TOPIC 6 MONEY SUPPLY

LEARNING OUTCOMES
At the end of this unit, you will be able to:
 Define money supply and describe its different components
 List out the need for and rationale of measuring money supply
 Elucidate the different sources of money supply
 Illustrate the various measures of money supply
 Distinguish between money multiplier and credit
multiplier, and
 Describe the different determinants of money supply

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Mark

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 INTRODUCTION
Money plays a crucial role in the smooth functioning of an economy.
Money supply is considered as a very important macroeconomic variable
responsible for changes in many other significant macroeconomic
variables in an economy and is therefore considered as a matter of
considerable interest to the economists and policy makers. Economic
stability requires that the supply of money at any time should to be
maintained at an optimum level. A pre-requisite for achieving this is to
accurately estimate the stock of money supply on a regular basis and
appropriately regulate it in accordance with the monetary requirements
of the country. W e shall look into various aspects related to the supply
of money.
The term money supply denotes the total quantity of money available to
the people in an economy. The quantity of money at any point of time is
a measurable concept. It is important to note two things about any
measure of money supply:
(i) The supply of money is a stock variable i.e. it refers to the total
amount of money at any particular point of time. It is the change in
the stock of money (say, increase or decrease per month or year,),
which is a flow.
(ii) The stock of money always refers to the stock of money available to
the ‘public’ as a means of payments and store of value. This is
always smaller than the total stock of money that really exists in an
economy.
The term ‘public’ is defined to include all economic units (households,
firms and institutions) except the producers of money (i.e. the government
and the banking system). The government, in this context, includes the
central government and all state governments and local bodies; and the
banking system means the Central Bank of Kenya and all the banks
that accept demand deposits (i.e. deposits from which money can be
withdrawn by cheque mainly). The word ‘public’ is inclusive of all local
authorities, non-banking financial institutions, and non- departmental
public-sector undertakings, foreign central banks and governments and
the International Monetary Fund which holds a part of Kenyan money in
the form of deposits with the CBK. In other words, in the standard
measures of money, interbank deposits and money held by the
government and the banking system are not included.
 RATIONALE OF MEASURING MONEY SUPPLY
Empirical analysis of money supply is important for two reasons:
1. It facilitates analysis of monetary developments in order to provide a
deeper understanding of the causes of money growth.
2. It is essential from a monetary policy perspective as it provides a
framework to evaluate whether the stock of money in the economy is
consistent with the standards for price stability and to understand
the nature of deviations from this standard. The central banks all
over the world adopt monetary policy to stabilize price level and GDP
growth by directly controlling the supply of money. This is achieved
mainly by managing the quantity of monetary base. The success of
monetary policy depends to a large extent on the controllability of
money supply and the monetary base.

THE SOURCES OF MONEY SUPPLY

The supply of money in the economy depends on:
(a) the decision of the central bank based on the authority conferred on it, and
(b) the supply responses of the commercial banking system of the
country to the changes in policy variables initiated by the central
bank to influence the total money supply in the economy.
The central banks of all countries are empowered to issue currency and,
therefore, the central bank is the primary source of money supply in all
countries. In effect, high powered money issued by monetary authorities
is the source of all other forms of money. The currency issued by the
central bank is ‘fiat money’ and is backed by supporting reserves and its
value is guaranteed by the government. The currency issued by the
central bank is, in fact, a liability of the central bank and the government.
Therefore, in principle, it must be backed by an equal value of assets
mainly consisting of gold and foreign exchange reserves. In practice,
however, most countries have adopted a ‘minimum reserve system
’wherein the central bank is empowered to issue currency to any extent
by keeping only a certain minimum reserve of gold and foreign securities.
The second major source of money supply is the banking system of the
country. The total supply of money in the economy is also determined by
the extent of credit
 created by the commercial banks in the country. Banks create money
supply in the process of borrowing and lending transactions with the
public. Money so created by the commercial banks is called 'credit
money’. The high powered money and the credit money broadly
constitute the most common measure of money supply, or the total
money stock of a country.

MEASUREMENT OF MONEY SUPPLY

There is virtually a profusion of different types of money, especially
credit money, and this makes measurement of money supply a difficult
task. Different countries follow different practices in measuring money
supply. The measures of money supply vary from country to country,
from time to time and from purpose to purpose. Reference to such
different measures is beyond the scope of this unit. Just as other countries
do, a range of monetary and liquidity measures are compiled and
published by the CBK. Money supply will change if the magnitude of any of
its constituent’s changes.
The Central Bank of Kenya has been compiling and disseminating
monetary statistics. The empirical definitions of these measures are
given below:

M1 = Currency notes and coins with the people + demand deposits

of banks (Current and Saving deposit accounts) + other deposits with the
CBK.
M2 = M1 + savings deposits with post office savings banks.
M3 = M1 + net time deposits with the banking system.
M4 =M3 + total deposits with the Post OfficeSavings
Organization (excluding National Savings C e r t i f i c a t e s ).

Central Banks regard these four measures of money stock as representing

different degrees of liquidity. It has specified them in the descending order
of liquidity, M1 being the most liquid and M4the least liquid of the four
measures.
We shall briefly discuss the important components of each. Currency
consists of paper currency as well as coins. Demand deposits comprise the
current-account deposits and the demand deposit portion of savings
deposits, all held by the public. These are cheapest sources of finance for
a commercial bank. It should be noted that it is the net demand deposits
of banks, and not their total demand deposits that get included in the
measure of money supply. The total deposits include both deposits from
the public as well as inter- bank deposits. Money is deemed as something
held by the ‘public’. Since inter- bank deposits are not held by the public,
they are netted out of the total demand deposits to arrive at net demand
deposits.
Following the recommendations of the Working Group on Money
(1998), the CBK has started publishing a set of four new monetary
aggregates on the basis of the balance sheet of the banking sector in
conformity with the norms of progressive liquidity. The new monetary
aggregates are:
Reserve Money = Currency in circulation + Bankers’
deposits with the CBK + Other deposits
with the CBK
= Net CBK credit to the Government +
CBK credit to the Commercial sector +
CBK’s Claims on banks + CBK’s net
Foreign assets + Government’s Currency
liabilities to the public – CBK’s net non -
monetary Liabilities

NM1 = Currency with the public + Demand deposits

with the banking system + ‘Other’ deposits with
the CBK.
NM2 = NM1 + Short-term time deposits of residents
(including and up to contractual maturity of one
year).
NM3 = NM2 + Long-term time deposits of residents +
Call/Term funding from financial institutions
In the monetary literature, money is usually defined in alternative ways ranging from
narrow to broad money. Empirically the M1 (narrow money) is defined as the sum of
currency held by the public, demand deposits of the banks and other deposits of CBK.
Reserve money is comprised of the currency held by the public, cash reserves of
banks and other deposits of CBK. On comparison, we find that the difference between
M1 and reserve money is that the former includes the demand deposits while the latter
includes the cash reserves of banks. Reserves are commercial banks’ deposits with
the central bank for maintaining cash reserve ratio (CRR) and as working funds for
clearing adjustments.
Reserve money, also known as central bank money, base money or high-
powered money, needs a special mention as it plays a critical role in
the determination of the total supply of money. Reserve money
determines the level of liquidity and price level in the economy and,
therefore, its management is of crucial importance to stabilize liquidity,
growth, and price level in an economy.
The central bank also measures macroeconomic liquidity by formulating
various ‘liquidity’ aggregates in addition to the monetary aggregates.
While the instruments issued by the banking system are included in
‘money’, instruments, those which are close substitutes of money but are
issued by the non-banking financial institutions are also included in
liquidity aggregates.

DETERMINANTS OF MONEY SUPPLY

There are two alternate theories in respect of determination of money
supply. According to the first view, money supply is determined
exogenously by the central bank. The second view holds that the money
supply is determined endogenously by changes in the economic activities
which affect people’s desire to hold currency relative to deposits, rate of
interest, etc. The current practice is to explain the determinants of money
supply based on ‘money multiplier approach’ which focuses on the
relation between the money stock and money supply in terms of the
monetary base or high-powered money. This approach holds that total
supply of nominal money in the economy is determined by the joint
behavior of the central bank, the commercial banks and the public. Before
we discuss the determinants of money supply, it is necessary that we
know the concept of money multiplier.

THE CONCEPT OF MONEY MULTIPLIER

The money supply is defined as

M=mX
MB
Where M is the money supply, m is money multiplier and MB is the
monetary base or high powered money. From the above equation we can
derive the money multiplier (m) as
 Money
Money Multiplier (m)=

…
Monetary
supply
base
Money multiplier m is defined as a ratio that relates the changes in
the money supply to a given change in the monetary base. It denotes by
how much the money supply will change for a given change in high-
powered money. The multiplier indicates what multiple of the monetary
base is transformed into money supply.

If some portion of the increase in high-powered money finds its way into
currency, this portion does not undergo multiple deposit expansion. In
other words, as a rule, an increase in the monetary base that goes into
currency is not multiplied, whereas an increase in monetary base that
goes into supporting deposits is multiplied.

THE MONEY MULTIPLIER APPROACH TO

SUPPLY OF MONEY
The money multiplier approach to money supply propounded by Milton
Friedman and Anna Schwartz, (1963) considers three factors as immediate
determinants of money supply, namely:
(a) the stock of high-powered money (H)
(b) the ratio of reserves to deposits, e = {ER/D} and
(c) the ratio of currency to deposits, c ={C/D}
You may note that these represent the behavior of the central bank,
behavior of the commercial banks and the behavior of the general public
respectively. We shall now describe how each of the above contributes
to the determination of aggregate money supply in an economy.
a) The Behavior of the Central Bank
The behavior of the central bank which controls the issue of
currency is reflected in the supply of the nominal high-powered
money. Money stock is determined by the money multiplier and
the monetary base is controlled by the monetary authority. If the
behavior of the public and the commercial banks remains
unchanged over time, the total supply of nominal money in the
economy will vary directly with the supply of the nominal high-
powered money issued by the central bank.
b) The Behavior of Commercial Banks
By creating credit, the commercial banks determine the total
amount of nominal demand deposits. The behavior of the
commercial banks in the economy is reflected in the ratio of their
cash reserves to deposits known as the ‘reserve ratio’. If the
required reserve ratio on demand deposits increases while all the
other variables remain the same, more reserves would be needed.
 This implies that banks must contract their loans, causing a
decline in deposits and hence in the money supply. If the required
reserve ratio falls, there will be greater expansions of deposits
because the same level of reserves can now support more
deposits and the money supply will increase.
c) The Behavior of the Public
The public, by their decisions in respect of the amount of nominal
currency in hand (how much money they wish to hold as cash) is in
a position to influence the amount of the nominal demand
deposits of the commercial banks. The behavior of the public
influences bank credit through the decision on ratio of currency
to the money supply designated as the ‘currency ratio’.

What would be the behavior of money supply when depositors decide to

increase currency holding, with all other variables unchanged? In other
words, you decide to keep more money in your pocket and less money
in your bank. That means you are converting some of your demand
deposits into currency. If many people like you do so, technically we say
there is an increase in currency ratio. As we know, demand deposits
undergo multiple expansions while currency in your hands does not.
Hence, when bank deposits are being converted into currency, banks
can create only less credit money. The overall level of multiple expansion
declines, and therefore, money multiplier also falls. Therefore, we
conclude that money multiplier and the money supply are negatively
related to the currency ratio c.
The currency-deposit ratio (c) represents the degree of adoption of
banking habits by the people. This is related to the level of economic
activities or the GDP growth and is influenced by the degree of financial
sophistication in terms of ease and access to financial services,
availability of a richer array of liquid financial assets, financial innovations,
institutional changes etc.
The time deposit-demand deposit ratio i.e. how much money is kept as
time deposits compared to demand deposits, also has an important
implication for the money multiplier and, hence for the money stock in the
economy. An increase in TD/DD ratio means that greater availability of
free reserves and consequent enlargement of volume of multiple deposit
expansion and monetary expansion.
To summarize the money multiplier approach, the size of the money
multiplier is determined by the required reserve ratio (r) at the central
bank, the excess reserve ratio (e) of commercial banks and the currency
ratio (c) of the public. The lower these ratios are, the larger the money
multiplier is. In other words, the money supply is determined by high
powered money (H) and the money multiplier (m) and varies directly
with changes in the monetary base, and inversely with the currency and
reserve ratios. Although these three variables do not completely explain
 changes in the nominal money supply, nevertheless they serve as useful
devices for analyzing such changes. Consequently, these variables are
designated as the ‘proximate determinants’ of the nominal money supply
in the economy.

EFFECT OF GOVERNMENT EXPENDITURE ON

MONEY SUPPLY
Whenever the central and the state governments’ cash balances fall short
of the minimum requirement, they are eligible to avail of a facility called
Ways and Means Advances (WMA)/overdraft (OD) facility. When the
Central Bank of K e n y a lends to the governments under WMA /OD, it
results in the generation of excess reserves (i.e., excess balances of
commercial banks with the Reserve Bank). This happens because when
government incurs expenditure, it involves debiting the government
balances with the Reserve Bank and crediting the receiver (for e.g.,
salary account of government employee) account with the commercial
bank. The excess reserves thus created can potentially lead to an increase
in money supply through the money multiplier process.

TOPIC SEVEN: PAYMENT AND SETTLEMENT

Some of the inherent risks involved in the settlement process can be reduced or eliminateddepending
upon the method of payment selected. Therefore, it is necessary for the exporter and importer to agree
upon the methods of payment and incorporate the details in the contract of sale. There are four main
Terms of Settlement in the international trade
1. Advance payment;
2. Open account;
3. Bill of collection/ Documentary collections;
4. Letter of credit
Advance payment
Under this term of settlement, the importer will pay to the exporter the goods before the exporter
delivers them. Although full payment in advance is obviously most desirable for the exporter, he will
only be able to obtain such terms when there is a seller’s market, or occasionally when such terms
are customary in that particular trade.
In fact, this is a credit granted by the importer to the exporter. Being a credit, the importer can ask the
exporter the payment of an interest. This term is very useful for the exporter.
It is quite common for a sale contract to require partial payments in advance; for example, the contract
could stipulate, say, 20% payable on the signing of the contract with the remaining 80%payable after
dispatch of the goods under one of the other means of payment.
The risks of the exporter the goods received can be specialized goods and if the importer cancels the
order before the payment is made, the exporter cannot sell these goods easily.

The risks of the importer.

 sometimes the exporter does not send the goods;
 the documents can be wrong;
 the goods are sent with a delay or to a wrong destination.
This method of settlement is used between old partners with a long business relationship. Another
method of advance payment can be the following: “30% of the value in advance and 70% of the value will
be paid upon delivery”.
Advantages to the importer:
 Few arrangements have to be made other than ensuring that funds are available to meet
payments when they are due;
 The importer has the control over the timing of settlement and the method by which funds are
remitted;
 Inspection of the goods is usually possible before payment is made
Open account
When a buyer and a seller agree to deal an open account term, it means that the seller will dispatches
goods to the buyer and will also send an invoice requesting payment. The seller loses control of the
goods as soon as he dispatches them. He trusts that the buyer will pay in accordance with the invoice.
Open account is the simplest method of settlement. However, because the exporter is delivering the
goods without payment or some other absolute means of insuring that payment is received, this method
presents the greatest risk.
Despite all of this, the majority of international trade transactions continue to be settled this way.
The exporter requires payment, protection of the goods until they are paid and perhaps, financial
assistance in the intervening period. The importer wants the goods to be delivered on time at the right
place and of the correct quality and perhaps, with a period of credit
Advantages to the exporter
:1. Because this method of settlement tends to be used when there is a long standing relationship
between the seller and the buyer, the open account balance is settled on a monthly or quarterly basis
and transactions can be dealt with in very much the same way as the domestic trade;
2. subject to any contract with the buyer, there are less constraints on documentation, timing of
shipments and places of dispatch that make this method more feasible;
3. as only the settlement payments pass through the banking system, the exporter incurs no charges.
Disadvantages to the exporter:
1. There is no guarantee of payment and control if the goods are lost;
2. The exporter is exposed to political, economic and country risks unless other steps are taken to
cover these risks;
3. Because, often there is no specific constraint on the timing of the payments, it is very difficult to
control the cash flow;
4. There is a possibility that delays in the banking system will delay the transfer of funds;
5. when received, payment can be in the form of a foreign cheque that will have to be negotiated or
collected, causing further delay;
6. greater debtor control may be required in the form of the maintenance of a sealed ledger and
sending out statements and reminders of payment due.
One method by which the exporter can reduce the risk of non-payment is relevant here and that is the
use of advance payments, which involve the buyer being persuaded to provide part or the entire payment
before receiving the goods.
Advantages to the importer:
1. The importer retains control over the timing of settlement and the method by which funds are
remitted;
2. Inspection of the goods is usually possible before payment is made.
Disadvantages to the importer
1. The importer has little control over shipment details and the timing of the receipt of the goods;
2. There is no control over the quality of the goods. If special documents (certificates of origin) are
required, there is no guarantee that these will be received

Documentary collections
Parties to a documentary collection are:
- The principal (exporter). This is the customer who entrusts the operation of collection to his bank;
-The remitting bank, or the exporter’s bank. This is the bank to which the principal entrusts the
operation of collection;
 -The collecting bank, or the importer’s bank. This is the bank involved in processing the collection
order;
- The presenting bank is the collecting bank which makes presentation to the drawee;
-The drawer(importer). This is the one to whom presentation the payment is to be made according
to the collection order.
Under the provisions of the Uniform Rules for Collection, the handling of documents by banks or
instructions received in order to:
- Obtain acceptance and/or, as the case maybe, payment, or
- Deliver commercial documents against acceptance and/or, as the case maybe, against payment,
or
-Deliver documents on the other terms and conditions.
This method of settlement provides some comfort to the exporter, who will ship the goods and then
arrange for the documents of title and collection instructions to be sent by the exporter’s own bank
(remitting bank) to a correspondent bank (the collecting bank) in the importer’s country. The documents
may include a bill of exchange drawn by the exporter on the importer for the amount of the invoice and
payable at sight or at a fixed or future determinable time.
The documents of title are usually sent via the following route:
(a) The exporter ships the goods and obtains documents of title;
(b) The exporter sends documents of title to his bank with appropriate instructions;
(c) The exporter’s bank sends documents of title to the importer’s bank with the instruction that the
documents can only be released:
(i) on payment; or
(ii) on acceptance of the bill of exchange
(d) On payment or acceptance of the bill of exchange, the importer’s bank releases the documents
of title so that the importer can obtain the goods on their arrival in his country.
It can be seen that the exporter retains control over the goods under this method until either payment
made, or a legally binding undertaking to pay is given.
Where the Bill of Exchange is not accompanied by documents, these having been sent to the importer,
the transaction is known as a clean collection. The collecting bank will be instructed to release the
documents and, therefore, title to the goods, to the importer against payment (D/P) or acceptance (D/A)
of the bill of exchange. Payment or the accepted Bill of Exchange will be sent to the remitting bank that
will, in the latter case, present it for payment on the maturity date.
The documentary collection transactions are handled on the basis of the following documents:
 - Documents against Payment (D/P).
The exporter takes the goods for shipment and the collecting bank may only deliver the documents to
the importer in exchange of his immediate payment (at sight).
Or
- Documents against Acceptance (D/A).
The exporter takes the goods for shipment and the collecting bank may only deliver the documents
against acceptance of a draft issued by the drawee (importer).
The documentary collections are governed by the International Chamber of Commerce and is known as
Uniform Rules for Collections No. 522.
Summary of the provisions of the Uniform Rules for Collections:
(a) The four main parties to a documentary collection are:
(i) the principal, i.e. the exporter;
(ii) the remitting bank. This is the bank to which the principal entrusts the collection order.
This is normally the exporter’s own bank.
(iii) the collecting bank. This is any bank other than the remitting bank which is involved with
the collection. Normally this will be a bank in the importer’s country.
(iv) the presenting bank. This is the bank which notifies the drawee of the arrival of the
collection and which requests payment or acceptance from him or her. The collecting and
presenting bank will normally be the same bank, but they could be different banks.
(b) Documents are of two types:
(i) financial documents – the instruments used for the purpose of obtaining money (e.g. Bills
of exchange).
(ii) commercial documents – the documents relating to goods for which the financial
documents are to secure payment (e.g. bill of lading, insurance document).
(c)
Articles 1 and 2 state that banks will act in good faith and exercise reasonable care. Banks must
verify that they appear to have received the documents which are specified in the collection order.
(d) Banks have no liability for any delay or loss caused by postal or telex failure.
(e) Duties of the remitting bank:
-to check the principal’s collection instructions;
-to check that the presented documents are complete;
 -to pass on the principal’s instructions to the collecting bank/presenting bank;
-to monitor the operation collection.

(f) Duties of the presenting bank:

- to confirm receipt of the documents;
- to present the documents to the drawee in strict compliance with the collection instructions
(D/P or D/A);
- in the case of D/P, to effect payment to the remitting bank in accordance with the latter’s
instructions;
- to notify the remitting bank that the draft has been accepted at its maturity date, or, if
requested, to return the bill to the remitting bank.
Advantages to the exporter
1. the exporter has some measure of control over the documents and goods unless there is no
document of title and/or the goods consigned direct to the importer or the importer’s agent;
2. If the exporter has to pay charges for the collection, allowance for these, including interest, can
be computed when the invoice price is calculated;
3. this method is less expensive than a documentary credit.
Disadvantages to the exporter:
1. if control is not retained through the documents of title, the exporter relies entirely on the ability
and willingness of the importer to pay
2. if documents against acceptance (D/A) terms are granted to the importer, control of goods is
lost once the bill of exchange has been accepted.
Advantages to the importer:
1. a period of credit can be obtained through the use of a term bill or promissory note;
2. the exporter will normally be responsible for the charges;
3. finance can be raised using the goods as security;
4. it is more convenient and less expensive than a documentary credit
Disadvantages to the importer:
 1. Payment or acceptance is required on presentation when the commercial documents have
arrived at the collecting bank and before the arrival of the goods;
2. If the bill is accepted the importer is legally liable despite, for example, any clauses in the
contract relating to defective goods;
3. There is no guarantee that the goods will be received as ordered or on time.
LETTERS OF CREDIT
What is a letter of credit?
A documentary credit can be simply defined as a conditional guarantee of payment made by a bank to a
named beneficiary, guaranteeing that payment will be made, provided that the terms of the credit are
met. These terms will state that the beneficiary must submit specified documents, usually to a stated
bank and by a certain date.
The letter of credit is a letter or other authenticated communication addressed by one bank (at the
request of its customer) to another bank requesting the bank to whom it is addressed to make payments
to (or advance payment to) or accept or negotiate bills of exchange (drafts) to or to the order of a third
person (known as the beneficiary) either against stipulated documents or upon condition that all the other
terms and conditions of the credit are complied with or upon the performance (or non-performance in the
case of stand-by credits) of any other act by the said beneficiary.
In most banks throughout the world, documentary credits are governed by a code of practice drawn up
by the International Chamber of Commerce Commission on Banking Techniques and Practice.
The code is called “The Uniform Customs and Practice for Documentary Credits” or “UCP” for short. It
was last revised in 2007 ICC Publication No. 600, applicable since 2008, January 1. Under the provisions
of the "UPC”, a documentary credit is defined as: “An arrangement between a customer and a bank to
make payment to, or to the order of the beneficiary, - or to pay or accept Bills of exchange drawn by the
beneficiary, - or to authorize another bank to effect such payment, or to pay, accept, or- negotiate such
bills of exchange, - against stipulated documents, provided that the terms and conditions are complied
with”
The general procedure is that the importer’s bank (issuing bank) issues at the request of the
importer(applicant) a credit in favor of the exporter (beneficiary). The exporter may be advised directly
but normally will be advised of the credit through a bank (advising bank) in his own country.
The basic steps of making a payment by documentary credit are as follows:
 A contract is made between an importer in one country and an exporter in another in which it is
agreed that payment will be made by documentary credit.
 The exporter prepares the goods for export
 The importer arranges the documentary credit by applying to his bank for a letter of credit to be
issued.
 The importer’s bank (issuing bank) draws up the letter of credit (if it considers the importer is
creditworthy) including in it the details of the documents that the exporter will have to provide. The
letter is sent to the exporter’s bank.
 The exporter’s bank (the advising bank) advises the exporter that the letter has been received
and the exporter than provides the documents to show that the goods have been sent. By
providing documents that comply exactly with the terms of the letter of credit the exporter can be
sure of payment, guaranteed by the bank that has issued the letter of credit. In some cases, the
contract between exporter and importer will arrange for a bank in the exporter’s country to add its
guarantee or confirmation that payment will be made; such a bank is known as
 a confirming bank The exporter sends the goods to the importer.
 The exporter presents the documents showing that the goods have been sent to his bank.
 The exporter’s bank checks the documents and if they are correct
 If the documents are correct the importer’s bank will pay the exporter’s bank as agreed in the letter
of credit by one of the three basic methods of payment: draft, mail transfer or urgent transfer.
 The importer will receive the documents and collect the goods
Types of Credits
All types of credits should be issued as a subject matter of the Uniform Custom Regulations of the
International Chamber of Commerce.
A documentary credit
It involves payment or acceptance or negotiation against stipulated documents, provided that the
terms and conditions of the credit are complied with. Since over 99% of all credits handled at branch
level are documentary credits we shall talk more about these ones. Credits are classified as either
irrevocable or revocable
A revocable credit may be cancelled or amended at any time without prior notice being given to the
beneficiary. This type of credit is rare.
Some characteristics of revocable credits:
a) A revocable credit cannot be confirmed
b) The advising bank should advise such revocable credits to the beneficiary with the following
phrase added: “Without engagement on the part of the advising bank”
c) The issuing bank can cancel such a credit provided that, prior to receipt of advice of
amendment or cancellation of the said credit, the beneficiary had not submitted the “stipulated
documents” under the credit for payment, acceptance or negotiation.
An irrevocable credit constitutes a definite undertaking by the issuing bank to make payment without
recourse. Irrevocable credits can only be amended or cancelled with the agreement of all parties.
Irrevocable credits can be either confirmed or unconfirmed by the advising bank. This is the most
common form of letter of credit used in international transactions, and it is defined, as constituting in
 Uniform Custom: “a definite undertaking of the issuing bank provided that the stipulated documents
are presented and that the terms and conditions of the credit are complied with:
A – if the credit provides for sight payment – to pay;
B – if the credit provides for deferred payment – to pay or to provide that the payment will be made
on the date(s) determinable in accordance with the stipulations of the credit;
C – if the credit provides for acceptance – to accept drafts drawn by the beneficiary if the credit
stipulates that they are to be drawn on the issuing bank;
D – if the credit provides for negotiation – to pay without resource the drawer and/or bona fide
holders, drafts drawn by the beneficiary at sight or at a tenor, on the application for the credit or on
any other drawee stipulated in the credit other than the issuing bank itself.
Characteristics of irrevocable credit:
An irrevocable credit can only be amended or cancelled with the consent of all the parties to the
credit; once the exporter has complied with the terms and conditions of the irrevocable credit and has
submitted the “stipulated documents”, he will receive payment (or acceptance) from the issuing bank;
 where an irrevocable credit is routed through another bank located in the country of the
beneficiary (exporter/seller), the bank that notifies the terms and conditions of the credit to the
beneficiary is known as the advising bank;
 where an advising bank either declines confirmation or is not asked to confirm an irrevocable
credit, its role is confined to that of agent of the Issuing Bank. Its mandate is to follow the
instructions given by the issuing bank.
Irrevocable confirmed credits
It is, as the title implies, a type of credit carrying “the definite undertaking” of two banks: the definite
undertaking of the opening bank and the confirmation of the opening bank’s commitment by another
bank known as the confirming bank. Therefore “when an issuing bank authorizes or requests another
bank to confirm its irrevocable credit and the latter does so, such confirmation constitutes a definite
undertaking of such a bank (the confirming bank) in addition to that of the issuing bank, provided that
the stipulated documents are presented and that the terms and conditions are complied with
A – if the credit provides for sight payment – to pay;
B – if the credit provides for deferred payment – to pay or to provide that payment will be made on
the date(s) determinable in accordance with the stipulations of the credit;
C – if the credit provides for acceptance – to accept drafts drawn by the beneficiary if the credit
stipulates that they are to be drawn on the confirming bank, or to be responsible for their
acceptance and payment at maturity if the credit stipulates that they are to be drawn on the
applicant for the credit or any other drawee stipulated in the credit;
 D – if the credit provides for negotiation – to negotiate without recourse to drawers and/or bona
fide holders, draft(s) drawn by the beneficiary at sight or at a tenor, on the issuing bank or on the
applicant for the credit or on any other drawee stipulated in the credit other than the confirming
bank itself.
Characteristics of irrevocable confirmed credits:
a) when an advising bank agrees to add its confirmation to an irrevocable credit, it adds the
following clause to the credit: “This credit bears our confirmation and we shall accordingly honor
your drafts on us on due presentation if accompanied by documents as stipulated by and in
compliance with the credit terms and conditions.”
b) with such a confirmation, the beneficiary of the irrevocable confirmed credit has the
engagement of the banking institutions in the two countries;
c) this type of credit is most favorable to the exporter as he is assured of payment or eventual
settlement in his own country provided that he submits the stipulated documents and complies
with all the other terms and conditions of the credit
d) where an advising bank, upon being asked to add its confirmation, is unable to do so, “it must
so inform the issuing bank without delay”
e) amendments or cancellations of any of the terms and conditions embodied in the irrevocable
confirmed credit cannot be made “without the agreement of the issuing bank, the confirming bank
and the beneficiary”.
f) partial acceptance of amendments contained in one and the same advice of amendment is not
effective without the agreement of all the above mentioned parties.
Sight credits.
These allow for payment to be made as soon as documents are presented.
Deferred Payment Credit.
This type of credit is becoming increasingly popular. It allows for payment at a future date without
calling for a Bill of Exchange. The terms of such credit would state for instance: “available against
presentation of the following documents…but payable only.days after date of invoice. Bill of lading.
Presentation date, etc”
The provisions of UCP mention some specialized credits, such as:
Transferable credit.
It is one that can be transferred by the original beneficiary to one or more second beneficiaries. It is
normally used when the first beneficiary does not supply or manufacture the goods himself, but is a
middleman and thus wishes to transfer part, or all of his rights to the actual supplier or manufacturer.
This type enables the middleman to give the supplier an undertaking from a bank to pay, against
 which they would probably be prepared to supply the goods. Without a transferable credit, a
middleman of little financial standing would probably not be able to get a bank to issue such an
undertaking, and so the deal would probably fall through. This type of credit can only be transferable
once, i.e. the second beneficiary does not have the right to transfer the credit to anyone else.
Back to back credits.
Under the “Back to back” concept, the beneficiary of the first credit offers it as “security” to the
advising bank for issuance of the second credit.
Red clause credits.
The so-called “Red clause” credit incorporates a special concession to the beneficiary allowing the
advising bank to advance a percentage of the total credit amount before presentation of shipping
documents. The clause was originally written in red ink to draw attention to this special condition.
Revolving credit.
It is one where the amount can be renewed or reinstated without specific amendments to the credit
being needed. The purpose of a revolving credit is to replace a series of credits to the same
beneficiary, and be able to control the size of shipments at any one time.
Standby credits.
This type of credit (is referred to in Articles 1 and 2 of UCP) can be issued by a bank on behalf of a
customer and in favor of an overseas party in the same manner as an ordinary credit except that it will
not call for payment, acceptance or negotiation by it or an overseas advising/confirming bank; instead
it is payable against a simple document (e.g. confirmation of shipment, simple receipt, etc.) and is
irrevocable. This type of credit serves to act as a guarantee by the issuing bank to the overseas
beneficiary against defaults by its applicant customer. As you can see, the basic forms of
documentary differ in respect of the degree of security they provide for the beneficiary. Credits are
further classified into various types according to the method of settlement employed. There are also
special arrangements involving combinations of separate credits or the assignment of credit
proceeds.

TOPIC 8: DEFICIT FINANCING

Meaning of Deficit Financing:

Deficit financing in advanced countries is used to mean an excess of expenditure over revenue—the gap
being covered by borrowing from the public by the sale of bonds and by creating new money. In Kenya,
and in other developing countries, the term deficit financing is interpreted in a restricted sense.
The essence of such policy lies in government spending in excess of the revenue it receives. The
government may cover this deficit either by running down its accumulated balances or by borrowing from
the banking system (mainly from the central bank of the country).

‘Why’ of Deficit Financing:

There are some situations when deficit financing becomes absolutely essential. In other words, there are
various purposes of deficit financing.

Developing countries aim at achieving higher economic growth. A higher economic growth requires
finances. Being poor, these countries fail to mobilize large resources through taxes. Thus, taxation has a
narrow coverage due to mass poverty. A very little is saved by people because of poverty. In order to
collect financial resources, government relies on profits of public sector enterprises. But these
enterprises yield almost negative profit. Further, there is a limit to public borrowing.

Purposes of deficit financing.

I. To lift the economy out of depression so that incomes, employment, investment, etc., all rise

II. To activate idle resources as well as divert resources from unproductive sectors to productive
sectors with the objective of increasing national income and, hence, higher economic growth

III. To raise capital formation by mobilizing forced savings made through deficit financing

IV. To mobilize resources to finance massive plan expenditure

V. If the usual sources of finance are, inadequate for meeting public expenditure, a government
may resort to deficit financing.

Deficit Financing
i) Raising the rates of taxation or by the charging of higher prices for goods and public utility
services.
ii) Out of the accumulated cash balances of the government
iii) Borrowing from the banking system

Effects of Deficit Financing

i. Deficit financing and inflation
 It is said that deficit financing is inherently inflationary. Since deficit financing raises
aggregate expenditure and, hence, increases aggregate demand, the danger of inflation
looms large. This is particularly true when deficit financing is made for the persecution of
war.
ii. Deficit financing and capital formation and economic development

To promote economic development in several ways. Nobody denies the role of deficit
financing in garnering resources required for economic development, though the method is
an inflationary one. Economic development largely depends on capital formation. The basic
source of capital formation is savings. But, LDCs are characterized by low saving-income
ratio. In these low-saving countries, deficit finance- led inflation becomes an important
source of capital accumulation.

iii. Deficit financing and income distribution.

Deficit financing tends to widen income inequality. This is because of the fact that it creates
excess purchasing power. But due to inelasticity in the supply of essential goods, excess
purchasing power of the general public acts as an incentive to price rise. During inflation, it
is said that the rich becomes richer and the poor becomes poorer. Thus, social injustice
becomes prominent.

Advantages of Deficit Financing

1. Massive expansion in governmental activities has forced governments to mobilize
resources from different sources.
As a source of finance, tax-revenue is highly inelastic in the poor countries. Above all,
governments in these countries are rather hesitant to impose newer taxes for the fear of losing
popularity. Similarly, public borrowing is also insufficient to meet the expenses of the state.
2. Creation of additional money by borrowing from the Central bank of Kenya
Interest payments to the CBK against this borrowing come back to the Government of Kenya in
the form of profit. Thus, this borrowing or printing of new currency is virtually a cost-free
method.
3. Certain of amount required and source is known before hand

Financial resources (required for financing economic plans) that a government can mobilize
through deficit financing are known before hand

4. Multiplier effects on the economy.

 Deficit financing has certain multiplier effects on the economy. This method encourages the
government to utilize unemployed and underemployed resources. This results in more incomes
and employment in the economy.

5. Promotion of economic development

Deficit financing is an inflationary method of financing. However, the rise in prices must be a
short run phenomenon. Above all, a mild dose of inflation is necessary for economic
development. Thus, if inflation is kept within a reasonable level, deficit financing will promote
economic development —thereby neutralizing the disadvantages of price rise.

6. Setting the process of economic development rolling.

During inflation, private investors go on investing more and more with the hope of earning
additional profits. Seeing more profits, producers would be encouraged to reinvest their
savings and accumulated profits. Such investment leads to an increase in income—thereby
setting the process of economic development rolling.

Disadvantages
1. Exposed to the dangers of inflation.
It is a self-defeating method of financing as it always, leads to inflationary rise in prices. Unless
inflation is controlled, the benefits of deficit-induced inflation would not fruitful. And,
underdeveloped countries— being inflation-sensitive countries—get exposed to the dangers of
inflation.

2. Income inequality increases.

Deficit financing-led inflation helps producing classes and businessmen to flourish. But fixed-
income earners suffer during inflation. This widens the distance between the two classes. In
other words, income inequality increases.
3. Distortion investment pattern
Higher profit motive induces investors to invest their resources in quick profit-yielding
industries. Of course, investment in such industries is not desirable in the interest of a
country’s economic development.
4. It does not create employment opportunities
 Deficit financing may not yield good result in the creation of employment opportunities.
Creation of additional employment is usually hampered in backward countries due to lack of
raw materials and machineries even if adequate finance is available.
5. Decline in purchasing power of money
Purchasing power of money declines consequent upon inflationary price rise, a country
experiences flight of capital abroad for safe return—thereby leading to a scarcity of capital.
6. Larger volume of deficit in a country’s balance of payments.
Inflationary method of financing leads to a larger volume of deficit in a country’s balance of
payments. Following inflationary rise in prices, export declines while import bill rises, and
resources get transferred from export industries to import- competing industries.

TOPIC 9: DEBT FINANCING

What is Debt Financing?

Debt financing occurs when a company raises money by selling debt instruments,
most commonly in the form of bank loans or bonds. Such a type of financing is
often referred to as financial leverage

Debt Financing Options

1. Bank loan

A common form of debt financing is a bank loan. Banks will often assess the
individual financial situation of each company and offer loan sizes and
interest rates accordingly.

2. Bond issues

Another form of debt financing is bond issues. A traditional bond certificate

includes a principal value, a term by which repayment must be completed,
and an interest rate. Individuals or entities that purchase the bond then
become creditors by loaning money to the business.

3. Family and credit card loans

 Other means of debt financing include taking loans from family and friends
and borrowing through a credit card. They are common with start-ups and
small businesses.

Debt Financing Over the Short-Term

Businesses use short-term debt financing to fund their working capital for day-to-
day operations. It can include paying wages, buying inventory, or costs incurred
for supplies and maintenance. The scheduled repayment for the loans is usually
within a year.

A common type of short-term financing is a line of credit, which is secured with

collateral. It is typically used with businesses struggling to keep a positive cash
flow (expenses are higher than current revenues), such as start-ups.

Debt Financing Over the Long-Term

Businesses seek long-term debt financing to purchase assets, such as buildings,

equipment, and machinery. The assets that will be purchased are usually also
used to secure the loan as collateral. The scheduled repayment for the loans is
usually up to 10 years, with fixed interest rates and predictable monthly
payments.

Advantages of Debt Financing

1. Preserve company ownership

The main reason that companies choose to finance through debt rather than
equity is to preserve company ownership. In equity financing, such as selling
common and preferred shares, the investor retains an equity position in the
business. The investor then gains shareholder voting rights, and business
owners dilute their ownership.

Debt capital is provided by a lender, who is only entitled to their repayment

of capital plus interest. Hence, business owners are able to retain maximum
ownership of their company and end obligations to the lender once the debt
is paid off.

2. Tax-deductible interest payments

Another benefit of debt financing is that the interest paid is tax-deductible. It
decreases the company’s tax obligations. Furthermore, the principal payment and
interest expense are fixed and known, assuming the loan is paid back at a
constant rate. It allows for accurate forecasting, which makes budgeting and
financial planning easier.

Disadvantages of Debt Financing

1. The need for regular income

The repayment of debt can become a struggle for some business owners.
They need to ensure the business generates enough income to pay for
regular installments of principal and interest.

Many lending institutions also require assets of the business to be posted as

collateral for the loan, which can be seized if the business is unable to make
certain payments.

2. Adverse impact on credit ratings

If borrowers lack a solid plan to pay back their debt, they face the
consequences. Late or skipped payments will negatively affect their credit
ratings, making it more difficult to borrow money in the future.

3. Potential bankruptcy

Agreeing to provide collateral to the lender puts their business assets at

risk, and sometimes even their personal assets. Above all, they risk potential
bankruptcy. If the business should fail, the debt must still be repaid.