Money, Finance and Economic Growth the Case of Saudi Arabia Abdullah H.

Albatel Associate Professor Department of Economics King Saud University Riyadh P. O. Box 87105 Riyadh 11642 Saudi Arabia Phone Fax 966 1 467 4178 966 1 467 4142

e-mail Albatel@ksu.edu.sa

2 Money, Finance and Economic Growth the Case of Saudi Arabia Theoretical and empirical relationship between money, finance and output continue to produce conflicting evidence. While some researchers question the role of money in explaining output behavior and suggest that it has no significant impact on deviation of real output from its potential others challenge the argument that money does not affect real output and stress the role of money and financial intermediaries in pooling funds and acquiring information that enables them to allocate capital to its highest valued use, so raising the average return to capital. Some rationalize treating money balances as a factor of production by the increased productivity gains and, in particular for developing countries that it releases capital and labor from facilitating exchange to more specialized productive task, thus enhancing productivity. It has been suggested further that asset demands change systematically as the economy grows. In particular, the value of privately issued debt outstanding relative to the value of the government issued money supply increases overtime. It is generally accepted that the first stage of the development process of an economy is the mobilization of savings. The inadequacy of financial capital is usually considered as one of main impediments to economic growth. The mobilization of financial resources is vital to capital formation. Capital formation involves three interdependent steps. The first step is increasing the volume of real savings so that resources are available for investment purposes. The next step is channeling of savings through a finance and credit mechanism. This step involves allocating these savings to investors. The third step involves the act of investment itself by which resources are used for increasing the capital stock. That is, in the early stages of development well developed financial system should be established to provide needed financing for development. In addition, as the economy grows, the demand for financial services will rise, which will require parallel financial development for economic development.

3 Before 1952 the monetary and financial system in Saudi Arabia was primitive and simple. There was no central bank or any other institution, private or public, discharging the function of a central bank. The country did not have a currency of its own, and it was dependent on hybrid of foreign metallic currencies. Thus, the need for advanced financial system was recognized. The increase in oil prices during the 1970s and the huge projects and economic development in the country which took place during the period of the 1970s and early 1980s made it important to speed up the development of the financial system and establish a modern stock market. Since then, the Saudi Arabian financial system has undergone tremendous changes beginning with the establishment of the Saudi Arabian Monetary Agency (SAMA) in 1952. the increased monetization of the economy, the gradual adaptation of banking habits by the citizens of the country, and the actual institutionalization of commercial banking banking law in 1966, the establishment of the specialized credit agencies and institutions, the suadization, of commercial banks in the 1970s, and formally establishing and regulating stock market in the 1980s, were the major developments in the monetary and financial system. The aim of the study is to investigate and examine the effect of money and financial development on the growth of income in Saudi Arabia with annual data covering the period 1964-2001. Because most macroeconomic time series data are non stationary and might lead to spurious relationships and misleading results thus to provide valid evidence to the order of integration, before proceeding to the estimation of the long run relationship between the variables, time series properties of the individual variables are examined by conducting stationarity tests. Then the short run dynamic and long run co-integration relationship by using the multivariate co-integration and its vector error correction (VEC) models. Further from, the vector autoregressive (VAR) model, variance decomposition (VDCs) and impulse response function (IRFs) can be used.

4 Literature Review The rational for the inclusion of money balances in the production function relates, to the increased economic efficiency of a monetary economy compared to a barter economy. In a barter economy, labor and capital may be diverted from production to distribution in order to achieve the double coincidence of wants required in such a system. With money entering as a medium of exchange this search can be avoided. Therefore, in a monetary economy, productive efficiency may increase as labor and capital services, released from the special tasks required in a barter economy, are used in production (Friedman, 1969; Johnson, 1969; Levhary and Patinkin, 1968; and Baily, 1971). These models have simply included real money balances as an input in the aggregate production function. Or as Johnson (1969) has shown by modifying one assumption of the monetary neoclassical growth model that the very presence of money causes a higher capital intensity than that of a barter economy. However, Moroney (1972) suggests that money can be treated as an economic innovation. He notes that money should not be considered as an ordinary input of the firms production. It is, as he assumes a sources of technological change that may be regarded as an external economy for each firm. He indicates that, it is external in the sense that the creation of a generally accepted means of exchange is a matter over which the firm exerts no control. Yet, as he notes, money is clearly an innovation for which the firm is willing to pay. Eventhough the impact of financial development on economic activity and growth had been recognized in early studies of economic development, this relationship became an important issue and a subject of debate. Several studies have attempted to establish whether financial deepening leads to improved growth and performance of the economy ( Tobin, Patrick, Gurley and Shaw, McKinnon, Shaw, Fry, and Rajan). However, other studies have focused on identifying the channels of transmission from financial intermediaries to growth of the economy and emphasized the roles played by financial liberalization in increasing

5 savings and hence, investment ( King and Levine, Levine, Levine and Zervos, Ranjan and Zingalis, Odedokun, Khan and Hasan, Chang and Ho, and Chang among others). Financial factors influence economic development by the way in which savings become available and the intermediation of these savings to investment opportunities that brings the highest return. Thus creation and development of financial institutions lead to a positive relationship between financial intermediation and economic growth. That is, financial intermediaries play a central role in allocating capital to its best possible use. If this is the case, then underdeveloped or poorly functioning financial system would become a constraint on economic growth and development. Financial development is characterized by the increasing role of indirect finance and channeling savings to productive investment. Thus, it has been argued that increasing financial intermediation in the economy creates better opportunities for economic development and growth. That, is increasing financial resources, by providing wide ranges of financial assets and liabilities to the public, brings into contacts a greater number of ultimate borrowers with ultimate lenders, facilitates the flow of inter-and-intra-sectoral savings, distributes risk more evenly on investment, and takes advantages of administrative and other economies of scale in investing as well as mobilizing savings. Thus, the critical role of financial instruments in the context of economic development is that of facikitating and encouraging both saving and investment by providing efficient means of transferring claims over resources from savers (lenders) to investors (borrowers). Therefore, in accordance with the argument of goldsmith, the more developed the financial structure the faster will be the rate of economic development of a country. That is, financial development is perceived as having positive impact on economic growth and development. He stresses the connection between a countrys financial superstructure and its real infrastructure and suggests that financial superstructure of an economy accelerates economic growth and improves economic performance to the extent that it facilitates the migration of funds to the

6 best user, i.e., to the place in the economic system where the funds will yield the highest social return. Further, he documents that the cost of financing is lower in financially developed than less developed economies. Shaw also suggests that real growth in financial institutions provides more investors with access to borrowing and gives them incentives to save and accumulate the equity that makes borrowing cheaper Moreover, studies of the determinants of growth in developing countries show that growth of capital stock as being critical factor in explaining the rate of economic growth and that financial deepening contributes to the accumulation of capital. Thus, World Bank Report (1989) notes: As more saving moves through the financial system, financial depth increases. The financial systems of higher income countries are usually deeper than those in poor ones. They are also deeper in most rapidly growing countries than in the slowest growing countries. It also suggests that Faster growth, more investment, and greater financial depth also contributes to growth by improving the productivity of investment. Investment productivity is significantly higher in the faster growing countries, which also have deeper financial system. This suggests a link between financial development and growth. Research studies (Drake, 1980; Porter, 1966; and Cameron, 1972) indicate that financial development: (1) augments the quantities of real saving and capital formation from any given national income, (2) increases net capital inflow from abroad, (3) raises the productivity of aggregate investment by improving its allocation , (4) improves macroeconomic stabilization as suggested by Porter greater stabilization of the economy through monetary controls is attainable when banking system is more widespread, (5) bank provide a basic intermediary function between savers and investors, or surplus and deficit spending units, since they are unique in being able to supply liquidity to the economy by creating money. They are in position not merely as the custodian of the stock of money but also to increase or decrease the stock. The consequences of this power for

7 society at large can be considerable and either favorable or unfavorable. (6) Cameron further suggests that the banking system may function as the provider of entrepreneurial talent and guidance for the economy as a whole. As potential entrepreneurs, they may ste their country on the road to continuing growth, or they may waste its resources in uneconomical or fraudulent activities. King and Levine (1993) further suggest that financial systems influence decisions to invest in productivity enhancing activities through two mechanism: they evaluate productive entrepreneurs and they fund the most promising ones. Financial institutions can also provide research, evaluate, and monitoring services more effectively and less expensively than individual investors, they also are better at mobilizing and providing appropriate financing to entrepreneurs than individuals. Overall, the evaluation and sorting of entrepreneurs lower the cost of investing in productivity enhancement and stimulate economic growth. Shaw (1973) further suggests that Real growth in financial institutions provides more investors with access to borrowing and gives them incentives to save and to accumulate the equity that makes borrowing cheaper. Thus, financial sector distortions can therefore reduce the rate of economic growth. Methodology In the original quantity theory, money (M) has a direct impact on nominal income (Y or GDP). Since the quantity equation of exchange MV = Y (1) Is an identity, in order for a change in M to not change Y, the income velocity of money (V) must change proportionally in the opposite direction. Thus, the new quantity theory as set forth by the Cambridge equation may be more appropriate, M = kY (2)

8 Where k= (1/V) is the proportion of nominal income held as money. If people are holding the desired equivalent of their annual income as money, a change in M creates disequilibria. Therefore, an increase in M causes actual k to exceed desired k, unless desired k increases for some reason. If desired k does not increase, equilibrium is reestablished by an increase in GDP, not by a decrease in M; all money must be held by someone. The increase in Y comes about by an increase in spending as people attempt to draw down their monetary assets. The opposite occurs if M decreases. Now actual k is less than desired k. to build up their money balances, people decrease their rate of spending, thereby reducing Y, and reestablishing equilibrium k. The main use of the new quantity theory is to explain and predict changes in k or V. Consider an increase in M that exceeds the growth of real output. There will be inflationary pressure, unless desired k increases (V decreases). But during inflation money becomes a less desirable asset to hold. Therefore asset holders will attempt to decrease k rather than increase it. Although individuals can rearrange their asset mix, away from money in favor of other assets, in the aggregate they cannot. Yet asset holders can reestablish equilibrium to the new, smaller desired k by increasing Y, that is by spending at a faster rate as they attempt to draw down their monetary balances. Thus, any change in k or V that occurs because of an increase in the growth rate of M can be expected to accentuate rather than mitigate the effects of the change. In the event of a decrease in M, or a decrease in its rate of growth, the opposite can be expected. If actual k falls below desired k, agents can reestablish equilibrium by spending at a slower rate, causing Y to decrease, or at least decrease its rate of growth. Further, some researchers have used money and /or financial development as an argument in the production function such as Cobb-Douglas production function to test for the effect of these variables on output.

9 Data and Empirical Results Time series data for Saudi Arabia are used in this study with annual data covering the period 1964-2001. The choice of annual data is due to the fact that most of the available data reported annually. Furthermore, it has been suggested that more observations are better, because more observations allow us of better discrimination among hypothesis. However, Shiller and Perron (1985) argue forcibly that, particularly when analyzing the long run characteristics of economic time series, the length of the time series is far more important than the frequency of observations. Moreover, Hakkio and Rush (1991) point out that, cointegration is a long run concept and, hence require long run span of data, thus they suggest that there is little gain from increasing observation using higher frequency with the same time span, but there is a gain from using the same frequency data with a longer time span. Further, Kennedy (1998)suggests that the power of unit root tests depends much more on the span of the data than on the number of observations for macroeconomic data where long business cycles are of importance, a long run span of annual data would be preferred to a shorter span with, say, monthly data, even though the latter case may have more observations. That is the longer span has greater chance of containing a structural break. Although real gross domestic product (GDP) is a good indicator of the overall level of economic development and activity in any economy, however, it could be argued that, for Saudi Arabia, this variable does not accurately reflect the level of economic activity within the economy. This is attributed to the economys reduced ability to influence oil production level and the price of oil in international markets. With the extraction and export of oil production being the dominant component of GDP and government revenue to a large part of the economic activity within the country is determined outside its system and has very little control over it. Therefore, as Saudi Arabia is an oil based economy, in which most economic activities are liked to oil, it is generally believed that this basic and important

10 characteristic has a bearing on every aspect of economic activity. While, during the last two decades, the significance of oil in the economy has declined, it remains the dominant sector, thus non oil GDP represents income (Y), investment (I), Labor (L), the ratio of credit available to the private sector from government specialized institutions and Banks to GDP (SPC), the ratio of credit available to the private sector from Commercial banks to GDP (CCP) and the ratio of money supply to GDP (M3). Data on these variables are obtained from Ministry of Planning Facts and Figures different issues and from Saudi Arabian Monetary Agency (SAMA) annual reports different issues. Tables 1-5 and figure 1 show the empirical results. Table 1 presents stationarity tests results which indicates that the variables are non stationary in levels, however, with first difference they become stationary, thus they are I(1). Johansen-Jueslius Cointegration tests are presented in table 2 where the results show that the variables are cointegrated and significant at the 5 level. Thus, these results suggest that a long run and stable relationship between the variables exists. Further, the results indicate that financial development represented by development of the financial system and proxied by (SCP), (CCP) and (M3) has significant long run impact on the growth of the economy. It seems also that commercial banks are encouraged by the activities of specialized credit institutions and act to complement these activities by filling the gap between credit needed by the private sector and that can be granted by specialized credit institutions. According to Engle and Granger (1987) a system of cointegrated variables can be represented by a dynamic error correction model. Thus, we proceed to test for error correction by using the Johansen-Jueslius vector error correction method (VEC) and the results are shown in table 3. the coefficient on this term, which ranges between 0.40 and 0.96, reflects the process by which the dependent variable adjust in the short run to its long run position. This VEC term provides also a channel through which Granger causality can occur in addition to the traditional channel through lagged independent variables.

11 Table 4 presents a regression analysis which show that financial development represented by (SCP), (CCP) and (M3) have positive and significant impact in stimulating private the growth of the economy. These results are supported by the variance decomposition (VDCs) presented in table 5 which that the effect of the innovation shocks can have a long lasting effects especially (SCP) and (M3), where these effect increase with time to reach about 50 percent in 10th period. The impulse response function (IRFs) presented in figure 1 also supports these findings. These results assert that real money and financial development are important factor of production which might be omitted from the production function.. thus, real money balances and /or a measure of financial development should be included as arguments in the production function along with other factors of production. Conclusion This paper provides an examination of the impact of money and financial development on the growth and development of the economy of Saudi Arabia. Stationarity tests, JohansenJueslius cointegration tests, impulse response functions (IRFs) and variance decomposition (VDCs) tests are used to test the hypothesis that money and financial development have positive impact on economic growth. The result show that a long run relationship exists among the variables. Therefore, development of an effective financial system will positive impact on the growth of the economy. Furthermore, Saudi Arabia has by no means achieved an advanced stage of financial development since the financial system has not realized its full potential. The financial system remains inadequate with respect to: the kind and number of financial institutions, the extent of the development of the economy, and the integration of financial and capital markets.

12 Establishment of financial institutions as investment banks and institutions ahould be a priority. In addition, development of non bank financial institutions which invest in equity shares and debt will facilitate the development of public equity market. The establishment of non bank financial institutions and advanced public security market will enhance the saving rate because they provide a broader set of choices among risk return trade off to individuals and institutions. For Saudi Arabia to maintain its economic growth, it is important to effective monetary tools that will allow the necessary monetary policy to be carried out. Development of financial and capital markets is crucial for economic development since financial and capital markets can mobilize savings and channel them to productive use. Domestic financial and capital markets should be designed and directed to meet several specific needs by: 1) making yields on financial instruments sufficiently attractive to raise new savings and divert savings from the alternatives of real estate investment and caoital flight, 2) creating and developing medium and long term debt markets to finance domestic investment, 3) providing access to new equity funds by corporations and to ownership of equity by the public, 4) insuring that investment in socially desirable sectors and infrastructure would receive enough financing, 5) assuring that firms are constrained by the shortage of liquidity.

References Baily, M. National Income and Price Level. New York: Mc Graw-Hill, 1971. Cameron, R. Banking and Economic Development: Some Lessons of History. New York: Oxford University Press, 1972. Chang, T. Financial Development and Economic Growth in Mainland China, Applied Economic Letters, 2002 (9), 869-873. Chang, T. and Ho, Y. Financial Development and Economic Growth in Shouth Korea, The Indian Journal of Economics, 2001 (82), 153-160. Drake, P. Money, Finance and Development. New York: Halsted Press, 1980. Friedman, M. The Demand for Money, Journal of Political Economy, 1959, 327351 Fry, M. Money, Interest, and Banking in Economic Development. Baltimore: John Hopkins University Press, 1995. Goldsmith, R, Financial Structure and Development. New Haven: Yale University Press 1969. Gurley, J. and Shaw, E. Financial Structure and Development, Economic Development and Cultural Change, 1967 (15), 257-268. Hakkio, C. and Rush, M. Cointegration: How Short is the Long Run, Journal of International Money and Finance, 1991 (10), 571-581. Johnson, H. Inside Money, Outside Money, Income, Wealth and Welfare in Monetary Theory, Journal of Money Credit and Banking, 1969 (1), 30-45. Khan, A. and Hasan, L. Financial Liberalization, Saving and Economic Development in Pakistan, Economic Development and Cultural Change, 1998, 581697. King, R. and Levine, R. Finance, Entrepreneurship and Growth, Journal of Monetary Economics, 1993 (33), 513-542. Levhary, D. and Patinkin, D. The Role of Money in a simple Growth Model, American Economic Review, 1968 (58), 713-753. McKinnon, R. Money and Capital in Economic Development. Washington: D.C. Brooking Institution, 1973. Moroney, J. The Current State of Money and Production Theory, American Economic Review, 1972 (62), 335-343. Odedokun, M. How the Size of Monetary Sector Affect Economic Growth, Journal of Policy Modeling, 1999 (21), 213-241. Patrick, H. Financial Development and Economic Growth in Underdeveloped Countries, Economic Development and Cultural Change, 1966 (14), 174-189. Porter, R. The Promotion of Banking Habit and Economic Development, Journal of Development Studies, 1966 (2), 346-366. Rajan, R. and Zingales, L. Financial Development and Growth, American Economic Review, 1998,(88), 559-586. Shaw, E. Financial Deepening in Economic Development. New York: Oxford University Press, 1973. Shiller, R. and Perron, P. Testing for the Random Walk Hypothesis: Power versus Frequency of Observation, Economics Letters, 1985 (18), 381-386. Tobin, J. Money, and Economic growth, Econometrica, 1965 (33), 671-684. World Bank, World Development Report. New York: Oxford University press, 1989.

Table 1 Unit Root Tests Variables ADF PP Levels Differenced Levels Differenced ------------------------------------------------------------------------------------------------------lnY -1.486 -2.544*** -0.840 -2.293*** lnL -0.356 -2.834** -0.610 -4.634* lnI -1.647 -2.628** -2.245 -3.002* lnSCP -1.937 -3.600* -1.779 -4.096* lnCCP -1.354 -3.252* -1.542 -3.4203* lnM3 -2.380 -5.180* -1.233 -6.680* ------------------------------------------------------------------------------------------------------In all tables * significant at 1%, ** significant at 5%, and *** significant at 10%. Table 2 Johansen-Jueslius Cointegration Test -----------------------------------------------------------------------------------------------------Eigenvalues trace 5% for trace Hypothesis lnY= f(lnI, lnL, lnSCP) 0.6175 73.826 54.64 r=0* 0.4827 42.112 34.55 r1* 0.3371 20.359 18.17 r 2** 0.1860 6.792 3.74 r3* lnY=f(lnI, lnL, lnCCP) 0.5858 71.034 54.64 r=0* 0.4706 41.944 34.55 r1* 0.3308 20.958 18.17 r2** 0.2082 7.7034 3.74 r3* lnY=f(lnI, lnL, lnSCP, lnCCP) 0.6973 116.713 77.74 r=0* 0.5937 77.283 54.64 r1* 0.4718 47.56 34.55 r2* 0.4311 26.499 18.17 r3* 0.2125 7.883 3.74 r4* lnY=f(lnI, lnL, lnM3) 0.6574 75.142 54.64 r=0* 0.4646 46.223 34.55 r1* 0.4401 29.357 18.17 r2* 0.3980 13.700 3.74 r3* -------------------------------------------------------------------------------------------------------

Table 3 Vector Error Correction (VEC) Results ------------------------------------------------------------------------------------------------------Y=0.195 +0.278lnYt-1 +0.195lnYt-2 +0.22lnLt-1+0.0368lnLt-2 +0.0789lnIt-1 (3.02)* (2.013)** (1.947)** (1.216) (1.204) (4.764)* +0.604lnIt-2 +0.455lnSCPt-1 +0.258lnSCPt-2 0.491VECt-1 (2.979)* (2.387)** (1.930)** (2.512) Adj-R-sq =0.692 , F= 7.967*, Log Lik=34.07, AIC= -1.442, SC= -0.938. Y=0.025 +0.823lnYt-1+0.792lnYt-2+0.0303lnLt-1+0.0205lnLt-2 +0.164lnIt-1 (1.27) (3.218)* (2.247)** (0.8401) (0.5144) (2.341)** +0.504lnIt-2 +0.624lnCCPt-1 +0.277lnCCPt-2 0.400VECt-1 (1.882)** (2.201)** (1.911)** (2.350)** Adj-R-sq =0.807, F = 13.938*, Log Lik = 85.988, AIC= -4.687, SC= -4.182 Y=0.0053 +0.566lnYt-1+0.943lnYt-2+0.1049lnLt-1+0.505lnLt-2 +0.264lnIt-1 (0.078) (1.700)** (1.958)** (1.871)** (1.99)** (2.320)** +0.246lnIt-2 +0.205lnM3t-1 +0.197lnM3t-2 0.961VECt-1 (1.874)** (1.854)** (1.625)*** (-2.219)** Adj-R-sq = 0.83, F= 7.322*, Log Lik = 59.553, AIC= -3.735, sc= -3.203. ---------------------------------------------------------------------------------------------------------Adj-R-sq= Adjusted R squared, F= F-statistics. Log Likelihood, AIC= Akaike Information Criteria, SC= Schwartz Criteria. Table 4 Regression Analysis (Y Dependent Variable) ---------------------------------------------------------------------------------------------------------1 2 3 C 0.0337 0.0324 0.007 (5.231)* (4.688)* (2.130)** lnL 0.0707 0.0702 0.108 (3.098)* (3.0359)* (1.303) lnI 0.1573 0.1520 0.055 (10.673) (8.483) (1.213) lnSCP 0.0020 (1.874)** ---------------------lnCCP 0.0118 ------------(1.954)** ------------lnM3 0.472 -----------------------6.413)* Adj-R-sq 0.69 0.807 0.637 F 7.967 13.938 18.54 ----------------------------------------------------------------------------------------------------------

Table 5 Variance Decomposition ---------------------------------------------------------------------------------------------------------A- Variance Decomposition of lnSCP: Period S.E lnY lnI 1 0.466 20.254 0.0318 2 0.618 34.376 0.0235 3 0.806 55.029 3.732 4 0.988 56.4313 7.0186 5 1.082 54.746 8.5139 10 1.228 46.636 8.543 ----------------------------------------------------------------------------------------------------B- Variance Decomposition of lnCCP: Period S.E. lnY lnI ----------------------------------------------------------------------------------------------------1 3.713 2.5002 1.128 2 5.885 1.0127 0.8229 3 6.804 1.1057 2.9995 4 7.425 2.8909 5.0633 5 8.014 7.6909 6.5810 10 9.3062 18.888 9.492 ----------------------------------------------------------------------------------------------------C- Variance Decomposition of lnM3: ----------------------------------------------------------------------------------------------------Period S.E. lnY lnI 1 0.0365 0.5000 27.364 2 0.049 1.127 22.749 3 0.0649 20.638 14.247 4 0.0875 40.0448 7.831 5 0.1069 47.614 5.6044 10 0.1587 50.1689 5.0285 -----------------------------------------------------------------------------------------------------