Savings and investment no unconditional panacea for growth

by Chakravarthi Raghavan

Geneva, 9 May 2001 - - Savings and investment are not an unconditional panacea for development and growth, and they can perform the role of engine only in a healthy macro-economic environment and coherent and consistent long-term policy.

This view of the UN’s Economic Commission for Europe, in a chapter of its Economic Survey of Europe 2001:1, on questions of domestic savings and investment, in relation to the transition economies, in particular the members of the Commonwealth of Independent States (CIS), the countries of the former Soviet Union, has a bearing on similar problems faced by the developing countries.

In discussing the issue of savings, investment and growth, and the various growth-models used in economic theory, based on neo-classical traditions, the ECE notes the widespread agreement about mobilisation of domestic resources as crucial for raising economic growth and promoting development, and support from research for the common sense view that capital investment is a powerful engine of growth and higher levels of savings are associated with higher levels of investment.

But while foreign investment may be important, its role is essentially complementary, and is usually subsequent to domestic efforts. Historically, domestic private savings have played a major role in supporting investment in the industrialized countries.

In looking at the linkages between savings, investment and growth, and the growth models, the ECE points out that these models are all based on assumptions of perfect markets which clear instantaneously through adjustment in prices, a tendency towards full utilization of factors of production, social endowments of production factors etc, and generally focus on the supply side, assuming that output is determined by supply conditions alone.

Neo-classical economic models based on these, or the earlier models, the ECE economists note, have a key underlying assumption that both domestic and foreign savings are fully channelled into productive investment - “a strong, but not realistic assumption, especially as regards developing or transition economies.”

This assumption has to be tested against the absorptive capacity of developing as transition economies - a capacity constrained by institutional bottlenecks or lack of profitable investment opportunities.

Another basic assumption of these models is that the economy has a positive and sufficiently large marginal savings rate (share of savings in an incremental change of income) to embark on a path of self-sustained growth. If this condition is not met, official credit will fail to generate growth, while external debt will grow,

One of the main conclusions emerging from empirical studies is that historically that countries have relied on domestically generated savings to finance domestic investment

The savings-investment balances of economies, drawn from national accounts of countries, is an accounting identity between groups of spending and financing items, and does not imply any specific causal relationships. But both theoretical and empirical research support the common-sense view that capital accumulation is an engine of growth and increased domestic savings lead to higher levels of investment and thus contributes to long- run growth.

And while the conventional prescription, namely economic policies should encourage higher domestic savings to achieve higher rates of long-run growth, may not be universally valid nor always working in same direction, more often than not it appears to fit the experience of many fast growing economies.

However, both theory and evidence are more ambiguous on assessment of actual financing needs of developing or transition economies, and the mechanisms best suited to channel external financial assistance.

Common sense would suggest if domestic savings and investment are low, an approach to accelerating development would be to complement domestic resources through foreign savings, possibly through international financial assistance programmes - the implied logic of many development aid programmes.

But inherent problems and unresolved issues, and lack of analytical tools and models used for this purpose, have proved inadequate and ex-post performance of recipient countries have not validated either the prescriptions of the models or amounts of resources allocated for assistance.

While there are many explanations and elements, the main conclusion is that there are no “easy fixes” to deep developmental problems that many of the transition economies face, and there is need for a comprehensive, long- term policy approach to these problems, in which external assistance should be an integral part.

Attracting external resources has been important for development and growth, but for this to happen on a massive scale, capital inflows have to be attracted by gainful investment opportunities.. By applying appropriate public policies, it may be possible to generate and attract more resources to finance the process of economic transformation in the transition economies.

Several elements are determinant of private savings, some subject to direct policy control, others indirectly affected by policy, and yet others policy-neutral, at least in the short run.

Among the policy factors found by the ECE to have been statistically significant in the transition economies are the depth and level of development of the financial system, the level of government savings and level of social security spending. The impact of monetary policy, in particular interest rate policy (the favourite prescription of the IMF and World Bank) has been “more ambiguous”.  Factors that have an indirect influence are found to be current account balance, rate of inflation and level of per capita incomes.

The level of per capita incomes and depth of the financial system have also been found to be major determinants of private savings. This implies a priority for financial reforms in the transition economies.

The ECE finds that foreign capital that has been attracted to the transition economies in recent years has tended to crowd out domestic savings, and this has been especially so in the CIS countries, but less so in eastern Europe and the Baltic region. Government savings in the CIS region tend to be almost fully offset by private savings and vice versa.

The high rate of substitutability between these flows may reduce efficiency of policies promoting one particular type of savings, the ECE concludes.

Savings and investment are not an unconditional panacea for development and growth, and they perform this role only in a healthy macro-economic environment and coherent and long-term policy. Only then can a virtuous circle of ‘high savings-high investment-high growth’ can become a reality, and first signs of this can be seen to be emerging in some transition economies, the ECE says.

What can be the role of FDI?

As finance, FDI is an inflow of foreign resources that can raise domestic savings rates. The finance can include purchases of equity capital by the foreign direct investor in the Foreign Investment Enterprise (FIE), reinvestment of profits by the FIE and loans to the FIE by the parent firm. The FIE can also borrow abroad on its own account, but this will not be FDI. If these funds are used to build new capacity or upgrade an existing one, there is increase in domestic fixed capital. But where it involves acquisition of existing plants and equipment, or sale of state assets, they are absorbed into the budget, and the FDI has no direct impact on real investment, though there may be transfer of technology over time.

The transnational corporations (TNCs) are usually seen as facilitating technological and organizational change - directly or internally to the FIEs and indirectly or externally by diffusion of technology, irrespective of their own ownership and control.

Analysing the various transfers of technology and their diffusion and spillovers, the ECE points out however that not all TNC activity leads to technology transfer and positive spillovers. They can have a negative impact on transfer of technology to the FIE and reduce the spillover of FDI in the host economy in several ways.

Affiliates can be provided with too few, or the wrong kind of technological capabilities, or even limiting the access to the technology of the parent - restricting the production of its affiliate to low-value activities and reducing the scope for technical change and technological learning. Even if the TNC transfers the technology, it can limit the scope for technology spillover by limiting downstream producers to low value added activities or eliminating them altogether by relying on foreign suppliers, including itself.

[Though the ECE report does not address the solutions to this issue, many development groups, developing countries, and even the international labour movements that want to associate labour standards with foreign investment, reject the theoretical ‘efficiency’ argument against intervention and advocate the host developing country government having the full right to direct and regulate the investment, and the use of domestic and foreign inputs and outputs, to establish backward and forward linkages in the domestic economy. In this light they also argue against international investment rules, whether multilateral in the WTO/OECD contexts, or regional in the various regional and sub-regional preferential arrangements for free trade.]

The ECE notes that technology spillovers from TNCs tend to occur more frequently when the social capabilities of the host and the absorptive capacity of the host firm are high. While relatively backward countries have a certain scope for catching up, it is often difficult for the country to build the necessary social capabilities and absorptive capacities that allow firms to take advantage of technology spillovers.

Countries and firms lacking capability to assimilate new technology tend to attract mainly market-seeking or resource-seeking FDI, while countries with this capability tend to attract more efficiency-seeking and asset seeking FDI, comments the ECE.

Closing the technology gap will be difficult without the relevant capabilities, and there is a certain threshold that countries must cross before the potential for technological spillovers can be realised. Such spillovers, the ECE adds, tend to occur more frequently in countries with relatively high levels of social capabilities -education levels, technological capacities and legal systems.

The ECE discussion however does not touch on the limitations imposed by the WTO trading system in this matter - the TRIPS agreement, ensuring global patent monopoly rights, and the TRIMs agreement limiting abilities of countries to prescript local content and other requirements for backward and forward linkages with the domestic economy and firms.

Most of the current economic literature, based on developing country experiences have not factored in these new elements that have come with the WTO, and the agreements that have begun to apply to developing countries since 2000.

The ECE paper also discusses the effect of FDI and the balance-of-payments (BOP), and the theory and arguments based on these about FDI’s ability to increase a country’s exports and its current account balance, and hence the view that increasing current account deficit financed by FDI should not be a cause for concern.

But assessing the impact of FDI on BOP is difficult, the ECE notes, “not least because of data limitations.”

Four items in the BOP accounts deal specifically with TNC transactions - FDI flows, including reinvested earnings in the financial capital account and, in the current account, interest on inter-company debt, repatriated profits and reinvested earnings from direct (equity) investment.

A narrow measure of direct impact of an FIE is the difference between FDI inflows and repatriated profits, which can increase as a function of growth of the FDI stock and FIE profitability - a reminder that FDI is not ‘free’ source of finance, even if it is preferable to debt which requires servicing irrespective of performance of the asset.

The ECE notes that data for the transition economies suggest that net inward transfers have been positive, owing to the small scale of profit repatriation so far, generally less than 10% of net FDI inflows. But this is likely to change as FDI stocks increase, and the FIEs move out of the startup phase and become profitable.

A broader measure of direct FIE cross-border activity includes their exports and imports of goods and services. The current account will remain under pressure if FIEs import merchandise for production or distribution. If they begin to export, as is generally assumed for investments in the tradeable goods sector, and/or if they replace imported inputs by local products, the current account balance will improve. Even if the FDI-linked activities lead to foreign exchange deficits, such investments may still improve the BOP if they create externalities that enhance the export potential of the economy.

Although the net effect is often assumed to be positive, it can well be negative in practice, says the ECE. It cites the case of Malaysia where the data available permit evaluation of the direct BOP impact of FDI, and this has been assessed in UNCTAD’s 1999 Trade and Development Report. The ECE notes the positive trade balance of Malaysian FIEs in the late 1980s, due to strong export growth, the negative balance that then developed in view of the import-intensivity of the exports, with outflows on current account being balanced by inflows of FDI on capital account.

“But the cumulative impact during the whole period was negative,” the ECE notes and adds that there are indications from other parts of the world that the negative trade impact of FDI is not unique to Malaysia - citing in this regard the cases of Thailand and the Mercosur countries, and of Austria, where the merchandise trade deficit of resident FIEs has been persistently negative during 1990-1997.

“The case of Austria is interesting,” the ECE comments, “since it is a developed country where FIEs may be expected to establish linkages with local suppliers, reduce dependence on imported intermediate inputs and generate a trade surplus.”

The ECE cites also the cases of Hungary and Azerbaijan among the transition economies, where the FIE have had a positive trade balance impact, but says that both are atypical.

Citing studies on developing country experiences, which claim a statistical relationship between FDI flows and growth in host economies, the ECE report outlines both the positive and negative spillovers in these.

The studies show, according to the ECE, that:

·        one study showed that FDI stimulated long-term expansion of per capita GDP, by bringing in productivity higher than in domestic investment, but that this occurred only when the host country has a minimum of human capital. And in these cases, every 1% increase in FDI-GDP ratio has been associated with 0.4-0.7 percent rise in long-term GDP per capita growth.

·        a second study showed that FDI had stimulated long-run growth of China, Indonesia, Hong Kong, Japan and Taiwan, but had no such relation in South Korea and the Philippines.

·        a third study of 18 countries of Asia and Latin America found most pronounced positive impact on domestic savings and economic growth - less in Asia than in Latin America, because domestic savings play a larger role in Asia than in Latin America.

[But a study by Chilean economist Agosin showed that a positive impact, $1 dollar of FDI resulting in more than a dollar of domestic capital accumulation, has been much less conclusive in Latin America].

As for positive spillovers of FDI, ECE says that data from developing countries provide little or no empirical support for positive productivity spillover effects, and even some negative effects on the local economy as a whole. Studies of positive spillovers (in Morocco and Indonesia) seem to be industry specific, and related to low- level technology as in Morocco or export-oriented as in Indonesia. There is also evidence that the presence of US TNCs in Europe did not result in significant productivity spillovers. An analysis of UK also showed that presence of foreign firms did not lead to wage and productivity spillovers.

There is also little evidence of productivity spillovers in eastern Europe, the ECE adds.

As for technology transfer, the ECE concludes that there may be alternative paths to diffusion of technology to domestic firms. International trade can be an important source of R&D spillovers, the ECE adds. – SUNS4893

The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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