Research Proposal: Bank Credit Creation and SA Economic Problems

This research proposal examines the utilization of bank credit creation to address economic challenges in South Africa. It begins with an introduction to the financial sector's role and the impact of global events, including the 2007/8 financial crisis. The study highlights the dominance of a few major players in the South African banking system and the importance of monetary policy. It explores the concept of money creation through credit and the contrasting views of mainstream economics. The problem statement focuses on the slowdown in South Africa's economic growth and the critical role of credit for new firms. It discusses the financing gap for SMEs and the challenges they face in accessing bank credit. The research will analyze the theory of credit creation, contrasting it with the financial intermediation theory. The study aims to understand how banks create money and allocate it, and how these processes impact economic development. The research will use secondary data, econometric methods, and ethical considerations will be addressed. The study will contribute to the understanding of monetary and fiscal policies and their potential for sustainable economic development.

Utilizing the power of bank credit
creation in solving South African
economic issues.
N.P Mphahlele
25416553
Research proposal for the submitted in fulfillment of the
requirements for the degree Honours in Economics at the North-
West University
Supervisor/Promoter: Prof. Dunga
Co-supervisor/ Co-Promoter: Dr. Meyer
Date of submission: 2019/04/27
Version: 2

Table of content
1. INTRODUCTION AND BACKGROUND TO THE STUDY.................
2. PROBLEM STATEMENT...........................................................
3. THEORETICAL PERSPECTIVES.................................................
4. RESEARCH OBJECTIVES..........................................................
4.1 Primary objective.................................................................................................5
4.2 Theoretical objectives..........................................................................................5
4.3 Empirical objectives.............................................................................................5
5. RESEARCH DESIGN AND METHODOLOGY.................................
5.5 Secondary data....................................................................................................6
5.5.1 Data sources........................................................................................................6
5.5.2 Econometric methods of analysis.........................................................................6
5.5.3 Model................................................................................................................... 6
6. ETHICAL CONSIDERATIONS....................................................
7. CONTRIBUTION OF THE STUDY...............................................
8. SECTION CLASSIFICATION......................................................
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Utilizing the power of bank credit creation in solving South African
economic issues
Keywords: bank credit creation, credit allocation, money supply, financial sector, stable
growth
1. INTRODUCTION AND BACKGROUND TO THE STUDY
The past two decades saw the financial sector decisions taking economies through booms and
preceding severe bust periods. They include the 2007/8 financial crisis, 1999-2000 dotcom
bubble, Asia 1997/98 economic crisis and Tequila crisis of 1994 to highlight a few. Although the
financial crises were caused by various systematic and systemic issues, the role of banks and
the role of credit that seems to supersede these crises (Ivashina & Scharfstein, 2010).
Globalisation has increase integration between South Africa economy and other countries
national economies and are beneficial to the economy. Equally so, with globalisation came
financial integration which rendered South Africa’s financial and economic progressively
sensitive linked countries financial decisions. A rapid crash from the 2007/8 financial crisis
dislocated the South African economy from the longest period of sustained growth. Followed by
a loss of nearly a million jobs in the economy in the preceding year (Steyler & Powell, 2010:1-4).
Companies reverted into survival mode with some industries already in recession phase, such
as the mining sector, manufacturing sector and trade and further perpetuated the crises (Bexter,
2013).
History teaches us that systems change fundamentally when there is a crisis and thanks to the
2007-8 European American banking crisis there is an increasing interest in the role of banks
within the economy (Werner, 2014:1). Werner (2012:14) conducted a survey of that posed the
question; between the government, central banks or commercial banks, which of these
institutions is responsible money creating money in the economy. The results reflected that 90%
of the respondent held the view that it was the reserve bank. The reality is however different as
Werner (2018) concluded, based on a study of England’s private banks and Bank of England
that 97% of the money supply was created by private banks while 3% only were created by the
Bank of England. The South African banking system is well developed and resembles systems
of the United Kingdom which suggest that South Africa’s money supply is dominated by bank
credit creation (Mishi & Tsegaye, 2012).
There is grave concern about credit from private banks in South Africa as 82% of the total share
of the banking industry is dominated by 5 major players (BASA, 2015). This essentially renders
South Africa’s credit decisions to few industry captains guided by the monetary policy. Monetary
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policy plays a critical role in South Africa’s economy as it upon which development, growth and
sustainability of economic activities are dependent on as it guides activities of banks to a certain
degree without interfering with day to day activities (Mshishi & Tsegaye, 2012). Banks charge
high interest rates to less credit worthy borrowers in market segments and reallocate credit
towards captured borrowers, and although they have greater information asymmetries, it allows
for more capital flight risk (Dell'Ariccia & Marquez, 2004).
Banks create money through a process of credit creation by using deposits and providing loans
to the public. Legally, this is contrary to mainstream economic literature which suggest that
banks are financial intermediaries (Mohr, Van Zyl & Pretorius, 2018; Janse van Rensburg,
McConnell & Brue, 2015). Although central banks have control over money supply, money is
created by commercial banks. Wicksell (1916), Schumpeter (1954) and Moeller (1912) suggest
that banks create money and that theory of credit creation by banks hold. Werner (2014)
conducted as study based on empirical evidence, concludes that banks create money ‘out of
thin air’ which reinforces Schumpeter and Moeller conclusions that banks create money.
Over the past 100 years, the world has faced financial economic disasters, which disrupt
economies for prolong periods of time of up to 20 years or more (Johnson, 1974:87). Recurring
banking crisis are preceded by high unemployment, volatile business cycles and
underdeveloped finite resources are the current challenges facing the world economic stage but
also more importantly, due to globalisation South Africa is sensitive to the task (Bar, 2013).
Through solving the anomalies in the macroeconomics and more importantly, in respect to
monetary and fiscal policies possible sustainable economic development can be a reality.
Werner (2011), based on his (1992-1997) quantity theory of credit, reiterates the bank’s sole
monopolization on money creation and in turn the shaping of economic landscapes. The
consideration in this case following the debunking the myth of the role of banks, is where the
money ‘created out of thin air” is allocated. The economy consists of non-GDP and GDP
transaction. The former is concerned with financial transaction, such as asset prices which in
essence is never sustainable as it is the so sole reason behind, banking crises, income and
wealth inequality. The latter is alternatively called the real economy (GDP transaction) which
consist of the consumption economy, that creates consumer price inflation (unsustainable) and
production side that, although not enticing can create high, stable, sustainable growth without
inflation. When money is created for production purposes in the real economy, it creates
productive credit creation (Werner, 2014). Money in its nature and its various forms, underpins
all economic transactions (Mises, 1980).
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Post the 1994, the South African economy has been riddled with many economic challenges
and in attempt to be equal to the task. Monetary policies, that not only failed but systematically
affected other policies (Kane, 1977). The economic systems of South Africa are however
political and whether useful economic policies are beneficial in literature can affect change
economic challenges concerned (Cotzee & Woolfrey, 2012). Makes the conclusion that, banks
are special and their capacity to mobilize resources financial resources in the economy can play
a crucial role in the economy. The mobilization and allocation of financial resources for
investment purposes can be integrated into the economy through linking complimentary
activities and ultimately accomplish the same goal as the rest of the economy (Mashelel, 2017).
Solving anomalies in the macroeconomics and more importantly, in respect to monetary and
fiscal policies possible sustainable economic development can be a reality.
2. PROBLEM STATEMENT
South Africa’s economic growth has slowed down significantly since 2011 and forecasts remain
hopeless at 1.5 from 1.7 percent in 2020 (SARB). Schumpeter (1943) holds the view that new
firm creation is vital for the progression of capitalism. The importance of new firms in the
economy are the innovative products and technology they develop which bring competitive
pressure to industry giants. Considering that new firms are important to solving much of South
Africa’s economic issues, credit plays a fundamental role of access to much needed capital for
development of products and technologies. Underhill Corporate Solutions (2011) estimated the
total financing gap in South Africa (which focuses on economically significant SME’s) to be 45-
48% of SME’s. According to Finmark Trust (2006), South African banks only fund 2% of the
new firms. Foxcroft (2011) probe into bank credit granting for SME in South Africa is revealed
that 75% of credit application to banks are rejected. The lack of support from banks in the
economy to main drivers of economic growth and development, even with valid reasoning
impedes survival and growth of South Africa (Madula, 2015).
The uninspiring economic performance by the South African economy may have long term
consequences of economic structural transformation (Hittler, 2009). There multiplicity of
problems which affect the economic performance are a cause for concern. South Africa has a
well-developed and well-regulated banking sector that ranks 3rd out of 148 countries. However,
financial well-development does imply economic prosperities.
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The way in which banks create money is nothing short of magic (Tolinson, 2019). The extent of
the understanding of the ‘magic’ is an interest that serves the discussion of the paper and
provide economic solutions. The concern is that money is created out thin air in the economy,
by private companies and legally so through the South African Reserve bank licensing. The
mandate of the South African Reserve bank is to serve the interest of the South Africans in line
with the constitution. The theory of money creation through credit creation is not only a legal
concern but also a moral concern. If the constitution protects the independence of the reserve
banks, yet one of the main responsibility is outsourced to private individuals with private
interest, is it within the best interest of South Africans. Secondly, adjustment to new reforms can
be a concern to the South African financial economy if the money creation responsibility is taken
away from the private banks however, since the mandate is ‘borrowed’ by the private banks, a
reconsideration of the licensing should take place. Money created for non-Gpd transaction such
as speculative financing and asset purchasing affect the entire economy negatively. More so,
access to such speculative money through credit is in turn given to large asset management
companies that have no concern for the South African economy or the citizens but solely for
profit maximisation. This is an entrenching cycle of exclusion from financial participation at the
cost of economy.
3. THEORETICAL PERSPECTIVES
THEORY OF CREDIT CREATION
Influential economist ague that commercial power to create money out through their credit
providing capabilities (Wicksell, 1998; Withers, 1909; Schumpeter, 1912 and Moeller, 1925)
Reviewing the proponents of credit creation begin with Macloed (1855:113-132), who produced
an influential opus on banking, titled “The Theory of Banking and Practice”. Macloed’s
publishing’s review credit creation by commercial banks and unequivocally argues that banks
create money from nothing when they practice what they call ‘lending’. The linking of credit
creation to macroeconomics are inked by the “Quantity theory of credit’ (Werner, 2012:78-98)
which essentially argues credit that credit for (a) productive purposes in the form of investment
for services and goods, is more sustainable and non-inflationary in the long term. Moreover,
productive credit is less likely to become non-performing, (b) unproductive lending practices
either for consumption purposes are likely to result in consumer price inflation (c) or for asset
transactions which are constituted by speculation which adds no value to the economy create
inflation and if large enough, create banking crises (Cecchetti & Kharroubi, 2015). Since the
1920’s, concerns arose about the veracity of the credit creation theory of banking. The concerns
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arose from economists that initially supported the theory in principle however, downplayed it
significantly for the financial intermediation theory This formed a stepping stone towards the
fractional reserve ratio, which argues that the banking system in aggregate creates money and
not individual firms. ((Werner, 2016:8-27). This fractional reserve ration does not play a
significant aspect with regards to the discussion and thus we turn to financial intermediation
theory.
FINANCIAL INTERMEDIATION THEORY
The fractional reserve ratio was influential between 1930 and 1960, however Keynes sow
influential seeds of doubts. Keynes (1930) uses inverted commas in his ‘Treatise’ suggestively
to “The ‘Creation’ of Bank money (a section title). This rhetorical device, implied disapproval and
mockery of banks having the ability to create money out of nothing. The device was later
adopted by many economists that emphasised the role of banks as financial intermediaries. In
Keynes words ‘A banker is in possession of resources which he can lend or invest equal to a
large proportion (nearly 90%) of the deposits standing to the credit of his depositors’.
Suggesting that insofar as savings and deposits are concerned, banks are the provider of
resources to customer borrowing which are provided by money depositors deposit (Keynes,
1930:213).
4. RESEARCH OBJECTIVES
4.1 PRIMARY OBJECTIVE
The primary objective of the evaluate how, through utilizing bank credit creation for productive
purposes can solve most of South Africa’s economic issues.
4.2 THEORETICAL OBJECTIVES
For the study to achieve its primary objective, a variety of study objectives are undertaken:
 To provide definitions and concepts relating to banking, credit creation, economic issues;
 To discuss the three theories of banking of banking, how they create money it translates
in money supply;
 To review which part of the economy is allocated the most money supply;
 To outline the economic issues South Africa faces;
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 To provide public sector recommendation on how to go about addressing economic
issues;
4.3 EMPIRICAL OBJECTIVES
The following empirical objectives are formulated:
 To determine the contribution of bank credit into money supply;
 To determine where the prevailing bank created credit is allocated in the economy;
 To compare the effect of productive unproductive bank credit allocation;
 To assess the sustainability of the credit in such dire economic situation in South Africa;
5. RESEARCH DESIGN AND METHODOLOGY
This study of this paper looks at the data amount of money supply in the economy, created by
banks vis-à-vis the reserve banks money supply. This is done by looking at M1, M2 and M3
from the reserve bank data. Secondly data of where the much of the money supply is allocated
by assessing the three sectors of the economy, namely; financial economy and real economy
which is comprised of the consumption economy and production economy. The study utilises
qualitative data from the reserve bank and traces from the source to the part of the economy
where it is utilised the most.
5.5 SECONDARY DATA
5.5.1 DATA SOURCES
The secondary data used in reaching research objective will be obtained from various sources,
in the local publications as well as desktop research. The data will be synthesized in an orderly
manner in response to research question considered. The period of data is between 2000 and
2019 as studying data immediately post 1994 might affect the result of the data. The study
hypothesis is that there is a fractional part of the money supply that banks create from offering
loans (credit) and introduce problems in the economy. The problem in the economy is also
identified by analysing data on money allocation in the economy.
5.5.2 ECONOMETRIC METHODS OF ANALYSIS
The use of the regression model is to test relationship between bank credit growth and money
supply growth. This will be done by using the Vector auto-regressive models and utilize
Johansen co-integration approach to measure the long run and the Vector Error Correction
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Model to measure the short run relationship. All econometrics assumptions still apply in testing
the relationship and VAR allows for, in processing the data, to automatically determine the
correctness of the selected lag order if necessary. The method of analysis comprises of two
variables which are essentially utilized in understanding the variable impact of bank credit and
gdp.
5.5.3 MODEL
MSGt = F(BCGt)
MSG is the money supply growth over time while BCG is the bank credit growth over time.
6. Ethical Considerations
Conducting the study using secondary data, is derived from the free and easily accessible
databases of South Africa Reserve Bank. Ethical clearance is not required thus the study
will be subject to ethical consideration of North West University. Regarding the study paper,
achieving high standards of technicality in line with referencing the right sources and not
falsifying information. Ensuring that no plagiarism is detected in line with publishing
practices is also a priority for the paper.
7. Contribution of The Study
South African population faces economic plight with much of the economy experiencing
unemployment rates, underdevelopment, high poverty rates and recurring boom and bust
cycles which adversely affect businesses and in turn, the economy as a whole. The contribution
of the study is to understanding bank credit creation in South Africa as a game changer to
solving much of financial and economic problems. This is achieved through showing ways of
harnessing already existing bank’s money creating capabilities to reshape South Africa’s
economic landscape.
Section 1: Introduction and background to the study: This section serves to outline the
broad structure of the dissertation. It presents and outlines the main points which are to be
discussed, and comprise of the problem statement, objectives the scope of research and the
contribution of the study.
Section 2: Literature review: This section pertains to evaluate the theories of banking and how
money is created through interbank processes of credit. Secondly, economic literature is
reviewed regarding purposeful lending and non-purposeful lending in the economy.
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Section 3: Research design and methodology: This section deals with explaining the
sources of data and types of data which are used in the study and how they ultimately achieve
empirical objectives.
Section 4: Results and findings: This section presents the results and finding as a result of
analysing bank credit contribution to money supply and the prevailing sector allocation of the
money supply in the South African economy.
Section 5: Conclusions and Recommendations: Lastly this section provides summarises the
studies undertaken and concludes with major findings of the study and provide recommendation
for policy and ideas for further research.
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