Delano P. Villanueva
A major characteristic of primitive economies is that investment in productive equipment (tools, roads, houses, etc.) is financed out of the savings and the labor of the people who will be using such equipment. As standards of living rise and the capacity to save increases, some will have savings in excess of desired investments in productive equipment, while others will have more investment opportunities than savings. The emergence and development of a “market” in which excess savers and excess investors can meet is therefore both a sign of and a stimulus to economic development. The historical background outlined below suggests that a large role for financial intermediaries—institutions that are the chief means of making the connection between excess investors and savers—in less advanced economies has been in fact associated with the willingness of people with surplus funds to purchase the forms of savings (specified in units of money) that are offered by the financial system. This willingness, in turn, depends largely on policies affecting the rate of inflation and the entire structure of money interest rates on financial savings (bank deposits).
Framework of Analysis
Investments may be financed out of the investor’s own savings or by obtaining others’ savings. The latter may be mobilized in various ways as indicated in the chart. From this we see that borrowers may sell paper (government bonds and stocks, corporate bonds and stocks, mortgages, foreign borrowing, etc.) either directly to lenders, as indicated by arrow (1), or indirectly to (and thus through) the financial system, as indicated by arrows (2) and (3). If security issues are sold to nonfinancial economic units (government, business and individuals, foreign), then the financing is direct; lenders accumulate the securities in the same form in which they were issued. On the other hand, if security issues are sold to the financial system (banks and other financial institutions), then the financing is indirect. The financial system does not simply pass on the securities it purchased to the ultimate lenders; it finances its acquisitions of securities by issuing its own more liquid liabilities (currency, bank deposits, etc.), and these find their way into the portfolios of the ultimate lenders. Lenders in this sense are those who accumulate the liabilities of the financial system.
The ratio of total security issues [sum of (1), (2), and (3) in the chart] to gross national expenditure measures investment expenditure as a proportion of gross national product (GNP) that is financed with resources other than the investors’ own savings. The ratio of security issues purchased by the financial system [(2) + (3)] to total security issues measures the degree of importance of the financial system as an intermediary between savers and investors. What follows is a brief survey of historical data of the financial system in terms of these ratios. The data cover comparable periods in countries whose economies at the times compared were similar enough to each other to make comparisons meaningful. This comparison may be useful to other developing countries today.
“Security Issues” refers to issues of government bonds and stocks, corporate bonds and stocks, household mortgages, variety of debts with varying degree of maturity, and foreign borrowing.
“Increase in Money Supply” refers to increments in currency (notes and coins) and in demand deposits.
“Increase in Nonmonetary Assets” refers to increments in the financial system’s liabilities other than currency and demand deposits, e.g., savings and loan shares, insurance, etc.
The Issues/GNP Ratio
Economic development is, of course, retarded if it must rely on the investor’s own savings. An efficient selection of investment projects must choose those that promise the highest rates of return; but many of these will be projects that are heavily dependent on outside financing. Without it, such investment projects will not materialize.
In the mid-1960s, the issues/GNP ratio in the Philippines was about 9 per cent; that of Korea was about 5 per cent. These figures mean that investment expenditure of about 9 per cent and 5 per cent, respectively, of Philippine and Korean GNP was financed by means other than the investors’ own savings.
The Korean Experience
Prior to 1965, the Korean financial sector was not as active as the Philippine financial sector. In 1963, the indirect finance ratio (i.e., the ratio of security issues purchased by the financial system to total security issues) was only 12 per cent in Korea, one seventh that of the Philippines. The growth of the organized financial sector—measured by its ability to attract savings—had been stunted by inflation; and the associated payment of negative real rates of interest discouraged savings in financial forms (bank deposits). The smallness of the organized financial sector relative to economic and financial activity reflected the substantial flow of funds into the unorganized financial markets. Out of the small inflow of funds, the organized financial sector was able to undertake only minimal financing of private businesses and individuals, which produced 85 per cent of the net national product. In fact, as measured by the size of the deficit in the country’s balance of payments, foreign sources provided more finance for the economy than did all commercial banks and other financial institutions combined.
In 1965, a drastic interest rate reform designed to offer “realistic” real interest rates to depositors and to induce a reflow of funds from the unorganized sector back into the organized sector was adopted. As Table 1 shows, the reform, in conjunction with other appropriate fiscal and monetary policies, caused time and savings deposits to rise sharply. Whereas aggregate domestic savings represented only about 2 per cent of GNP in 1962, the ratio rose to 15 per cent in 1968.
|Time and Savings Deposits (In billions of won)||Deposit Rates||Real Rate on 12-Month Time Deposits (Adjusted for change in consumer prices)|
|Time Deposits||Short-term savings|
|Date of change||3 months||6 months||12 months|
|(In per cent per annum)|
|1966||87.3||Sept. 30, 1965||9.0||12.0||15.0||3.65||9.6|
|1967||160.8||Sept. 30, 1965|
|(Interest rate reform)||18.0||24.0||26.4||5.00||15.2|
|1968||311.5||Apr. 1, 1968||15.6||20.4||26.4||5.00||16.5|
|Oct. 1, 1968||14.4||19.2||25.2||5.00|
|June 2, 1969||12.0||16.8||22.8||5.00|
The Philippine Experience
The Philippine financial sector was consistently active as an intermediary between savers and investors at least through the mid-1960s. The indirect finance ratio was about one half in 1950-54, two thirds in 1955-60, and seven eighths in 1961-64. The background for this steady advance of financial intermediation was postwar price stability. The financial system was more active in the short-term securities market (debts with maturities of less than five years). In the early 1950s, the short-term issues that the financial system purchased were only 29 per cent of total issues (short-term plus long-term); in the latter half of that decade, the ratio rose to 38 per cent; and in the early 1960s it made a decisive thrust to 68 per cent. Financial institutions as a group purchased a moderate volume of long-term issues. These trends are not surprising because short-term issues closely matched the structure of the monetary system’s liabilities (short-term deposits), and the monetary system was the dominant financial subsector.
The financial system supplied most of its funds to the private business and individual sector, which produced the bulk of net national product. The trend was toward more indirect financing of this sector. The financial system’s purchases of paper issued by this sector were 36 per cent of total security issues (government, private, and foreign) in 1950-54, 42 per cent in 1955-60, and 66 per cent in 1961-64.
This brief historical comparison cannot be stretched too far. Many financial and administrative factors are involved that are not touched upon. But the historical survey does strongly suggest that inflation in Korea prior to the 1965 interest rate reform had a crippling effect on the financial sector. Inflation, coupled with low money rates of interest paid on deposits, withheld savings from financial forms (bank deposits). After the 1965 reform, positive levels of real interest rates led to increased deposits, feeding increased resources into the financial system and enabling it to perform its intermediary role on a greater scale. The Philippine experience suggests that, even in the absence of “high” levels of money rates of interest on deposits, price stability encourages active financial intermediation.
See Gurley, John G., Hugh T. Patrick, and Edward S. Shaw, U.S. Agency for International Development, 1965, The Financial Structure of Korea; and Anand G. Chandavarkar, “Interest Rate Policies in Developing Countries,” Finance and Development, March 1970.
For a detailed discussion, see Delano P. Villanueva, “Financial Growth and Economic Development: The Philippines,” The Philippine Review of Business and Economics, April 1967.