July 25, 2011Doug Hadden
Carlos Lipari, FreeBalance Washington
This is a blog series discussing factors that impact development in developing countries. As a For Profit Social Enterprise (FOPSE), improving country growth through good governance is the core company mandate at FreeBalance. As such, FreeBalance participates in governance, development, foreign aid, ICT for development and transparency discussions globally.
In the previous section, we discussed about how important investment is for the economic growth of a nation and, therefore, for its development. It is of upmost importance, though, to understand that in order to have a sustainable economic growth, countries need to produce savings. In developing countries this issue gains greater importance because low incomes make it particularly difficult to save, which can easily produce vicious cycles of poverty.
Evidence has been found that in pretty much all economies there is a strong correlation between internal savings and investment (Marianne Baxter and Mario J. Crucini 1993). In normal circumstances, investors tend to be more risk averse to investing abroad than then they are when it comes to investing in their own country and borrowing from foreign countries is usually a limited option. Therefore, even in a context of very open economy, one can expect to find a strong correlation between gross savings and Investment, with most of the savings being invested in the domestic economy.
In the following graph, we can see how investment, gross savings and current account deficits have changed in the US over the last decades. Savings are presented as gross savings.
Note: By gross savings, the International Monetary Fund (IMF) refers to the overall savings of an economy before subtracting depreciations. Investment, for the same reason, could be referred to as gross investment.
The Case of the United States
The US is a nice example of how investment and savings tend to move in line. One should not expect perfect correlation in an open market because external financing is available but a strong correlation still holds.
As we can see in the graph above, savings have declined severely in the US over the last 30 years, from almost 20% of the GDP in the beginning of the 80s to little more than 10% in recent years. This decrease translated into lower investment rates despite larger current account deficits used to finance some of its national investment.
Some Lessons Learned
Borrowing money from abroad has its costs, with interests paid on foreign loans reducing the amount of cash available to benefit from future investment opportunities but, as mentioned before, access to external financing has also its restrictions and running deficits for a long period of time has its risks. As external debt increases, foreign lenders might start demanding higher risk premiums for the money they borrow and when this happens, often, this interest rate increase occurs too quickly for an economy to properly adjust itself without falling into a recession. Also, these risks tend to be higher among poor and underdeveloped economies, as they tend to be weaker to resist speculation movements against their currency and economy, Due to this, developing countries should be careful enough to have a high level of savings and avoid running large external deficits for a long period of time.
The Case of China
If the US runs large external deficits and low savings, China does the extreme opposite. In fact, when it comes to savings, China is a unique case within large economies. China saves most of its GDP. In 1982, savings were representing slightly more than one third of its GDP, an impressive figure itself, but since then they were increased to 54%. Also in China, savings and investment move in line.
In net terms, about 90% of Chinese gross savings are invested in the Chinese market. Investment itself represents almost half of the country’s GDP. Only a relatively small fraction of this volume of gross savings is actually been invested abroad but the size of this economy and its huge savings rate have contributed, indirectly, to generate large trade deficits in developed countries and the US is particular. In fact, this has led many economists to recommend China to increase private consumption and explains why so much pressure has been done to force China to increase the value of its currency and, by doing this, saving less and buying more American products.
The Case of Portugal
In Portugal, gross savings have dropped massively from 28.4 % of the GDP in 1990 to 8.9% in 2010. This has led investment to fall considerably and the country to finance its investments via higher current account deficits. Current account deficits increased indebting the country beyond reasonable levels. One fundamental reason why this country could allow itself to maintain high external deficits for such a long period of time had to do with the fact that it had joined the euro currency, therefore facing lower exchange rate, inflation and interest rate risks. Following the recent financial crises, investors have become more averse to credit risk and this together with recent developments in the EU involving the Greek and Irish sovereign debt crises is forcing Portugal to take action to rapidly reduce its budgetary and external deficits, while also increasing gross savings.
Note: In brief, the most recent bailout to Portugal can be pointed out as a consequence of the combination of high levels of public and external deficits and debt, together with low investment and gross savings rates and marginal economic growth, leaving this country, for too long, vulnerable to speculators.
The Case of South Korea
Also in South Korea, Investment and Savings tend to move in the same direction and the ability to finance investment, and therefore growth, with foreign capital is very limited. Prior to 1997, the existing currency indexation against the dollar resulted in greater volatility of the current account balance. This volatility translated into a lower correlation between changes in gross savings and investment rates but, following the 1997 Asian crises, the currency has started to float, producing more balanced current accounts and a greater correlation between investment and gross savings.