Understanding the "Financial Intermediation Services" in Gross Domestic Product Compilation

Census and Statistics DepartmentHong Kong Special Administrative Region

People’s Republic of ChinaWebsite: http://www.info.gov.hk/censtatd/

1

Introduction

Gross Domestic Product (GDP) is oneof the core items of NationalAccounts statistics. NationalAccounts provides a comprehensiveframework to measure the value andstructure of economic activities (e.g.production of goods and services,distribution and use of income,external transactions withnon-residents) within an economy.

GDP can be disaggregated to showthe value added (VA) figures ofvarious economic sectors, which areuseful for measuring the relativeeconomic contribution of individualeconomic sectors.

This pamphlet explains the treatmentof financial intermediation servicesprovided by banks in the nationalaccounts framework. To understandthe relevant concepts, it is necessaryto first understand some basicconcepts of GDP.

Basic concepts of GDP byproduction and income approaches

GDP is a measure of the total value ofproduction of all resident producingunits of an economy in a specificperiod, say a calendar year or aquarter, before deducting allowancefor consumption of fixed capital.

2

“ ” 3

Under the production approach, GDPis the sum of “value added” ofresident producing units (e.g.factories, shops, service organizations)of a country or territory. Asillustrated in Chart 1 on page 3 :

= –= (B) – (A)

Value added of a producing unit

= Gross Output – Intermediateconsumption

= (B) – (A); and

GDP is the aggregate of value addedof all producing units.

In brief, value added is derived asgross output less intermediateconsumption i.e. deducting the valueof goods and services (e.g. purchaseof materials and supplies, rental,business services) used in productionfrom the value of output.

(C)

(D)

In Chart 1, viewing from the incomeangle, the value added of a producingunit is also equal to the sum of itscompensation of employees (C)(comprising wages, salaries and otheremployee benefits) and grossoperating surplus (D).Compensation of employees and grossoperating surplus are factor incomesdistributed by the producing unit asrewards to the factors of production(labour, capital, entrepreneurship).Viewed from this angle, or the incomeapproach, GDP, being the value added

3

of all producing units, is thus equal tothe sum of the compensation ofemployees at economy-wide level andthe gross operating surplus of allresident producers.

Physical flow

Value flow(i.e. money or equivalent)

B = A + C + D, B = A + C + D,

∴ B – A = C + D ∴ B – A = C + D

= = “Value added”

(B)Value of products

Producing

Unit

Input (1):Intermediateconsumption

Chart 1

Gross output

(A)Value ofmaterials andservicesconsumed Input (2):

Labour

Input (3):Capital andentrepreneurship

(D)Return tocapital andentrepreneurship:“Gross operatingsurplus”

(C)Return to labour:“Compensationof employees”

(1):

(A)

(B)

(2): (3):

(D)(C)

4

Value added is gross of interestpayment

(A)

“ ”

A producing unit (e.g. amanufacturing firm) may need to payinterest to bank for obtaining loans(e.g. for purchase of plants andmachinery). However, it should benoted that for national accountspurpose, the interest payment to banksis not regarded as payment forservices consumed in the productionprocess, and hence is not included inintermediate consumption (A) of theproducing unit. Similar todividends, interest payments areconceptualized as “second stage” (i.e.subsequent) redistribution of theprofits earned in the process ofproduction.

( )( )

Consider two firms A and B, Firm Auses equity capital while Firm B usesbank loan to finance the operation ofbusiness. Suppose both Firm A andFirm B have $1 million profits. Ifinterest payment (I) is counted as cost,then the profits for Firm B willbecome $1 million minus (I) whilethat of Firm A will remain as $1million.

In national accounting terms, thevalue added of economic sectorsrepresents the value of productionbefore deducting interest payment tobanks. From the income angle,interest is regarded as a reward to theprovision of capital services involved

5

(D)

(D)

in production activity and hence isredistributed out of the value added,or more specifically, the grossoperating surplus (D) of the producingunit. In other words, gross operatingsurplus (D) is a measure of the surplusaccruing from the process ofproduction before deducting interestpayment.

Services provided by banks

Banks provide a wide range ofservices to their clients, includinghouseholds, business establishmentsand non-residents. The services canbe broadly classified into two types :

(a) (a) Provision of fee-based financialservices such as issuing letter of creditfor import/export traders, arrangementof syndicated loans, stock dealing andbrokerage services, discretionaryportfolio management services,custodian services. In return for thefinancial services provided, bankscharge explicit service charges, i.e.fees and commissions from theircustomers. Therefore, the value ofthe output of banks in respect ofprovision of fee-based financialservices is equal to value of the feesand commissions received. Thiscalculation method is strict forwardand poses no problem in GDPcompilation;

(b) (b) Provision of financialintermediation services to depositors

6

and borrowers, i.e. channeling fundsfrom depositors to borrowers. In theprocess, banks :

(i) (i) receive money from depositorsby providing saving accounts,current accounts etc. In returnfor money being obtained, bankspay interest to their depositors;

(ii) (ii) make loans to their borrowers bymobilizing the money ofdepositors. In return for theloans provided, banks receiveinterest from their borrowers.

In providing financial intermediationservices, banks do not simply takedeposits and make loans. Banksprovide a lot of services to depositors,say by establishing branch offices andautomatic teller machines to facilitatedeposit, withdrawal and transfer offunds at the convenience of thedepositors. Banks also provideservices to their borrowers, such asassessing the creditworthiness ofborrowers, mobilizing funds toprovide credit facilities at theconvenience of borrowers.

In providing these financialintermediation services, banks do notcollect explicit service charges fromdepositors and borrowers. Instead,they charge indirectly by lending athigher interest rates and borrowing atlower interest rates.

7

The need for special treatment offinancial intermediation services

(a)

(b)

Given the special nature of indirectcharges on the financialintermediation services, both banksand their customers (e.g. real estatedevelopers) do not know the marketvalue of the financial intermediationservices produced and consumed.Therefore, in GDP compilation, it isnecessary to develop a method to (a)estimate the market value of financialintermediation services produced bybanks and include this value in theoutput of banks. If the market valueof financial intermediation serviceswere not included in output of banks,the banks’ contribution to GDP wouldbe unreasonably small. This isbecause financial intermediationservices are actually the main businessof banks; (b) estimate the marketvalues of financial intermediationservices consumed by variousindustries (e.g. import/export trade,real estate development) in theirproduction processes and includethese values in the intermediateconsumption of various industries.

International convention made in1968 to deal with financialintermediation services in GDPcompilation

(a) (a) Estimating the market value offinancial intermediation services

8

produced by banks

“”

The international convention made in1968 to estimate the market value offinancial intermediation servicesproduced by banks was given in the“1968 System of National Accounts”(SNA), which was an authoritativemanual providing guidelines of thecompilation of national incomestatistics. In the internationalconvention, the market value offinancial intermediation servicesproduced by banks is recommended tobe estimated by the differencebetween banks’ interest receipts andinterest payments. The value offinancial intermediation services iscalled imputed bank service charge in1968 SNA and FinancialIntermediation Services IndirectlyMeasured (FISIM) in 1993 SNA, thelatest version of internationalstandards.

(a)(b)

The value of financial intermediationservices is included in gross output ofbanks, along with the value of explicitservice charges (e.g. commissions forproviding security dealing/brokerageservices and fund managementservices). In this way, gross outputof banks includes the value of all theservices produced, viz. (a) financialintermediation services provided todepositors and borrowers; and (b)fee-based financial services, such assecurity dealing/brokerage and fund

9

management services. If the value offinancial intermediation services werenot included in gross output, the valueadded of banks would be substantiallyunderestimated. This is becausefinancial intermediation services areactually the main business of banks.

(b) (b) Estimating the market value offinancial intermediation servicesconsumed by various economicsectors

Different types of establishments (e.g.real estate developers which obtainloans for financing real estate buildingdevelopment projects, importers/exporters which obtain loans forfinancing external trade) consumedifferent amount of financialintermediation services provided bybanks in the process of theirproductive activities. Therefore, incalculating the value added of variouseconomic sectors, it is necessary toestimate the respective value offinancial intermediation servicesconsumed by economic sectors andtreat them as the intermediateconsumption of the respectiveeconomic sectors.

However, at the time when theinternational convention was made in1968, it was considered very difficultin practice to find a method toestimate the value of financialintermediation services consumed by

10

“”

various economic sectors. As apragmatic solution, it wasrecommended to treat the whole valueof financial intermediation services asintermediate consumption of alleconomic sectors combined. Inother words, it is assumed thatfinancial intermediation services areall consumed by businessestablishments. That is, no financialintermediation service is assumed tobe consumed by households andnon-residents. In compiling GDP byproduction approach, an item called“Adjustment for FinancialIntermediation Services IndirectlyMeasured (FISIM)”is deducted fromsum of value added of all economicsectors to arrive at GDP.

“”

In Hong Kong, the approachrecommended in the 1968international convention is slightlymodified, as that adopted by otherfinancial centres and serviceeconomies. Under the modifiedapproach, the value of financialintermediation services is deductedfrom the sum of value added of allservice sectors, rather than the sum ofvalue added of all economic sectors.The deduction item is called“adjustment for FISIM” in tableshowing GDP by economic activitypublished in the annual report of“2004 Gross Domestic Product”.

11

The need for a new method

Under the convention of the “1968System of National Accounts”, it istantamount to assuming that financialintermediation services produced bybanks are all consumed by economicproducers, and such services are notconsumed by households andnon-residents. This treatment isbecoming more and moreinappropriate. Along withdevelopment of globalization andpromotion on personal bankingservices, including personal loans,credit card, the consumption offinancial intermediation services bynon-residents and households hasbeen increasing rapidly in recentyears. Hence, there is a need todevelop a new method to estimate thevalue of financial intermediationservices consumed by various users,particularly by households andnon-residents.

The new method recommended inthe latest international guideline

To solve the problem of estimatingthe value of financial intermediationservices consumed by varioususers/sectors, the “1993 System ofNational Accounts” (SNA) mentionstwo methods, viz. the relevantindicator method and the referencerate method.

12

The reference rate method is thepreferred method in 1993 SNA. Thismethod is conceptually moreappealing but complex and demands asubstantial amount of input data atdetailed levels. Compared with therelevant indicator method, thereference rate method takes intoaccount not only the stock of loansand deposits but also the differencesin the interest rates of loans anddeposits faced by differentusers/sectors. The latter isparticularly relevant for Hong Kong,as in Hong Kong most loans to anddeposits from non-residents areinter-bank loans/deposits which arelarge in amount but have muchsmaller interest margins than othertypes of loans/deposits. Indeed, alleconomies (including Australia, theUSA and member states of theEurostat) that implemented the newmethod chose the reference ratemethod.

In view of the complexity of thereference rate method, attempts toimplement the concepts of the methodby some statistically advancedeconomies have revealed the need toresolve many conceptual and practicalissues (such as the operationaldefinition of reference rate,occurrence of negative value offinancial intermediation servicesconsumed by some sectors). It tookseveral years of theoretical studies and

13

practical experiments beforestatistically advanced economiescould successfully implement theconcept given in the 1993 SNA.Australia was the first economy toimplement the reference rate methodin 1998, followed by the USA in 2003and selected member states ofEurostat in 2005.

“”

“ ”

Under the reference rate method, thevalue of financial intermediationservices consumed by various users isestimated based on the concept of“reference rate” of interest. Thereference rate of interest representsthe pure cost of borrowing. In otherwords, the reference rate of interestcan be regarded as a risk-free interestrate and does not include any financialintermediation services. Theinterbank rates are suitable proxies ofreference rate. This is because theborrowings/lendings among banksinvolve minimal risks, hence theinterbank rates are considered to befree of financial intermediationservices and close to the concept of“pure cost of borrowing” given in the1993 SNA .

(1%)(3%) 2%(3%) (1%)

Chart 2 illustrates how to use theconcept of reference rate incalculating the value of financialintermediation services provided bybanks to depositors and borrowers.To depositors, banks pay interest rate(1%) that is lower than the reference

14

(7%)(3%) 4%

(7%)(3%)

rate of interest (3%). The differenceof 2%, which is given by referencerate (3%) less actual interest rate ondeposits (1%), represents the interestmargins that banks earn throughproviding various financialintermediation services to depositors.Similarly, to borrowers, banks chargeinterest rate (7%) that is higher thanthe reference rate of interest (3%).The difference of 4%, which is givenby actual interest rates on loans (7%)less reference rate (3%), representsthe interest margins that banks earnthrough providing various financialintermediation services to borrowers.

Chart 2 ( )

The differences between the actual rates of interest and the reference raterepresent the interest margins that banks earn for providing financial intermediation services

Using the concept of reference rate ofinterest, the values of the financialintermediation services consumed bydifferent types of depositors andborrowers (e.g. households, business

7% - 3% = 4%

This is the interest margin that banks earned forproviding financial intermediation services toborrowers.

This is the interest margin that banks earnedfor providing financial intermediation servicesto depositors.

3% - 1% = 2%

Actual interest rateon loans

7%Reference rate

3%

Actual interest rateon deposits

1%

15

establishments, non-residents) can beestimated as follows :

(i) (i) For each type of depositor, thevalue of financial intermediationservices consumed is equal to thestock of deposits multiplied bythe average interest margins ofthat type of depositor;

(ii) (ii) Similarly, for each type ofborrower, the value of financialintermediation servicesconsumed is equal to the stock ofloans multiplied by the averageinterest margins of that type ofborrower.

The result of adopting the referencerate method in Hong Kong

2%

(a)

(b)

Hong Kong has adopted the referencerate method to calculate the value offinancial intermediation servicesconsumed by various users/sectors.After adopting this method, the levelof GDP in Hong Kong has increased,by around 2% in recent years. Thisis mainly due to the revised GDPfigures include: (a) the financialintermediation services consumed byhouseholds as reflected in privateconsumption expenditure in GDP; and(b) the financial intermediationservices consumed by non-residentsas reflected in exports of services inGDP. Before adopting the referencerate method, the old method impliesthat financial intermediation services

16

are all consumed by businessestablishments in the services sector,not by households and non-residents.The impacts on various expenditurecomponents of GDP and value addedof various economic sectors arediscussed below.

(a) (a) Expenditure components of GDP

In GDP by expenditure components,there is an increase in values ofprivate consumption expenditure,government consumption expenditure,exports of services and imports ofservices.

“ ”

The increase in value of privateconsumption expenditure is related tothe inclusion of value of financialintermediation services consumed byhouseholds when they make depositsat banks and obtain loans (e.g.personal loans, credit card advances)from banks. Here, it should be notedthat financial intermediation servicesrelating to dwelling loans ofhouseholds are not treated as privateconsumption expenditure. Rather, itis included in the intermediateconsumption of the item “ownershipof premises” in the GDP by economicactivity. This is becauseowner-occupiers are treated in thenational accounts as the owners ofenterprises engaged in the productionof housing services for their own final

17

consumption.

The increase in governmentconsumption expenditure is related tothe inclusion of value of financialintermediation services consumed bygovernment when it makes deposits atbanks.

The increase in exports of services isrelated to the inclusion of value offinancial intermediation servicesprovided by resident banks tonon-residents, e.g. loans tonon-residents by resident banks, anddeposits from non-residents. Thesubstantial value of exports offinancial intermediation services isrelated to the role of Hong Kong as aninternational financial intermediationservice centre.

There is also an increase in imports ofservices, which is related to thefinancial intermediation servicesprovided by non-resident banks toresidents, say through obtaining loansby resident establishments fromnon-resident banks.

(b) (b) Value added shares of economicsectors in GDP

(

After using the reference rate method,the percentage shares of variouseconomic sectors in GDP at factorcost (production–based GDP) havedecreased when compared to

18

)

“”

previously published figures (i.e.those figures published before 2005).This is because the financialintermediation services consumed byvarious economic sectors are nowincluded in the intermediateconsumption of the various sectors.In other words, the values of financialintermediation services consumed arededucted from value added of therespective sectors, rather than the sumof value added of all service sectors.Therefore, the deduction item“adjustment for FISIM” is no longerrequired to be presented in the tableshowing GDP by economic activity.

Larger decreases in the value addedshares are observed for theimport/export trading sector and realestate sector. This reflects that thesesectors consume a relatively largeamount of financial intermediationservices provided by banks, includingloans for financing external trade andloans for financing real estatedevelopment projects.

August 2005

政府統計處出版政府物流服務署印（採用環保油墨及取材自可再生林木的紙張印製）