IV Policy Determinants of Saving and Investment
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Abstract

Developing countries typically have available a number of policy instruments that can be expected to affect the level of national saving and investment. While some of these policies may be explicitly intended to promote saving (such as policies to raise interest rates), a number of policies designed with primary focus on other macroeconomic goals may also have indirect effects on national saving and investment. This section examines both the direct and indirect effects of adjustment policies on saving and investment. The policies to be considered include the reduction of fiscal deficits, control of domestic credit expansion, exchange rate adjustments, and interest rate reform and financial liberalization.35

Developing countries typically have available a number of policy instruments that can be expected to affect the level of national saving and investment. While some of these policies may be explicitly intended to promote saving (such as policies to raise interest rates), a number of policies designed with primary focus on other macroeconomic goals may also have indirect effects on national saving and investment. This section examines both the direct and indirect effects of adjustment policies on saving and investment. The policies to be considered include the reduction of fiscal deficits, control of domestic credit expansion, exchange rate adjustments, and interest rate reform and financial liberalization.35

Fiscal Policy

Fiscal restraint typically takes the form of the curtailment of current expenditures, improved revenue performance (for example, through more realistic pricing for the output of nonfinancial public enterprises, increases in taxes, and improved tax collection), and of a rationalization of the public investment program. These policies are primarily intended to bring the growth of aggregate demand in line with the growth of productive capacity, thereby diminishing the country’s claims on external resources and easing domestic inflationary pressures. At the same time, to the extent that such fiscal tightening takes the form of reduced current spending and/or increased revenue collection, these policies also raise public sector saving directly.

The consequences of such policies for national saving and private investment are more problematic, because these effects are indirect, emerging through general equilibrium interactions that depend both on the structure of the economy in question and on the initial conditions from which the policies are implemented. Nevertheless, certain broad considerations are widely applicable. A key issue is whether the fiscal adjustment results in a contraction of domestic demand beyond what is required to keep resources operating at full capacity. The discussion below will assume that the initial position is one of excess demand and that fiscal overshooting is avoided.

Consider first a reduction in public consumption. As indicated in Section II, existing evidence suggests that this reduction would not exert a significant effect on private consumption in developing countries and would therefore lead to an increase in national saving. The rise in national saving is likely to stimulate private investment indirectly through at least two important channels. First, to the extent that capital mobility cannot be considered to be perfect, an increase in national saving would increase availability of credit and lower domestic real interest rates. Second, if the fiscal correction is substantial and is perceived to be permanent, a diminished risk of future taxation would represent a separate, and possibly quite powerful, stimulus to private investment.

If the fiscal adjustment takes the form of increased revenues raised from the private sector, private saving is likely to fall. As long as the tax increase takes a form that reduces the after-tax rate of return on saving, this effect would be exacerbated, since the time profile of consumption would shift toward the present. Nevertheless, national saving may still increase as long as public consumption is restrained. Private investment will again be stimulated indirectly in this case, through the general equilibrium mechanisms described above. However, if the increase in taxation falls on profits, the stimulus to private investment will be at least partially offset. Thus, the composition of the tax increase becomes crucial in this case. If increased investment is not forthcoming, the rise in national saving will simply replace foreign saving; that is, it will result only in an improvement in the current account of the balance of payments.

Reductions in the size of the public investment budget do not, of course, directly affect private or public saving. Private investment, however, will be affected in a number of ways. In addition to the indirect effects discussed above, there are important direct complementarity and substitutability relationships between the public and private capital stocks. If the public investment projects that are curtailed are either unproductive or compete directly with private activity, private investment will receive a net stimulus. On the other hand, a reduction in public investment projects that are complementary to the private capital stock could lead to an improvement in the current account position but to a lower rate of economic growth.

Credit Policy

The restraint of aggregate demand through limits on the expansion of domestic credit can also influence saving. In countries with market-determined domestic interest rates, restrictive credit policy would raise interest rates and stimulate private saving. Even if credit is rationed, to the extent that the growth of credit to the private sector is restricted, households will be forced to finance investment through other means, including the curtailment of current consumption, thereby increasing the private saving rate.

The direct effects of restricting credit expansion on private investment, however, will be unfavorable, whether because domestic real interest rates rise or because credit availability is reduced. Stabilization programs often attempt to mitigate such adverse effects on private investment through subceilings on credit expansion to the public sector, which seek to shift the composition of credit toward the private sector within the framework of ceilings on the overall expansion of credit. To some extent, remaining negative effects on investment could prove to be of a shortrun nature, if the restrictive credit policy succeeds in bringing inflation under control. As the domestic macro-economic situation improves, the medium-term outlook for investment would become more favorable. The substantial contrast between the investment performance of high- and low-inflation countries in Table 2 supports this argument.

Exchange Rate Policies

Exchange rate policies such as devaluation or unification of multiple rate systems are likely to affect both national saving and domestic investment.36 Effects on private saving will operate both through the level of house-hold resources and through intertemporal rates of return. Regarding the former, since devaluation tends to increase the domestic price level, it acts as a capital levy on nonindexed financial assets denominated in domestic currency. The implied reduction in real private wealth diminishes the resources available to the household sector and thus reduces consumption relative to income. Furthermore, devaluation will tend to transfer real income between the private and public sectors, as will exchange rate unification. If the direction of the transfer is from the private to the public sector and public consumption does not increase appreciably, such transfers of real income are likely to increase national saving.

The effect of devaluation on intertemporal rates of return facing private savers depends on the degree of integration of the domestic economy into world capital markets. When the degree of integration is high, the expectation of a future real depreciation, engendered by a situation in which the domestic currency is overvalued, will imply that the real interest rate relevant to domestic consumers will exceed the external real interest rate. Since correcting the overvaluation removes this wedge, the domestic real interest rate would fall. On the other hand, if the degree of integration with world capital markets is less perfect, as is likely to be typical of developing countries, the price-level effects of devaluation may well raise domestic interest rates in the short run. This would tend to reinforce the positive effects of exchange rate action on national saving described above.

Turning to the public sector, if the traded goods component of revenues exceeds that of public consumption, public saving would increase as a result of devaluation. This effect may be offset, however, by an increase in the real cost of servicing external debt in countries where the stock of external debt is large. Overall, the effect of devaluation on public sector saving appears less clear-cut than in the case of the private sector.

From the standpoint of domestic investment, what would seem to matter most is whether the exchange rate action represents a credible commitment on the part of the authorities to avoid recurrent bouts of overvaluation in the future. Instability of the real exchange rate weakens the information content of relative prices and creates uncertainty by fostering stop-and-go aggregate demand policies, as well as giving rise to periodic episodes of exchange controls and import restrictions, all of which result in disincentives for domestic investment. Aside from this effect, the primary consequences of exchange rate action on domestic investment are likely to emanate from induced changes in domestic real interest rates.

Interest Rate Policy and Financial Liberalization

A key element of efforts to promote the efficient allocation of saving is the pursuit of realistic interest rate policies in the context of liberalized financial markets. The objective of adjusting interest rate policy is to allow interest rates on both the assets and liabilities of the domestic banking system to reflect market conditions, either by liberalizing controlled interest rates completely (as in Argentina and Chile) or by gradually phasing them out (as in Korea, Indonesia, and Sri Lanka). These changes in domestic interest rates are in some cases combined with financial sector reforms intended to increase the menu of assets available to private savers and to improve the efficiency of the domestic banking system.

Interest rate policies and financial reforms are intended not just to raise the overall level of private saving but also to influence its composition—to channel saving away from other destinations (such as informal financial markets or abroad, in the form of capital flight) and toward the domestic banking system or other organized markets, through which it can most efficiently be allocated to domestic investment.

The solution of the problem of capital flight that has plagued many heavily indebted developing countries in recent years requires that domestic savers find the holding of domestic assets—both physical and financial—to be remunerative. Unless investment in physical capital at home is profitable, even a well-functioning financial system would tend to place accumulated domestic savings abroad. On the other hand, even if opportunities for domestic investment exist, financial repression may induce private individuals to hold their assets abroad. In the presence of such capital outflows, domestic investment opportunities will go unexploited unless foreign financial intermediaries are willing to lend to domestic firms. Financial reform measures can obviate the need for this external financial intermediation by changing the composition of national saving away from the accumulation of foreign financial assets toward that of domestic assets.

The efficiency of investment is also expected to be improved by measures that allow greater reliance on price, rather than on nonprice, mechanisms for allocation of capital. Improved investment efficiency may be the most important contribution of financial liberalization to economic growth. Not only would an increase in efficiency increase the growth rate associated with a given increase in the capital stock, but since growth itself tends to promote saving, the level of saving may itself be indirectly stimulated by these efficiency gains.

Whether private saving is responsive to changes in interest rates has long been a subject of controversy. As indicated in Section II of Part Two, the predictions of theory are ambiguous on this score. Furthermore, the limited empirical evidence on the interest rate effect on saving in developing countries is mixed. The weight of the econometric evidence would seem to suggest that, while substitution effects are sufficiently strong so that an increase in the real interest rate has a positive effect on private saving, the size of this effect is small (see, for example, Rossi, 1988).

For a number of reasons, however, the conclusions from existing econometric work must be seriously qualified. First, saving data are notoriously weak in many developing countries, and the empirical estimates are thus likely to be unreliable. Second, regulated interest rates in many of these countries exhibit little variation over time, which complicates the task of deriving quantitative estimates from historical relationships. Moreover, the relevant marginal return to saving in such circumstances may frequently be the unpublished rate in informal markets, rather than the administered rate paid by financial institutions. In addition, the saving response may be stronger at positive real interest rates than at the negative real interest rates often observed when nominal interest rates are regulated. Third, the effects of interest rate changes on saving may depend on the macroeconomic environment in which those changes take place. Measures associated with a credible financial reform in countries with a stable macro-economic environment and no debt-servicing difficulties may well have more powerful effects on saving than those adopted in a context of economic instability and lack of confidence in the sustainability of policies. The favorable experiences of Korea, Sri Lanka, and Taiwan Province of China would seem to suggest that a measured program of removing financial distortions, particularly interest rate ceilings, while at the same time maintaining economic stability and boosting bank supervision, can lead to a significant rise in private saving as well as substantial gains in efficiency. Additional empirical research on this issue would appear to be necessary before drawing strong conclusions.

While there is ambiguity in the theoretical relationship between aggregate saving and interest rates and/or only a small, though significant, savings elasticity with respect to the interest rate, some studies (see Polak, 1989; and Gelb, 1989) have found a strong positive correlation between output growth and real interest rates. Since the effect of interest rates on aggregate saving is likely to be weak, two other channels may be at work: first, from interest rates to financial depth to increased investment (that is, the composition-of-saving effect); and second, from interest rates to financial depth to the productivity of investment. Although the first channel was found to be relatively weak, the second channel appeared to exert a powerful influence on growth. Thus, the strong relation-ship between real interest rates and growth may primarily reflect the more productive investments undertaken by countries with positive real rates.37

While interest rate reform is clearly desirable for efficiency reasons, its modality, design, and phasing may have important implications for private investment and growth, as suggested by the experiences of several developing countries in Latin America and Asia. When inflation is high and variable and where banks are poorly supervised, an abrupt financial liberalization coupled with stringent monetary contraction to correct macroeconomic imbalances may lead to excessively high and variable levels of real interest rates or to extreme credit rationing voluntarily imposed by the domestic banking system. Growth may decline in this case, indirectly resulting in lower rates of national saving. In several Latin American countries (Argentina and Chile, for example), what was first the corporate sector’s crisis became a system-wide crisis. By contrast, a few Asian economies (Korea, Sri Lanka, and Taiwan Province of China among others) softened the impact of high interest rates by pursuing a measured pace of financial liberalization while simultaneously intensifying efforts to bring inflation under control and bank supervision more effective. While it is difficult to draw comparisons across very different groups of countries, it does appear that a stable macroeconomic environment and strong prudential supervision of the banking system are key factors in the success of financial liberalization.

No less important than price stability and adequate bank supervision for the effectiveness of interest rate liberalization are financial sector reforms to develop institutional sources of credit (insurance companies, equity markets, and other nonbank financial institutions) and adequate systems of credit-rating and accounting standards. Because these key elements of the financial infrastructure are either lacking or are underdeveloped in most developing countries, banks and industrial firms in these countries are much more closely linked than they are in industrial countries. Consequently, there is a risk that abrupt financial liberalization could result in greater prudential risk, concentration of ownership, and moral hazard (see Dooley and Mathieson, 1987). The policy implication is that a measured, pragmatic, and gradual process of financial liberalization in developing countries should include the establishment and strengthening of the infrastructural elements mentioned above.

The limited empirical evidence on the effects of financial liberalization on national saving and domestic investment suggests that in this case as well, the beneficial effects of such policies on economic growth operate mainly through improvements in total factor productivity. Recent surveys of financial reforms (see Cho and Khatkhate, 1989; and World Bank, 1989) conclude that, although it is difficult to establish that financial liberalization has made a significant difference to overall saving and investment, liberalization has succeeded in channeling saving toward the domestic banking system, and thus to an allocation of financial resources oriented toward more productive investment.

Conclusions

In order to restore economic growth in developing countries, policies have to be geared toward creating an environment that is conducive to investment, along with promoting national saving with the aim of securing an appropriate level of aggregate demand. Without incentives to invest at home, an increase in national saving may largely replace foreign saving. Alternatively, for a given level of foreign saving, an attempt to increase national saving could result in excessive contraction of aggregate demand, reducing domestic income and leading to lower values of both national saving and domestic investment.

These considerations suggest that, for purposes of promoting saving, an appropriate policy mix would be one that pursues the aggregate demand objective through relatively tight fiscal policies while seeking adequate levels of private sector credit within the framework of ceilings on total credit expansion. The fiscal measures adopted, in turn, should avoid relying excessively on taxing income from capital or curtailing public consumption expenditure that fosters human capital formation or public expenditure on productive investment projects that are complementary to private investment. The most important requirement for fiscal policy, however, is that the fiscal adjustment be credibly viewed as permanent, rather than as a set of stop-and-go measures. Finally, the avoidance of periodic overvaluations of the real exchange rate can help foster a macroeconomic climate that is conducive to investment.

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