Monetization of the economy as a factor of economic growth: concept and measurement

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Monetization of the economy as a factor of economic growth: concept and measurement

Introduction

Today, many economists are concerned about the level of monetization ratio needed for recovery of economic growth after, coming as a massive shock to the world economy, the COVID-19 pandemic. There is also an active debate about the low level of monetization of the Ukrainian economy.

Deepening the financial sector is a means of economic growth, and, consequently, a higher monetization is associated with a higher level of economic growth. According to Schumpeter's theory of economic development, a higher level of M2 and correspondingly higher liquidity through financial intermediaries positively affect economic growth as opportunities for innovation increase. The monetization is especially important in low- to middle-income countries in which it is substantially correlated with the per-capita GDP and real interest rates [1]. Financial deepening accelerates economic growth by expanding access to financial resources, reducing income inequality, and diversifying production risks [2]. Insufficient monetization of the economy limits the opportunities for economic growth, the inability of the financial sector to ensure the effective redistribution of financial resources, as well as increases the risk of destabilization in the financial sector and narrows the range of tools and methods of financial and economic policy [3, p. 186].

However, the statement that any country will benefit from monetization maximization is not generally accepted. There is a risk of stagnation in monetization, financial deepening and even demonetization, with a negative impact on growth. For instance, the increase in the level of financial depth is accompanied by the risks of deterioration of the current account, unproductive investment, growth of employment in non-productive industries.

Presentation of the main material

Economy monetisation is an ambiguous concept. First and foremost, monetization is considered as the macroeconomic indicator, which characterizes the level of provision of the economy with the money needed to make payments and settlements [4]. Secondly, monetization of the economy addresses the process of saturation of the economy with money. It is an economic phenomenon that comprehensively reflects the degree of provision of the economy with money and the level of monetary balance of individual markets and sectors, and ensuring the stability of the banking and the country's entire financial system [5, p. 91]. Thirdly, economy monetization relates to the sufficiency of the issue of money for providing the circulation of goods. The central bank provides money supply in circulation, which is sufficient to sell all goods produced over time and services, and repay all financial obligations [6, p. 66]. Fourth, economy monetization is regarded as an indicator of the level of lending activity and public confidence in the national currency and monetary policy [4].

The monetization of the economy is an objective quantity. It is a characteristic of the economic system that reflects its saturation with liquid assets capable of performing such functions as means of circulation and payment. In turn, the monetization ratio is a subjective value. It is an indicator that reflects the monetization of the economy, which is calculated as the ratio of the average annual volume of broad money to nominal GDP formed in the same year [7, p. 63].

Similarly, Kremen and Ohol note that the objectivity of economy monetization expresses in the saturation of the economy with liquid assets, the adequacy of the issuance of money for the circulation of goods, and the national economy's provision with cash [3, p. 187]. In general, most definitions of monetization are limited by the peculiarities of calculating the monetization ratio.

Monetization measurement: methodical aspect. The monetization ratio of the economy is usually calculated as the ratio of the monetary aggregate M2 to GDP (the average annual money supply to nominal GDP), also called Marshallian k ratio. Importantly, M1 and M2 aggregates do not fully reflect the financial depth of the economy in countries with undeveloped financial systems, where there is a high ratio of monetary aggregates to GDP, as money is mostly used as a stock of savings in the absence of other alternatives.

Accordingly, as noted by Grekov, it is better to consider the broad money (which includes, besides M2, foreign currency deposits of national banks denominated in convertible currency). However, including in the monetization calculation of foreign currencies will distort the content of the monetization indicator from the standpoint of assessing the demand for national currency. The excessive number of foreign currency deposits indicates a reluctance to keep money in hryvnia and on hryvnia deposits. In the case of using M2, the monetization ratio characterizes the degree of confidence of economic agents in the national currency. While using broad money, the monetization ratio will demonstrate the saturation of the economy with money or the overall demand for money. It is believed that taking the foreign currency into account, which is in the population's hands, is unlikely to increase significantly monetization ratio. It is explained that most foreign currency is used as a means of accumulation and does not enter into business circulation. Moreover, foreign currency, serving the shadow economy, is not taken into account by statistics, and there is no increase in resources of official GDP. Furthermore, if foreign currency serves some transactions, which are reflected in the official GDP, the registered value of these transactions is often understated [7, p. 63].

Subsequently, the calculation of monetization ratio depends on the meaning of the concept of monetization of the economy. For example, M2, reduced by money in circulation, is also considered as better indicator of monetization, since money in circulation does not affect bank lending and deposit activities and, therefore, does not contribute to the development of the financial system.

In turn, Firdu and Struthers pointed to the limitation of the use of broad money as a measure of financial depth. Although capital inflows increase the amount of credit in the context of financial liberalisation, these foreign funds do not increase the money supply because they are excluded from it. Hence, credit expansion, which is a good indicator of financial deepening, may not be reflected in the movement of money supply in countries with financially unregulated economies with significant capital inflows. In addition, government borrowing in the banking system reduces the amount of credit available to the domestic private sector and may negatively impact economic performance, but this will not affect money supply trends [8]. Thus, there is no consensus in choosing a “real” indicator of monetization.

On calculating the monetization of the economy, its average annual value is taken as the money supply because GDP is an indicator measured over a while, and money supply is an instantaneous indicator measured on a specific date. However, there is a limitation in determining the average annual value of the money supply: based on a simple arithmetic mean at the beginning and end of the year or based on a chronological average, given the data at the beginning and end of each month in the period. As a rule, the second approach is used. Additionally, the structure of the money supply in different countries is different in the content of M1 and M2: while in some, there is a higher share of liquid components, in others - a higher share of time accounts [3, p. 188].

The country's GDP is used as an indicator of the size of the economy. On the other hand, the size of the economy and the GDP it creates are not equal as GDP does not cover many operations: intermediate product; production operations that cannot be taken into account (barter agreements, household product, shadow economy); non-production operations (transfer payments); financial and credit operations (except for net income in the form of interest). In this regard, the size of such sectors of the economy as the financial and credit system, the securities market, and the state budget cannot be exactly measured by GDP. Since these sectors redistribute the generated GDP, it is considered that accounting for their operations is optional [7, p. 63].

Likewise, Kremen and Ohol state that GDP does not reflect all the needs of the economy in money because, in fact, not only the final but also the intermediate product is sold [3, p. 188]. Nonetheless, the value of GDP is a universal indicator of the size of the economy. On calculating monetization, annual GDP data at nominal prices are usually used. At the same time, bringing quarterly GDP into the form of annual distorts the data due to the unevenness of the GDP deflator during the year. In this regard, the economy's current size could be ideal for calculating the monetization ratio at any date [7, p. 63]. So, the value of GDP, on the basis of which the monetization ratio is considered, only roughly reflects the objective level of monetization of the economy.

Overall, the monetization ratio of the economy reflects the amount of liquidity that can hold the national economy without inflationary consequences. The greater the monetization of the economy, the more saturated the economy with financial resources, the greater the market capitalisation. The amount of money in circulation should be directly proportional not to the value of GDP but to the amount of goods circulating in the market, that can be not only consumer goods and services and investment goods but also elements of national wealth such as stocks and bonds. Specifically, all developed countries have a highly developed stock market with a large number of different securities [9, p. 27].

The main factors of the monetization of the economy are changes in the equilibrium of the money market, the level of financial development, confidence in the banking system, and socioeconomic conditions. Real interest rates on loans and deposits, income level and the real exchange rate are often among the key macroeconomic factors influencing the monetization of the economy.

For instance, negative real deposit rates tend to deter households from making new bank deposits; and higher real deposit rates induce a substitution effect away from other financial asset holdings, such as informal credit markets. Demographic factors also impact the monetization of the economy by the propensity to invest in financial assets, and the urban population had a higher propensity than the rural population. Rural population density affects financial deepening, showing that geographical barriers to banking services affect the ease of access to finance. In a portfolio investment framework, higher returns on real assets would negatively affect the demand for money. In developing countries where financial assets are mostly limited to money, the expected inflation rate is shown to be a good proxy for the rate of return on real assets. Another factor is central bank financing of fiscal deficits, which is significant in many developing countries where limited government financing through capital markets. Central bank financing of the fiscal deficit tends to depress the demand for money because of higher expected inflation in the absence of credible constraints on monetary financing by the government [1, p. 3-4]. Thus, the critical prerequisite for a high level of monetization is the depth of the financial market and access to financial services and goods.

In practice, developed countries are characterized by high monetization rates (Fig.1). The saturation of the economy with money at high GDP growth does not cause significant inflation but significantly stimulates even more tremendous economic growth. Developed countries have a high level of public confidence in government, economic policy, national currency, and a developed financial market. In addition, in countries with reserve currencies (US dollar, euro, yen), their issue serves their economies and others.

At the same time, in countries with developed financial markets, there may be a decrease in the M2/GDP ratio. If the volume of non-cash payments increases, the amount of money needed to serve the economy is less because they circulate faster. That is, the same amount of money can provide more transactions [10]. Similarly, in Ukraine, non-cash payments are intensified. Consequently, cash is being pushed out of circulation, which leads to a decrease in the monetization rate.

Fig. 1. Broad money (% of GDP) of group of countries by income level, 1992 - 2020 Source: [11]

The experience of the Ukrainian economy also confirms the fact that monetization growth is not always a joyous process. In 2012-2013 the monetization of the economy increased, but GDP growth was almost zero. At that time, banks lent mainly to unreliable borrowers. Against the background of a slowdown in the velocity of money (until 2013), the monetization of the economy in M2 / GDP grew until 2013, which was evidence of NBU's monetary expansion policy. The process of cleaning the banking system in 2015-2016 was also one of the reasons for reducing the monetization of the domestic economy.

The rapid growth of economic monetization in countries with upper-middle-income and slower growth in high-income countries is evidence of expansionary monetary policy in the first group of countries. Although there is a slow increase of monetization in countries with lower-middle-income countries (where Ukraine is), the monetization of the domestic economy, by contrast, has been declining since 2014, indicating an insufficient degree of saturation of Ukraine's economy. A low level of lending is among the critical reasons for the low monetization of the economy.

Conclusions

monetization money supply economy

Monetization and financial depth are often used to reflect the same phenomenon - increasing the ratio of broad money to GDP. In general, economy monetization is defined as: the macroeconomic indicator, which characterizes the level of provision of the economy with the money needed to make payments and settlements; the process of saturation of the economy with money; the sufficiency of the issue of money for providing the circulation of goods; indication of the level of lending activity and public confidence in the national currency and monetary policy.

Monetization, characterizing the amount of money in circulation, affects the demand and supply of money. The monetization ratio is an indicator that characterizes the economy's need for money supply. It allows judging whether enough money has been issued for the circulation of goods and transactions.

Thus, to determine the level of financial depth, researchers use the ratio of monetary aggregates (M1, M2 or M3) to GDP depending on the level of financial development of the country's economy. In most countries, the main monetary aggregate in monetary statistics is the M2 aggregate, but in some countries where broad money is represented by the M3 monetary aggregate, such as Ukraine, where the official monetization rate is calculated based on the average annual monetary aggregate M3.

However, determining financial depth through M2 includes only private sector liquidity; excludes external capital inflows and public lending from the financial sector. Accordingly, the indicator M3 is more complete.

As practice shows, the higher level of monetization is characteristic of developed countries, where inflation is low and stable for a long time. Groups of countries with high and aboveaverage incomes have a higher level of financial depth, which indicates the positive nature of the impact of the financial market on economic development.

The lagging behind of monetization of the Ukrainian economy among countries with similar economic development highlights its bank-centricity and insufficient financial inclusion.

References

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