policy With regard credit expansion, both monetary and exchange rate policy play an important role, having as objective price stability and low rate of inflation, in addition to preventing financial crises and ensuring sustained growth and full employment. For exchange rate policy, countries are concerned with stable real exchange that is the relative price of tradable with respect to no tradable goods. The value of money depend on the interaction between supply and demand, but money supply (increase in money credit) can easily changed by policy which itself depend on convention and institutions, on what people expect about institutional policy credibility (e.g. independence of the Central Bank to create money credit). 30 VII Conclusion But in developing countries, particularly in Africa, the role of financial systems should strive non- only on the routine banking services like in developed countries, but rather they should play a more active and aggressive role in fighting against the underdevelopment and the promotion of poverty reduction. Since the level of saving in Africa is low for any meaningful and transformational investment, the alternative weapon they may have among others is through increased monetization or credit creation. 31 If Sub-Saharan African Africa is to achieve the goal of reduction of poverty by 2015, it should strive to grow by 7 per cent per annum, as spelled out in the various UN programme objectives (MDGs, Copenhagen Social Summit, LDCs, etc.). ECA calculated the baseline resource requirements to achieve this growth, which is 63.9 per cent of GDP for the investment rate each year during the baseline period 1999-2000. Considering the fact that domestic savings can only finance 17.1 per cent of it, the remaining resource gap to be financed by external resources would be 46.8 per cent. However, on the base of historical trends the external resources combined (ODA, FDI, Bond issues, and equity portfolio) will only contribute 20.5 per cent. How to finance the remaining gap? The financial intermediaries can intervene to finance it through bank credit. With external aid, the bank credit would amount to 26.3 per cent of GDP, and without external finance, the bank credit will finance the whole resource gap amounting to 46.8 per cent of GDP (See Annex 1 Table A1). 32 ANNEX A Table A1: SSA Resource Requirements to Reduce Poverty by a Half in 2015 Baseline: 2000-2005 2006- 2011- SSA GDP Growth Rate: 1999- 2010 2015 7 per cent per annium 2000 SSA ICOR 9.0 6.7 4.4 2.9 Investment Rate 63.3 51.7 33.9 22.0 Savings Rate 17.1 19.6 23.9 29.1 External Finance Rate 46.8 32.1 10.0 -7.1 Gap Financing: Net ODA Rate 6.1 6.0 6.5 6.8 FDI 0.5 0.8 1.5 2.0 Portfolio Equity 1.4 1.6 1.8 1.9 Bond Issues 1.2 1.1 0.9 1.8 Financing Overall Gap Bank Credit with External 37.6 22.6 -1.2 -8.2 Aid Bank Credit without 46.8 32.1 10.0 -7.1 External Aid Source: UNECA, Economic Report on Africa 1999; Our own Projections: J.K. Thisen, 33 “Hypothesis of BankCredit Spiral” Unpublished paper.