Correlation Between Savings and Investments and Their Impact

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INTRODUCTION The saving rate of any country is an important indicator of economic development since the domestic saving rate is directly related with the investment rate and the lending capacity of the banking system. Saving and investment are two key macro variables with micro foundations, which play a significant role in economic growth. Global emerging economies are experiencing record savings at a time when the developed world has been witnessing a decline in gross domestic saving rates, having a positive impact on the investment limate in these countries. Higher savings and investment rates eventually help in boosting GDP. This is another reason why GDP is growing faster in the emerging world than in the developed world. The organization of the paper is as follows: the next section provides an in depth literature review covering the three variables; savings, investments and GDP. Section III discuss the methodology, data and result of our research. Concluding remarks are given in the final section. LITERATURE REVIEW

Savings is defined by economists as that part of after tax income that is not spent, hence, it equals disposable income less consumption (McConnell-Brue, 7th edition). The close relationship between saving rate and economic growth is explained by many economic growth models. A large body of literature on economic growth tends to support the traditional Solow (1956) growth model and the “New Growth Models” of David Romer’s and others in which higher savings leads to higher growth.

The debate over the correlation between saving and investment has been initiated by the work of Feldstein and Horioka (1980). Savings are the main source of funds to finance capital investment, while the share of total GDP that is devoted to investment in fixed assets is an important indicator of future economic growth for an economy. According to Mckinnon (1973) and Shaw’s (1973) argument it is stated that in a financially repressed economy, interest rate remains below its market clearing value thereby generating ess than the optimal amount of savings and thus detracting from the pool available for investment which can lead to a decrease in the GDP of a country. Empirical studies suggest that increase in real interest rate provides an incentive to private household to save more, induce corporate sector to generate its own savings due to high cost of borrowing, thus overall saving would increase (Iqbal 1993). Further a higher rate of economic growth may also stimulate savings through what Mckinnon (1973) has termed as the ‘Portfolio-Effect’ of growth.

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Nasir, S. , & Khalid, M. (2004) state in their paper that one unit growth rate increase in GDP would lead to almost half unit increase in savings rate, suggesting that people tend to save more out of transitory income which is consistent with results of Qureshi (1981). Remittances showed similar results of positively effecting savings rate. Evaluating the second variable, which is that of investment, it is again significant that the determinants of investment be fully comprehended as well.

Provision of good infrastructure, creation of a favorable investment climate by adopting stable macroeconomic policies and by providing stability, secure property rights and good industrial relations have been important factors for raising rate of investment (World Bank 1993). Law and order situation, feasible and favorable investment opportunities and the economic credibility among the world economies leads to a positive impact on the total investment in a county. The role played by financial repression, keeping interest rates below market clearing levels, is, however, controversial.

In this respect, Christy and Clendinon (1976) concluded saving rate and interest as important determinants. Analyzing the third variable, which is the GDP, it is established theoretically that the growth rate of GDP depends on the level of investment, addition to the labour force, HRD and technological change. Traditionally, in projecting the growth rate of GDP, investment is considered to be the binding constraint and investment domestically obviously stems from savings.

For achieving a set growth rate in the real GDP and to match the per annum growth envisaged in investment, it is required that a saving rate be achieved that is broadly in line with the investment requirements. However the problem confronted by developing countries is that the saving ratios remain low. Low saving ratios result in low investment levels. At the same time, due to low income the taxable capacity remains lower, i. e. government earnings also remain low. In such situations, the country has to face saving investment deficit as well as the deficit in balance of payments (BOP) [Mohey-ud-din, Ghulam (2006)].

As a result most developing countries have to rely on Foreign Capital Inflows (FCI) to generate sufficient saving in order to achieve high levels of growth. According to Kumarasinghe P J, (2007), saving provides the wherewithal for capital formation, which in turn, is essential for economic development. If a country has a low rate of saving over a long period of time, the country’s economy would be entrapped in a vicious circle of low investment, low growth, low productivity and low real per capita income.

Thus, every country would like to have a higher rate of domestic saving. DATA AND EMPIRICAL METHODOLOGY This study includes panel data on investment and savings for three South Asian developing countries namely Pakistan, India, and China over the period of 2000-08 compiled from the Economic Surveys 2007-08 of the respective countries. We calculated investment as a share of GDP (investment–GDP ratio) and domestic savings as a share of GDP (saving–GDP ratio) to estimate our models. The methodology that will be used in this study is correlation. DEFINITIONS & ASSUMPTIONS

The savings of a specific sector is the difference between its disposable income and expenditure. In an economy, these sectors include households, enterprises (both private and public), and governments. Gross Domestic Savings = Gross Domestic Production – Total Expenditures Gross National Savings = Gross National Production – Total Expenditures Hence, gross national savings is the addition of gross domestic savings and net factor income from abroad plus private transfers. In both cases, savings can be split into private savings and public savings.

Private savings originate from two main sectors of the economy, namely corporate sector, and the household sector. Corporate mean the surplus and undistributed profit of public and private corporations. (Sc). Household savings equal the disposable income of households and private non-profit organizations minus their consumption expenditure. (Sh) Government savings denote the difference between the government revenue though taxes minus government expenditures which is public savings, also known as the Budget surplus. In a closed economy savings are assumed to be equal to investments i. . S = I, but in an open economy savings are not equal to investments as for a period of time, financial institutions can lend out (I) more than they receive from depositors (S) or vice versa. The main point here is that the decisions to save and invest are made by different people, and thus they plan to save and invest different amounts. In this paper, we are assuming Savings are not equal to investments as all the economies are open economies. FINDINGS AND ANALYSIS Countries like the US, UK, and the EU have seen a major shift in their structure of national savings.

For instance, almost two-thirds of the fall in savings rate in the developed world has been due to a fall in household and public savings, the major reason being the prevalence of credit cards has changed consumption behaviors by encouraging consumption and correspondingly discouraging savings. On the other hand, much of emerging Asia’s saving rates has been driven by increases in both household and public saving rates. The increase in the savings in emerging markets is due to following reasons: •Due to the absence of efficient credit and insurance markets, household savings are a crucial determinant of welfare in these economies.

As, without savings, households have few other mechanisms to smooth out unexpected variations in their income, and so, shocks may leave permanent scars. Hence, the emerging markets have seen a continuous rise in the household savings sector as a vehicle to enhance future income-earning possibilities. •More than expected development •Modigilani life cycle hypothesis: The hypothesis states that there will be little saving in early adult life, high saving at the middle and end of working life, and then negative saving after retirement. A defective social security arrangement •A broadening income inequality The principle is based on dual economic structure, that there are two classes rich and poor, with rich being very rich and the and poor being very poor. The principle assumes that the rich class has a very high MPS. •Increased savings in the corporate sector enterprises receiving profits. Now, we will be analyzing China, India and Pakistan in context of factors given above and will find the extent to which these domestic savings are translated into investments in each country.

CHINA China’s economy during the past 30 years has changed from a centrally planned system that was largely closed to international trade to a more market-oriented economy that has a rapidly growing private sector and is a major player in the global economy. The economy has actively engaged in financial liberalization since the mid-1980s. Interest rates, exchange rates, the entry and business scope of financial institutions and capital movements were progressively liberalized in line with their macroeconomic development.

This efficiency contributed to higher corporate profits and household income, which in turn helped accumulate domestic savings. China’s savings have thus been growing and this is reflected in all segments of its industrial and financial sector. Currently, the yearly GDP rate in China is increasing at around 10%. The ratio between domestic investment and GDP is quite high in comparison to other nations and it is increasing with the passage of time. A penny saved may be a penny earned, but in China a penny saved is usually invested in an infrastructure project or an increase in manufacturing capacity.

This substantial extent of investment has become possible due to the fact that the ratio of domestic saving to GDP in China has reached really high degree both in terms of historical figures and international figures as it can be seen from Table I. The ratio with which these domestic savings are being translated into the investments can be viewed by the third column of the Table I. The majority of domestic savings is utilized for internal or domestic investments as the very high correlation coefficient of 0. 977 explains. High saving rate boosts investment, which in turn speeds up economic growth.

The saving rate in China is one of the highest among major countries, and this positive correlation coefficient clearly indicates that as savings increase there’s almost an equivalent increase in the investment. By directing savings towards investment rather than using it to pay down the current account balance, lead to a further gain to GDP. There are a variety of causes behind the increased rate of correlation between savings and investment in China. Among those reasons, the financial system plays a very important role in bridging between savings and investments.

In other words, the financial system (including bond markets, stock markets, banks, etc. ) absorbs domestic savings and channels them to the most productive use. Therefore, a sound and well-functioning financial system of China has ensured the most appropriate allocation of savings. In addition, the displacement of Foreign Direct Investments (FDI) regarding domestic investment is expected to increase additional savings in China. INDIA Until the late 1970s the economy was controlled heavily by the government. Beginning in the late 1980s, India has started to liberalize its economy.

As a result of the policy reforms, the Indian economy is progressing well. India now has a higher GDP growth rate, lower inflation, and significant increase in foreign direct investment and a growing middle class of 150-200 million. Wolf (2005) point outs the economic reforms which were initiated in the early 1990s have affected the saving rate in India. Over the past four decades, as can be seen from Table II, Indian saving rate has been consistently increasing though there are some fluctuations from year to year.

India’s high savings rate has been a crucial driver of its economic boom, providing productive capital and helping to fuel a virtuous cycle of higher growth, higher income and higher savings. The rise in the savings rate has coincided with an increase in the rate of growth of GDP, suggesting that the economy is transiting to a sustainable, higher growth trajectory. According to the Reserve Bank of India (2005 and 2006), foreign remittances from Indian emigrants have increased since the late 1990s. Remittances from expatriates and others working abroad temporarily have contributed to the higher saving rate in the recent years.

FIGURE II The recent increase in the saving rate in India is primarily driven by the savings made by the financial household as India’s household sector (including some small businesses) continues to account for the lion’s share—some 70%—of savings. India’s large fund of household savings, stood at Rs9. 85trn (US$192bn) in 2006/07. In the past few years India has observed that household sector savings have in fact grown by far more than any of the other macro-indicators. The savings rate in India is comparatively on the higher side as compared to other countries.

The saving trend has seen some fluctuations because in the earlier years, it was directed towards household savings in the physical assets that used to dominate the domestic saving in the country. But the saving trend in India is different now. This trend partially reflects the relentless expansion of the various branch networks of the financial institutions into the county’s rural areas and partially holds the increasing trend of the easy accessibility of the alternative investment opportunities. Since independence, the investment rate has shown an upward trend for India with fluctuations around the trend.

However, a narrow saving-investment gap has been one of the main features of the Indian economy and one of the main reasons behind its economic success. PAKISTAN Since its independence, Pakistan faced a number of challenges on the political and economic fronts. Pakistan is a politically unstable country. From 1990, the government has started to follow an open economy policy. Since 2000, the government has begun to remove barriers to foreign trade and investment, reform the financial system, ease foreign exchange controls, and privatize state-owned enterprises.

According to State Bank of Pakistan (2004), economic mismanagement and fiscally imprudent economic policies caused a large increase in the public debt and led to fall in the foreign currency reserves in the 1990s. Pakistan is a low income country with uneven distribution of wealth. As a result there are two classes: rich and poor. Rich are very rich and poor are very poor. This dual economic structure, besides other implications, has resulted in low saving rates. In case of Pakistan, we cannot strictly apply the principle that with uneven distribution of income the savings rate will be high.

That principle is based on the assumption that the rich class has a very high MPS. But the upper class in Pakistan has a very high consumption (on luxuries) and relatively low savings. The poor class cannot save because of their low income. As a result, the savings rates in Pakistan are amongst the lowest in the world. This lack of savings is supposed to be one of the basic structural macroeconomic problems faced by the country. Table III shows the saving rates and trends of Pakistan. The table shows that the national savings and domestic savings rate are going down rather than going up like the other emerging economies.

Also, as can be seen from the table, due to the economic and political instability and higher foreign interest rate, people prefer to save outside Pakistan and the foreign savings rates are going upward. Low savings are an important reason why the actual rate of development has been below the potential rate of development. It has been responsible for increasing our dependency on external savings in the form of loans, investments and grants to an extent that it now impinges on our economic sovereignty. Low savings are leading to low investment, low productivity and then back to low real income.

The stats clearly state that the investments in the country are also going down. Other reasons behind the low savings and investments are as follows: •Only 50% of population banks in Pakistan, hence the domestic savings are never too much. •Inadequate returns on financial savings have exercised inhibiting impact on the process of savings and investment. Admittedly the rate of return is not the only determinant of savings, but the evidence suggests that it is far more important than bankers and policy makers have acknowledged for a long time. The lack of depth and breadth on the financial sector, since financial assets, markets and institutions are few and not well developed. •Government taxation policies •Rates of inflation higher than the rates of return on financial savings •High population growth rate with a concomitant high dependency ratio and low level of per capita income. As, growth and savings feed back into each other in the virtuous circle of savings – investment-growth-savings, the feedback mechanisms depend on the efficiency with which savings are channeled into productive investments.

So, we see that both the savings and the investments as percentage of GDP are declining in the country and the fragile relationship observed between the two variables explains the fact that even when savings are rising in the country, they are not channeled properly into productive investments and hence investment rates are not rising by the same proportions and hence the negative correlation exists between the two. The main imbalance between savings and investment in Pakistan arises in the public sector. Budget deficit i. e. he gap between consolidated public revenues and expenditures has been one of the most serious problems facing the economy and is an important cause of the low level of domestic savings. During the 1980s and 1990s it annually averaged 7. 1 per cent and 6. 9 per cent of GDP respectively. The budgetary deficit was brought down to 4. 3 per cent of GDP in FY06 and FY07. In FY08, however, the fiscal deficit rose sharply to 7. 4 per cent of GDP on account of heavy government borrowing for budgetary support rising by around 105 per cent over FY07 to Rs777 billion.

For the current fiscal year 2008-09 fiscal deficit is projected at between 4. 3 to 4. 8 per cent of GDP. The other important reason being that the people of Pakistan lock up their physical savings into unproductive physical assets such as houses, durables and jeweler due to ? Low return to economic activity ?The people of Pakistan do not have many entrepreneurship ideas Also, the savings are spent on maintenance of existing assets such as roads and railways rather than on making new and productive investments.

RESULT China and India weigh in as #2 and #4 largest economies respectively, in the world (adjusted for purchasing power parity), with 21% of global GDP. Their combined spending on infrastructure is estimated to be $3 billion per day and their 2008 – 2017 savings rates will be well in excess of the largest developed nations hence these trends are likely to continue presenting opportunities for both the government and financial-services providers to channel those savings productively.

While, for Pakistan the situation is not very bright, as a large savings-investment gap is not desirable for the country in the long run because of its negative impact on macro-economic stability. It results in accumulation of national debt and puts additional burden on the country’s balance of payments in terms of mounting debt servicing. And the prevailing rates of investment and savings in Pakistan are not adequate to support future economic growth at the socially necessary rate of 7 per cent per annum Pakistan therefore has no alternative but to make determined efforts to raise significantly its national savings and investment rates.

The negative correlation of Pakistan can further be explained if we compare the domestic savings percentage of GDP financing the fixed investments for the three countries in Table V. As we can see from Table V that domestic savings share for Pakistan since 2001-02 has been declining in financing the total fixed investments and hence the savings are not being transformed into the investments as in 2007-08 the lowest ever level, since 1999-2000, has financed 54. 17 percent of fixed investment in 2007-08 as against the high share of China and India.

CONCLUSION The level of national savings potentially plays a crucial role in the well being of a nation, as it is related to so many economic factors such as the current account, foreign debt, the exchange rate, asset prices, and inflation. However, while savings is important, the role of investments is equally as important, if not more so. Growth and savings feed back into each other in the virtuous circle of savings – investment-growth-savings. The feedback mechanisms depend on the efficiency with which savings are channeled into productive investments.

Growth led by consumption is merely short term, as it would ultimately push up inflation without the accompanying increase in the production capacity of the economy. Therefore, to boost the long term productive capacity of an economy the savings have to be properly channeled into investments. Countries across the world have divergent savings and investment patterns. Different explanations seem to work for different countries at different times, and savings differences are usually due to a combination of several factors.

Much of the difference is accounted for by higher rates of savings by households and mobilization of capital. REFERENCES Baxter, M. , & M. J. Crucini(1993), “Explaining Saving-Investment Correlations,” American Economic Review Bayoumi, T. , “Saving- Investment Correlations: Immobile Capital, Government Policy or Endogenous Behaviour? ” Feldstein, M. (1983), “Domestic saving and international capital movements in the long run and the short run”, European Economic Review Feldstein, M. and Bacchetta, P. 1991. National saving and international investment. Bernheim, D. and Shoven, J. B. , Editors, 1991. Kuijs, Louis, “How will China’s Saving-investment Balance Evolve? ” World Bank China Research Paper No. 4, May 2006 Kokila, D. (1994), “Determinants of the Saving Rate: An International Comparison”, Contemporary Economic Policy, Masson, P. R. (1998), “International Evidence on the Determinants of Private Saving”, World Bank Economic Review, www. econstats. com www. nationmaster. com www. inomics. com