July 19, 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.
As mentioned in a previous post, economic growth is highly correlated with development. Even though growth by itself does not ensure development, we can hardly have any sustainable development without long term economic growth.
One fundamental variable of economic growth is investment. This is so because investment determines the long term production capacity of an economy and by that it induces economic growth. Economic growth can also impact investment, especially in the short run, since it increases overall demand and further need for production capacity.
Having said this, short run increases or decreases on the rate of economic growth will tend to be followed by an increase/decrease of the level of investment but in the long run, the ability to sustain growth will depend on the volume of investment accumulated during previous years. Therefore, a country that reduces its levels of investment in percentage of its GDP will tend to reduce the potential growth of its economy by limiting its production capacity. Lower production capacity tends to translate in lower growth in future years.
The Case of the United States
Over the last 30 years, US investment and growth have had a strong correlation. Levels of investment have diminished slightly from an average of more than 20% of the GDP in the 80s to about 17% in 2012. This continuous decrease was partially offset during the 1997-2000 dotcom bubble and the 2003-2006 Real Estate bubble but the overall trend is negative. At the same, we see that the economic growth trend of the American economy following closely the one of the investment.
We should not assume that the ratio of investment per unit of output will remain completely constant over time but since the US is a mature developed economy, these changes tend to be more gradual. Fast changes tend to occur within fast growing developing countries.
The Case of China
Higher income, everything else constant, requires higher capital intensity, which means that in order to sustain the same growth rates, countries have to invest a higher portion of their GDP.
China is a very good example of an economy that over these last decades has increased substantially its investment rate in order to sustain high economic growth rates.
With an average growth of roughly 10% over the last three decades, the Chinese have been increasing the amount of their GDP that goes to investment in a very impressive way. In fact, they are currently investing almost 50% of their income, whereas in 1982, investment represented slightly more than one third of their GDP.
The Case of South Korea
Korea is an example of an economy that grew a lot over the last 30 years, doing an impressive transition from an emerging to a highly developed country. As it converged towards more developed nation’s standards, its economy became more capital intense but investment rates in percentage of the GDP were kept pretty much the same. As expected, growth rates fell over time and today, its economic growth rate comes much closer to the American one.
The Case of Portugal
Portugal is a good example of how a country extinguishes it growth ability by over consuming its GDP.
Right after joining the European Union (former European Economic Community) in 1986, Portugal was investing approximately 30% of its GDP and grew, from 1987 to 1990, at a yearly average rate of approximately 7%. Since the beginning of the 90s, investment started to fall, with economic growth following the same trend. With the exception of the 1996-2000 period, when investment rose up to 28.2% of the GDP, mostly due to the impact of lower nominal interest rates on consumption and construction, creating the late 90s Portuguese construction bubble and making Portugal, temporarily, the fourth largest investor of the OECD, the overall investment trend, though, is clearly negative.
The Portuguese investment rate fell dramatically over the last 20 years. As a matter of fact, Portugal is expected to become, after Greece and Ireland, one of the countries with the lowest investment rates in proportion of its GDP in the entire industrialized world. Not surprisingly, the IMF also expects this country to register one of the lowest economic growth rates in World in the years to come.
Certainly, investing more does not necessarily conduce to more growth, but it tends to do so and without investment, as mentioned before, there cannot be long term growth
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