The banking system reduces transaction costs and thus stimulates specialization, which, in turn, helps productivity and growth. We have selected the following indicators to evaluate the performance of the banking system in facilitating transactions: percentage of money outside the banking system and interest rate spread. The higher these indicators are, the worse the performance.
Money outside the banking system as a percentage of money supply is an indicator that helps us evaluate the overall health of the banking system. If a substantial portion of the money supply circulates outside the system, economic agents avoid conducting their transactions through banks because of the problems inherent in this system - high risks and/or high transaction costs. In addition, a poorly performing banking system stimulates the expansion of the shadow economy, which has a negative effect on the former. Thus, a powerful relationship of negative feedback develops.
This point is consistent with the pattern of money supply allocation in transition economies. Those economies that are considered to be more successful in their transitions, and which have better functioning banking systems, tend to have a lower portion of money outside their banking systems, compared to other CEE countries (Figure 10). Although Ukraine belongs to the latter group, one can observe a steady tendency for money to flow into banks (Figure 11), including an inflow of deposit savings, as discussed above.
Interest rate spread is calculated as the ratio of (1) difference between interest rate on credits and interest rate on deposits, to (2) interest rate on credits. This indicator can be used as a proxy for the degree of inefficiency of a bank in acting as an intermediary between savers and borrowers. It measures the proportion of funds raised from crediting which is absorbed by the banking system, rather than acquired by the investor (the owner of a deposit).
Currently approximately 70 percent of the money that Ukrainian banks earn from loans remains within the banking system, and 30 percent is returned to depositors, which is significantly less than in many other countries of the region (Figures 12 and 13).
Transaction costs have remained high for the last three years, mainly due to the huge Kartoteka #2, high taxes, and the inability of banks to effectively manage their operational expenses.
Figure 10
Money outside banks, percent of M3, transition countries, Q4’99
Figure 11
Money outside banks, percent of M3, Ukraine, Q4’95–Q3’00
Sources: Web pages of central banks Source: Harvard/CASE database
Figure 12
Interest rate spread, percent, transition countries, 1999
Figure 13
Interest rate spread, percent, Ukraine, Q1’98–Q4’00
Sources: Web pages of central banks Source: Harvard/CASE database
0 20 40 60 80 % 0 10 20 30 40 50 %
30 35 40 45 50
Q4’95 Q2’96 Q4’96 Q2’97 Q4’97 Q2’98 Q4’98 Q2’99 Q4’99 Q2’00
%
0 10 20 30 40 50 60 70 80
Q1'98 Q3'98 Q1'99 Q3'99 Q1'00 Q3'00
Ukraine Russia Latvia Lithuania Bulgaria Poland Hungary Czech Rep. Slovakia
Bulgaria Latvia Ukraine Lithuania Estonia Russia Czech Rep. Slovakia Poland Hungary
Conclusion
We believe that Ukraine can serve as an excellent case study for the role of the financial system in an economy. What we observed in Ukraine during the last decade provided us with a good illustration of, and yet another piece of evidence to support, the hypothesis presented above by Schumpeter, and systematically tested by Levine: the performance of the financial system and its banking industry is a good proxy for the current level of economic development and for future growth. A strong and growing banking system today means a strong and growing economy tomorrow. A weak banking system reflects a weak economy and weak prospects for future growth.
The transition period in Ukraine may be divided into several stages:
Stage 1. Early 1990s. The economy is still operating under the old Soviet institutions and is dominated by large state-owned factories - predominantly 19th century-type heavy industries with a focus on the military sector. Nominal GDP is relatively high. The whole consumer-oriented sector is weak, living standards are low, and the natural environment is devastated. Heavy distortions in prices and resource allocation prevent sustainable (and reasonable) economic growth. In this context, the banking industry is nominally large but fails to play any active role in the economy. Of the five banking system functions analyzed in this paper, only the facilitation of transactions is being performed (in a way). The passive and heavily distorted banking system reflects an economy in a state of imminent collapse.
Stage 2. Mid-1990s. The anticipated collapse of the economy is taking place. The banking sector is heavily affected, and its assets and activities are diminished by several times. The banking system, barely operating, supports a pessimistic forecast for the economy which is reflected in the gradual decline of GDP and a very low level of foreign direct investment in Ukraine.
Stage 3. Late 1990s. Sluggish reforms in 1995-97 fail to stop the decline, although the rate of decline decelerates. The financial sector operates at a very low level, several times lower than in many other countries of the region. The fall crisis of 1998 brings more decline to the economy and subjects Ukrainian banks to another painful shock. However, the effects of the crisis are encouraging.
The very significant devaluation of the hryvnia helps both foreign trade and the domestic economy. Reform efforts are increased. We observe a gradual hardening of budget constraints on the budget sector itself, as well as on commercial enterprises. Banking rebounds.
Figure 14
Real GDP and loans to GDP ratio, percent, 1993-2000
Source: Harvard/CASE database
Stage 4. 2000 to present.11 Ukraine’s economy remains at a very low level. Its GDP per capita, wages, etc. are comparable to the least developed economies. The current level of financial system development, including banking, is also very low. Yet, the economy is growing, and the banking indicators analyzed in this chapter appear to solidly support this growth. Three observations can be made. First, while remaining at a low level, most of the institutional indicators for banking show a significant improvement. The gap between Ukraine and more advanced countries in the region is narrowing. Second, as shown in Figure 14, most of these indicators already began to improve some time ago and preceded, rather than followed, the growth of GDP (household incomes, investment, and foreign trade). Third, while some of the indicators have not improved, there are well-founded expectations that the recent legislative efforts will bring significant improvements in the near future. Some reforms have already been implemented and some are forthcoming - in particular, in the areas of tax reform (including the abolishment of the disastrous Kartoteka #2 system), land ownership, and bankruptcy procedures, to name a few.
Our final comment concerns an issue addressed at the beginning of this chapter, namely, investment. It can be argued that, despite much attention to institutional development during the last decade,
11 See “The Economic Situation in Ukraine: 2000” in this volume.
40 50 60 70 80
93 94 95 96 97 98 99 00 0 10 20 Real GDP growth, 30
1991=100, left scale Loans/GDP, percent, right scale
this development is still under-estimated. We keep learning (and admitting) that institutional investment provides very high returns, yet the entire system of official statistics continues servicing physical investment. In other words, economists are still more concerned with physical capital allocations than with institutional efforts. It appears that in Ukraine this substitution – “institutional”
for “physical” – has been occurring for several years now, but was not reflected in the standard economic statistics. Our analysis of the banking system seems to confirm the existence of this substitution. In 1996-99 there was increasingly less physical investment, but more institutional investment, although the latter was certainly less visible and less measurable than the former.
Reform efforts are now beginning to bring more tangible fruits.
The financial sector is expanding and solidifying. In-depth analysis of this sector provides important insights, not available from the study of standard macroeconomic indicators. Our modest attempt to examine Ukraine’s banking system seems to confirm the optimistic evaluations and forecasts. The economy is growing and, if reform efforts continue, better and stronger institutions will further ensure a more rapid development of the financial sector and the entire Ukrainian economy.
References
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