Money Supply and Its Relevance to Macao

N. W. Ho Research and Statistics Department, Monetary Authority of Macao Abstract Developments of monetary aggregates play a pivotal role in the formulation and execution of monetary policy. Notwithstanding the decline in influence of monetarism, which advocates monetary targeting, in recent years, money supply is still believed to reflect the state of the economy in the long term and regarded as a vital variable monitored by economists and central bankers. This paper attempts to draw an overview of some of the major conceptual issues associated with how money is defined and explores their relevance to Macao. - 107 -

1. Introduction Monetary analysis undertaken by economists and central bankers is both necessary and important in the context of policy design and implementation. Given the underlying relationship between money and the price level, close monitoring on developments of monetary aggregates can help identify possible threat to price stability, at least in the long run. As Friedman (1963) puts it, inflation is always and everywhere a monetary phenomenon, followed by the conclusion from Taylor (1992) that there is ample evidence in many of the recent experiences with inflation and disinflation to support Friedman s (1992) point that substantial inflation is always and everywhere a monetary phenomenon. Crockett (1970) seeks to identify empirically the leading-indicator properties of the components and counterparts of money over future real spending and inflation in the United Kingdom, and asks whether and if so, when and why money might provide us with information about short-run real and nominal trends in the economy. In fact, the imbalance between money demand and the capacity of the economy to meet that demand are, to a large extent, reflected in changes in the general price level the level of inflation. Meanwhile, uncertainties on the extent of inflation, its accompanying effect and the actions the authorities taken to bring it under control usually arise. All of these uncertainties will ultimately distort saving and investment decisions towards a direction that tend to place excessive weight in the short term, and obscure the relative price signals that are instrumental to efficient resource allocation. Hence, it is believed that the control over the growth of monetary aggregates can bring inflation under control and reduce uncertainties, and this belief was especially popular during the monetarist heyday of the late 1970s and early 1980s. Monetary analysis begins with the very definition of a key monetary aggregate, i.e. money supply. Money has its primary functions in any economy: as a medium of exchange, as a unit of account, as a store of value and as a standard of deferred - 108 -

payment. Among these functions, medium of exchange represents the foremost property of money, distinguishing it from other types of assets such as stocks, bonds, and real estates. Therefore money, or money supply, is normally defined as anything that is generally accepted in payment for goods or services or in the repayment of debts. However, to define money merely as currency is much too narrow, and a broader definition of money may be needed because other financial assets such as savings deposits can, in effect, function as money if they can be quickly and easily converted into currency or checking account deposits. There is no universally agreed definition of money, and as a result, different countries in the world define money at their own discretion, in such a way that definition must be tailored to policy relevance. National definitions of money or money supply for most countries are published in the International Monetary Fund s publication, the International Financial Statistics (IFS). 1 The formation of these definitions virtually stems from the Manual on Monetary and Financial Statistics (MFSM 2000), which stresses the importance of the definition of money supply, in particular, the broad money. The MFSM states that the Depository Corporation Survey, 2 which contains stock and flow data on those depository corporations liabilities that are components of broad money, are the major focus of monetary statistics and constitute a core set of data for macroeconomic analysis (paragraph 365). However, the MFSM, based on the liquidity nature and store of value characteristics of the financial assets, also provides guidelines on what to be included in the national definition of broad money, with the choices of which assets should be included to the discretion of the national authorities. In the case of Macao, financial sector statistics compiled by the Monetary Authority of Macao (the AMCM) contain two measures of money supply, namely, the narrow 1 1 The IFS is a standard source of statistics on all aspects of international and domestic finance. It reports, for most countries of the world, current data needed in the analysis of problems of international payments and inflation/deflation, i.e., data on exchange rates, international liquidity, money and banking, interest rates, prices, production, international transactions, government accounts, and national accounts. Information is presented in country tables and in tables of area and world aggregates. 2 For countries/regions with narrower institutional coverage, it is referred as Monetary Survey. - 109 -

(M1) and the broad (M2) money supply. This paper tries to explore the rationales, which underlie the specific choices of financial assets included in the current definitions of money supply of Macao, and to explore their abilities in conveying information on the state of the economy. This paper contains five sections. Section 2 displays the general nature of the financial assets that should be included in the national definition of money supply. The section that follows describes the current definition of money supply in Macao. Section 4 reviews movements of Macao s money supply over the past few decades. The final session concludes. 2. Definition of Money Conceptually, the definition of money starts from money s very basic function that we learn from standard economics textbooks, i.e. medium of exchange. However, in an environment of continuing financial deregulation and innovation, the intrinsic nature of this basic function has evolved with the structural change of the economy. Financial assets that are embedded with other functions of money, namely store of value, unit of account and standard of deferred payment are now considered as close substitutes for the means of payment, and thus constitute a fuller measure of the potential purchasing power inherent in a given quantity of money. Nevertheless, the concept of money still lies at the core of both monetary theory and policy. The effort to define money can be approached from the standpoints of the economic units, i.e. households and business units, which use money. It starts from the question of what money is used for, or, equivalently, when it is demanded. Generally speaking, money is used to facilitate purchases, in other words, as a means of payment. Money should therefore be defined to include those assets used directly in making purchases and to exclude other assets. On the basis of this criterion, some economists define money as the sum of currency in the hands of the public and demand deposits held in - 110 -

the banking system, believing that such a definition could adequately reflect economic conditions such as the level of output, employment and prices. However, purchasing power should not be limited to those assets that can be used directly to facilitate payments. Other assets can also be employed as temporary reservoirs of purchasing power for anticipation of payments. For example, a portion of deposits held by households and firms is believed to serve as a temporary store of purchasing power for anticipation of payments. Besides, in line with financial deregulation and innovation, checking accounts have begun to pay interest, and it has become easier to write checks on accounts outside the narrow definition of money, often referred as M1. As a consequence, the distinction between money held inside and outside of M1 by firms and individuals is blurred. This development has sapped the stable relationship between M1 and economy-wide spending to disappear. For example, a small change in interest rates could cause individuals to move in or out of M1, which could, in turn, lead to substantial swings in the aggregate s growth rate that has little to do with the spending plan. Hence, the definition of money needs to extend beyond its means of payments concept to include a wider array of financial assets that can be considered as money. At this point, money might be defined more broadly than merely for exchange purpose. As mentioned above, defining money from the perspective of meeting anticipated payments only focuses on the relationship between money and current transactions, while money s function as a store of value should never be neglected. In other words, money can serve as a store of liquid wealth held to meet unanticipated contingencies necessitating payments as well as expected transactions and to balance illiquid assets such as long term securities and non-financial assets in households and business portfolios. Accordingly, the extent to which financial assets can be converted into money the degree of liquidity, should also be taken into consideration when defining money. - 111 -

In view of all the changes in the financial environment that have taken place, especially financial innovation in the area of derivatives and mutual funds, it seems that the broader measure of money supply still fails to serve as a reliable indicator of financial conditions in the economy. While the theoretical approach to defining money fails to produce any definitive agreement, for the purpose of international comparison and analysis of related policy implications, a general guideline is essential for countries to calculate their money supply. In the MFSM, the IMF provides a general guideline on the selection of financial assets in broad money, based on the notion of liquidity. 3 The definitions of monetary aggregates in various economies are displayed in the Table 1. Table 1: Components of Monetary Aggregates in Selected Economies Macao SAR Hong Kong SAR China US Japan Definition of money M1, M2 M1, M2, M3 M0, M1, M2 M1, M2 M1, M2 plus CDs, M3 plus CDs, Broadly defined liquidity Compositions in: M1 Currency+demand deposits Currency+demand deposits with licensed banks Currency+demand deposits Currency+travellers' Currency+demand deposits checks by nonbank issuers+demand deposits+negotiable order of withdrawal and automatic transfer service accounts and similar interest-bearing demand deposits. M2 M1+savings, notice, and M1+savings and time deposits time deposits+cds issued by of licensed banks+negotiable banks CDs issued by licensed banks M1+savings and time deposits+security margin requirement M1+savings and money M2 plus CDs=M1+savings and market deposits time deposits+cds issued by accounts+small time banks deposits+retail type money market mutual fund balances+overnight repos+overnight Eurodollars Other Measures NA M3 = M2+deposits with restricted lincesed banks and deposit-taking companies + negotiable CDs issued by these institutions held outside the banking system. NA NA M3 plus CDs=M2 plus CDs+postal savings deposits+cds; Broadly defined liquidity=m3 plus CDs+pecuniary trusts other than money trusts, investment trusts, bank debentures, commercial paper issued by financial institutions, repurchase agreements and securities lending with cash collateral, government bonds, and foreign bonds. Sources: Websites of various central banks; International Financial Statistics, May 2007, IMF. 3 Liquidity is defined as the extent to which financial assets can be sold at, or close to, full market value on short notice. See MFSM (2000), paragraph 287. - 112 -

Accordingly, currency and transferable deposits comprise the most liquid financial assets, and all countries include them in their broad money aggregates, always refer them as the narrow money. Other components of broad money might include: savings deposits; term deposits, other deposits issued by savings and loans associations, building societies, and credit unions; repurchase agreements; money market mutual fund shares; negotiable certificates of deposit; short-term and even some mediumterm securities that are convertible into cash or transferable deposits without incurring significant transaction costs or delays. Following this criterion, assets that could incur explicit costs in the form of fees or other changes or the implicit costs arising from delays in the conversion process into media of exchange, or those for which there is significant potential variability in their market price, such as in response to changes in interest rates, may be excluded from money. 3. Money Supply in Macao On a monthly basis, the AMCM publishes data on two measures of money supply: M1 and M2. The former measure comprises notes and coins in active circulation 4 and demand deposits held in the banking system. The amount of coins being used as a medium of exchange in this definition does not include the nominal values of any portion of those gold coins and commemorative coins, which are held for intrinsic or numismatic value. Dated back to inception, the original definition of M1 as a measure of narrow money had composed of three elements: the two elements in the current definition plus savings deposits held in the banking system. Following the recommendations put forth by some international organisations, since 2001, savings deposits, due to the fact that they are not directly usable for making third party payments by check, draft, or other direct payment facility, have been excluded from M1. Past data of M1 have then been adjusted to facilitate comparison. 4 This is the total amount of currency in circulation less currency held in banks vaults. - 113 -

After this modification, M1 defined in Macao should contain all those underlying characteristics 5 that a medium of exchange would require: notes and coins should be overwhelmingly held in the household sector, bearing no interest. The motives of holding notes, coins and demand deposits should be for transactions purposes, not as a store of value. All these imply a close correspondence between M1 and transaction balances in the economy. Generally speaking, broad money balances are held for two main reasons. First, they serve as a medium of exchange, since banks deposit liabilities are generally accepted as a final means of settlement, in much the same way as cash. Second, bank deposits can serve as a store of value. As a large portion of M2 is interest bearing, economic agents would hold broad money as part of a diversified wealth portfolio alongside other financial and real assets. In the same way as how M1 is defined, the selection of financial assets in the broad money of Macao can be justified from their degree of moneyness. Here, moneyness can be distinguished from the characteristics in transaction costs, divisibility, maturity and yield. However, what differentiate between the broad and narrow money rely on the relative importance of their functions as a medium of exchanges or as a store of value, i.e. the trade-off between the two when moving from narrow to broad money. Taking the transaction cost characteristic as an example, payment made by the components of M1 usually has no fees or relatively small fee. In contrast, if such a payment is made through those types of financial assets classified as broad money, substantial transaction costs could sometimes be involved, as the conversion of these assets, which are held for the store-of-value motive, involves explicit costs in the form of fees or other charges or the implicit costs arising from delays in the conversion process. Hence, liquidity progressively decreases but is compensated by the increase in interest yields. 5 These underlying characteristics include: a/legal tender or general acceptability; b/fixed nominal value; c/transferability; d/low or no transaction costs; e/divisibility; f/zero maturity, and g/no or low yield in holding. - 114 -

At present, institutional coverage of monetary statistics of Macao compiled by the AMCM includes all the commercial banks and a postal savings bank while all other financial institutions are excluded. The measure of broad money used by the AMCM, M2, consists of narrow money mentioned above, and quasi money that includes all other resident deposits 6 held at banks in Macao, together with certificates of deposit issued by Macao banks. At the end of December 2006, the stock of M2 totalled around MOP170 billion, equivalent to around 142% of nominal GDP for 2006 and almost 50 times the size of stock of Pataca notes and coins in circulation. One important feature in Macao s definition of money is the dominant position of foreign-currency denominated liabilities. To be precise, the financial system of Macao as a whole can be characterised as currency co-circulation, a co-circulation of the Hong Kong dollar with the domestic currency, Pataca. The use of the Hong Kong dollar 7 is popular in Macao, though legislation has been issued and measures have been undertaken to promote the use of the domestic currency. 8 As clearly exhibited in Table 2, the Hong Kong dollar is serves as a medium of exchange as well as a store of value. It takes a prominent share in one of the components of M1 - demand deposits, and all of those in M2. It should be noted that currency in circulation included in Macao s M1 reflects only the AMCM s liability for the outstanding amount of the Macao SAR currency that it has issued. 9 Liabilities for the co-circulated Hong Kong Dollar appear only in the records of the Hong Kong SAR Government. 6 This covers all types of nontransferable deposits: savings deposits, notice deposits, time deposits held by the resident sector of Macao, including foreign currency-denominated components. Due to the unique nature of the government s financing constraints, spending decisions, cash management techniques, and its flexibility in response to macroeconomic influences, Macao SAR Government deposits held in the banking system are not included in the broad money. 7 In fact, due to the long-standing relationship and geographical proximity with Hong Kong, the Hong Kong dollar has assumed a leading monetary role in the Macao economy for a long period of time. 8 For a detailed coverage of legislation and measures undertaken in this respect, please refer to Ho (2003). 9 In Macao, banknotes are issued by two commercial banks, namely the Bank of China and Banco Nacional Ultramarino through a currency board mechanism, in which Certificates of Indebtedness of equal amount will be issued to these two banks in exchange for new banknotes issued. Coins are directly issued by the Government via the AMCM. - 115 -

Table 2: Currency Structure of Money Supply, 1985-2006 M2 Shares of Hong Kong Dollar in: Shares of: Demand Savings Notice Time MOP HKD Deposits Deposits Deposits Deposits 1985 26.7 59.8 58.7 57.9 79.8 63.9 1986 25.7 54.2 54.5 56.5 54.0 56.3 1987 22.7 51.6 61.8 58.2 55.5 49.7 1988 19.1 56.3 60.2 50.6 58.1 59.7 1989 20.9 55.2 58.2 52.8 61.6 57.5 1990 22.8 49.0 61.3 48.2 75.6 49.1 1991 22.8 51.1 67.4 61.0 78.9 45.5 1992 24.2 50.7 64.6 58.0 50.4 46.1 1993 26.3 51.0 62.9 54.2 54.3 49.4 1994 27.1 55.6 62.7 55.4 65.7 56.5 1995 29.0 56.3 61.6 53.1 76.0 58.0 1996 29.9 55.4 56.9 52.0 75.8 57.5 1997 30.5 53.4 53.8 49.9 63.0 55.5 1998 30.6 53.3 54.9 50.9 63.3 54.9 1999 32.5 51.2 46.6 49.6 85.1 52.8 2000 27.3 52.4 52.6 50.1 86.5 54.0 2001 28.5 51.2 57.9 52.1 79.4 51.7 2002 27.8 51.8 55.0 55.0 81.5 51.6 2003 26.7 53.5 55.0 61.6 77.3 50.5 2004 25.9 54.7 63.2 61.2 69.6 51.0 2005 27.0 51.7 55.0 51.9 63.9 52.9 2006 26.8 53.9 54.1 56.9 74.3 54.1 Source: Monthly Bulletin of Monetary Statistics, AMCM. Note: The currency structure of M2 does not add up to 100% due to the existence of other foreign currencies except the Hong Kong dollar. (%) 4. Influences of Broad Money Growth As suggested by Friedman and Schwartz (1970), an appropriate definition of money should be sought for not on grounds of principle but on grounds of usefulness in organizing our knowledge of economic relationship. From this standpoint, the best definition of money should be the one producing the closest correlation between money and national income. - 116 -

The fundamental money-price relationship is often described in terms of the Quantity Theory of Money. 10 According to this proposition, the price level moves proportionately to the money supply, hence, in the long run, the rate of inflation depends on the rate of money growth, implying an essential link between money and prices. In economies where exchange rates are determined by market forces, the monopoly power of the central bank or monetary authorities over the creation of the legal tender for formulating monetary policy is ensured. From the monetarist perspective, an accumulation in money balances would be associated with an increase in nominal incomes, and given a stable demand for money, would eventually drive up the price level. Hence money is regarded as a useful instrument in the formulation of monetary policy. By limiting the growth in money supply, policymakers can maintain a desired rate of inflation, and ultimately, output level. Chart 1: Nominal GDP and Money Supply Growth (percentage change ) 37 32 27 22 17 12 7 2-3 -8 1985 1987 1989 1991 1993 GDP 1995 1997 M2 1999 2001 2003 2005 Sources: Monthly Bulletin of Monetary Statistics, AMCM; Gross Domestic Product, Statistics and Census Service (DSEC). 10 According to Irving Fisher s quantity theory of money, there exists a relationship, MV=PQ, where M=the money supply, V=velocity of money (which is defined as the ratio of nominal income to money), P=price level, and Q=the level of real output. Fisher assumes that V is constant and that in the long run, Q would be determined by the economy s productive capacity and be independent of the money supply. - 117 -

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 Money Supply and Its Relevance to Macao The trends of M2 and GDP growth are exhibited in Chart 1, while the income velocity of M2 which measures the ratio of nominal GDP to the stock of M2, is plotted in Chart 2. 1.1 (%) Chart 2: Income Velocity of M2 1 0.9 0.8 0.7 0.6 0.5 Source: Monthly Bulletin of Monetary Statistics, AMCM. It is observed from Chart 1 that the money stock of M2 grew more quickly than the nominal GDP for most of the period under review. Another important message derived from Chart 1 is the low correlation between the rate of money growth and the rate of growth of nominal income. Do these observations imply that the information content of M2 and its components are analytically unsound? Or putting in the other way, the inclusion of financial assets in broad money so defined in Macao is not extensive enough to convey useful information about the state of the economy? Under the present currency board arrangement with the Hong Kong dollar as the anchor currency, the principal determinants of broad money in Macao have some significant differences from those of other economies. Unlike the case of most economies where credit to the private sector is the most important determinant of money growth, the growth of money supply in Macao is mainly attributable to a strong growth of net foreign assets, an important component in the balance of payments. - 118 -

In fact, during 1996-1999, Macao experienced a positive growth of money supply coincided with a sluggish demand in consumption, investment, as well as credit to the private sector. The monetary survey published by the AMCM shows that the contraction in credit to the private sector exerted a contracting effect on money supply in the period. Furthermore, the traditional net creditor position of the Macao SAR Government has allowed fiscal surpluses to accumulate to a high level, which exerts a contraction impact on money supply, rather than the common situation whereby fiscal deficits add to monetary pressure. The continuous increase in net foreign assets has fully offset the contraction of domestic credit and has significantly contributed to the positive growth of money supply. In other words, monetary developments in Macao are essentially determined by fund flows, i.e. the balance of payments or supply of foreign assets. In fact, the increase in net foreign assets of the monetary system has been faster than the growth of M2 for the past nine years in a row. As a result, foreign assets amounted to MOP192.1 billion (US$24 billion) as at the end of 2006, equivalent to 134% of the broad money. 5. Conclusion Apparently, the choice of financial assets to be included in the definition of money varies across countries, depending on the depth and complexity of their financial structure. Nonetheless, the basic principles still apply. Even under a regime of fixed exchange rate, which imposes a degree of constraints on the implementation of discretionary monetary policy, monetary operations in Macao should still be exercised in a transparent fashion for maintaining monetary stability. The analysis of monetary developments thus provides the financial community and government officials with a tool for analysing monetary trends in Macao, in particular, fund flows in and out of the economy. In the case of Macao, it is clear that sluggish credit creation and prolonged fiscal surplus have dragged down monetary growth. - 119 -

Moreover, other factors, such as interest rate and exchange rate, are also at work to affect money growth. Given the lesser degree of complexity in financial structure of Macao, the current definition of money supply seems to be adequate to explain the financial condition of the economy. However, monetary definitions tend to be dynamic in nature in that they are subject to revisions and refinements whenever the traditional monetary definition no long satisfies the criteria for explaining the intrinsic link between the real sector and the monetary sector. The ongoing technological innovations in computer science and telecommunications and the growth in use of the Internet have spurred financial innovation in every aspect, leading to the creation of new financial assets and variations in economic activity and financial conditions over the business cycle. One such example is the spread of stored-value cards and e-money, which could have significant implications for the central bank s balance sheets and those for depository institutions. These might also increase the difficulties in implementing monetary policy when the issuers of e-money are not central banks or monetary authorities. The commitment to convertibility of such e-money might be subject to close scrutiny when the issuers face financial strains as a result of shocks or management difficulties. The increasing integration of Macao into the global economy, as evidenced by the increased inflow of foreign capital in recent years, and the changing structures of the local financial sector and the international standards of monetary statistics might urge the definitions of money to be reviewed in due course. Technical research on issues such as seasonal adjustment of data or compilation of Divisia money 11 would also help improve the quality and usefulness of monetary statistics. 11 Divisia money is a measure of the money supply that weights the money components currency, transferable deposits, time deposits, etc. according to the usefulness of each component for transactions purposes. This measure may produce a stronger link between money and aggregate spending in an economy. - 120 -

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Ragan, K. and B. Trehan (1998), Is Time to Look at M2 Again, Economic Letter, Federal Reserve Bank of San Francisco, March, 1-5. Salmon, C. (1995), Influences on Broad Money Growth, Bank of England Quarterly Bulletin, Vol. 35, February, 46-53. - 122 -