Role of credit in modern economies

The Reserve Bank of Zimbabwe (RBZ), in its monetary policy statement presented in January this year, affirmed that “credit growth in the banking sector has remained subdued during 2016. Banking sector loans and advances marginally increased from US$3,65 billion reported as at September 30 2016 to US$3,69 billion as at December 31 2016”. This entails a credit growth of just over 1% over the period.

Daniel Ngwira,Chartered Accountant

The statistics presented by the apex bank as shown below demonstrate that most of the loans went to individuals at the share of 28,77% in 2016. While Zimbabwe has always defined itself as an agricultural economy, loans to that sector played second fiddle to consumption. Sectors which can speed up job creation and export revenue generation, manufacturing and mining are nowhere near the top list of the credit share. The credit distribution does indicate the state and make-up of the economy.

Most of the loans have gone towards consumption by individuals. There has been an argument that individuals have borrowed the money to fund their small to medium enterprises (SMEs) due to the fact that it has been harder to get credit for these entities compared to borrowing as an individual. While this cannot be discounted, what is clear is that lending to productive sectors has been slow. This explains why job creation is slow while tax revenues are not sufficient to run the government’s affairs.

In 2014, total loans and advances grew by 8% to US$4 billion, while in 2015 loans and advances contracted 2,5% to US$3,9 billion. In 2016, credit decreased 5,38% to US$3,69 billion. From the close of 2014 to the close of 2016, it can be seen that total credit declined by 7,75%, with an arithmetic mean decline of 5,29% and a geometric mean of -0,122%. This is sufficient to show why and that the economy is at a standstill. This is in contrast to the United States of America where credit has grown by an average 6,67% since 2013.

The negative growth in credit over an extended period of time puts pressure on banks to make money through non-funded income. This, to some extent, explains why our bank charges are so high and why it is normal for customers to have their accounts closed due to their credit balances being swallowed by bank charges.

The monetary policy statement for the year ended December 2015 shows that the loans-to-deposits ratio peaked at 84,79% in 2011, while it was 78,4% in 2014, 68,81% in 2015. The monetary policy statement for the year ended December 2016 states that the loans-to-deposits ratio stood at 56,64% while it states that for the year ended 2015 the ratio was 86,07%.

Although there is lack of data consistency there with the monetary policy statement, for the December 2015 year which state, that the ratio was 68,81% in 2015, the trend shows a decline in the loans-to-deposits ratio if we are to adopt the assertion of the monetary policy statement for the December 2015 year. This indicates the growing discomfort by banks to extend credit. This is attributed to the deteriorating macro-economic environment. Credit has decreased notwithstanding the fact that deposits have grown from US$5 billion in 2014 to US$6,5 billion in 2016.

The three-year data shown in the table above shows that for the periods 2014 to 2016, the central bank has not been consistent in classifying the data. This lack of uniformity in data categorisation makes it difficult to analyse it.

Nonetheless, what is clear is that in the three-year period, individuals have been the biggest beneficiaries of the credit created by banks on aggregate even when we consider that in year 2014 the heavy and light industries took 25% of the total share of credit.

In the monetary policy report for the year ended December 31 2015, the RBZ noted that: “The banking sector remains largely constrained in meeting the long-term funding requirements of capital intensive sectors such as construction and mining. Meanwhile, the central bank expects banking institutions to continue to re-orient their lending towards productive and export sectors of the economy such as horticulture and mining in order to boost output and generation of foreign exchange earnings.”

Regrettably this has not been the case.

Credit is important as it drives spending. The aggregate of money in circulation and credit granted is a determinant of the aggregate expenditure in the economy. During and after the global financial crisis of 2008, banks ceased to extend credit to their customers. This caused a lot of discomfort in country leaders and businesspersons as they knew that a slowdown in credit entails that the economy would slow down due to subdued demand.

Banks were reluctant to lend as the economic outlook appeared gloomy following the unexpected failure of the subprime mortgage-based CDOs (collateralised debt obligations). These had been certified AAA by many of the reputable rating agencies. The failure of the CDOs due to default sent shockwaves across the economically progressive world. During the boom of the CDOs, more credit was created than what could be paid back by borrowers. As a result, the bubble did burst.

While only central banks are the ones with the power to create money, as in the RBZ being the sole issuer of bond notes, anyone can create credit. The central bank in response to the fiscal and macroeconomic development can make it difficult or easy for credit to be created. Under normal circumstances, the central bank does this through the use of interest rates using the various financial instruments at its disposal by communicating with the financial intermediaries.

For instance, in the event that the growth in spending is more accelerated than growth in the capacity to produce, then the central bank can tighten money supply through rate hikes. This is because any growth in spending which is out of line with production tends to lead to price misalignments, for example price hikes, ceteris paribus.

The founder of Bridgewater Associates, the biggest hedge fund in the world with funds under management estimated at US$103 billion at June 2016, Ray Dalio, describes credit as a “transaction between a lender and a borrower, in which the borrower promises to pay back the money in the future with interest”. Of course, the concept of interest (or riba in Arabic) is removed since it is prohibited when one talks of Islamic finance which is fast taking the world by storm.

As stated above, credit has the effect of expanding the ability to spend. On an aggregate basis, this results in raised incomes for households and companies. Using the income approach or the expenditure approach, the result is that the gross domestic product of a country rises. Advanced economies have an extended reliance on credit. Credit cards have been both a benefit and a headache in the advanced economies. They are easy to get and consequently they tend to be expensive.

As a consequence, the households in such economies tend to enjoy higher incomes and high income-related lifestyles due to credit. In the United States, for instance, one can drive a brand new car of their choice for as long as they are able to service their debt. Such financing is available in abundance. On the other hand, in Zimbabwe when one wants to drive a brand new car of their choice, they are not likely to afford it due to the restricted nature of the tenures owing to the restricted availability of such financing. Often, such financing tends to be too expensive to the extent that most of the people opt for used ex-Japanese vehicles.

The RBZ once raised the reserve requirement ratio to 50%. The idea was to curtail borrowing in the face of monetary expansion. Of course, it did not work because it kept on pumping money for quasi-fiscal activities. The essence of the reserve requirement ratio is that it gives rise to the money multiplier. A lower reserve requirement ratio signals that the central bank is keen on expanding credit in the economy. A reserve requirement ratio of 20% entails a money multiplier of five: money multiplier = 1/reserve requirement = 1/0,2 =5

This means that one unit of a deposit would at most create five units. So at a reserve requirement ratio of 50%, the banking system can only create two units per each unit of deposit. This is significantly lower than the case with a reserve requirement ratio of 20% as seen above.

Where credit is utilised to fund productive assets or to enhance and improve capital creation, it becomes a catalyst in the acceleration of economic growth. This is because equipment and machinery is used to generate increased production capacity.

To put things into perspective, let us suppose Zuvarashe & Co had a brick manufacturing plant with an extruder machine with capacity to extrude 15 000 bricks an hour, a drier with the capacity to hold 40 kiln cars and a kiln with the capacity to hold 40 kiln cars. If the company takes credit to install another extruder with the capacity to extrude 15 000 bricks an hour, and build similar drier, kiln and kiln car fleet as it has currently, then it means that it has doubled its capacity. This means it can hire more people and pay higher wages as a result of increased production. The administrative costs are unlikely to increase disproportionately as the company would not need two CEOs or CFOs, for instance.

If this were to happen at macro economy level, then economic growth would result and incomes would rise. This is the power of credit. Alternatively the company could wait for 10 years to make enough money to double its plant capacity.

This is slow and due to many intervening variables, it may not be possible or by that time demand patterns may have shifted.

The traditional and African cultural view of debt is that debt is not good. This is not wrong in that credit, if not properly managed, can result in distress. In Zimbabwe, those who do well are quickly discounted by their neighbours who would be quick to say “after all that is borrowed money”. Debt is good even at household level in that it enables people to buy houses through mortgages. Imagine without mortgage finance how many people would be able to buy the houses they have. One would possibly buy a house when they are 60 years of age, in which case it may not be an ideal house. Imagine saving for 30 years to buy a house in Borrowdale. How many would do it especially with the human temptation to spend? Others would struggle to pay lobola in the absence of credit.

How else does credit create jobs? It leads to the deepening of the financial system. Rating agencies will have more work to do; investors do not have time to do credit assessments so they rely on rating agencies. Treasury dealers would have more paper to trade. The vibrancy of the financial system would rise as derivatives are developed to transform or reduce the credit and interest rate risks that arise; these can be in the form of credit default swaps, forward rate agreements or options or any variants thereof. Speculators would also have a role to play.

Financial markets make money through trading debt. Here is how it works. When a bank finances a house through mortgage-based lending, it can hold the asset to maturity, which could be 30 years or it can securitise the loan and sell it into the market to raise more money. In essence, the bank will make a smaller margin but it would have liquidity to write more debt.

When the credit market is vibrant, one does not need their own money to make money; they only need an idea. The tested projected cashflows would help get funders to the project. Debt is a very important part of the economy. But for debt to exist there must be savers who are willing to fund it through the various intermediaries.

A vibrant debt market signals the health of the economy and so financiers from offshore are bound to follow such markets. This further leads to financial deepening. Zimbabwe can do far much better than the current state of affairs should there be more credit creation, however, for that to happen, there is need to correct some economic fundamentals and policies.

What is restricting debt creation is the economic outlook which is being thrown into uncertainty due to the current political vulnerabilities. If that is fixed, the country can put so much of its citizens to work and easily create a US$100-billion economy. Banks are also cautious in their lending due to high default risk and the absence of a financially resourced central bank.

Ngwira is a chartered accountant, former bank treasurer and former university lecturer. He holds finance and business qualifications. — daniel.ngwira@gmail.com, +267 73 113 161.

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