Is India investment constrained or saving constrained?

I think this is a fantastic research paper to attempt in Indian conditions.

Those who read this blog and Rodrik’s blog would know what to expect. This time he lends some support for his feelings for financial globalisation- It isn’t as good as it is promised.  His earlier paper which is often referred to in research papers is here.

This is an excellent paper and helps you think about these problems from a developing economy front. I am sure his upbringing in Turkey helps him think about the issues in a more realistic manner. As a result, he is radical and different.

This time he has something different to say on financial globalisation. The economists usually have heaps of praise for financial globalisation and how foreign savings can be useful for pumping growth in an economy.

But so far the evidence is at best mixed and this surprises the economists (not surprising though). This has led to variety of responses from the surprised economists – data is not right, looking at wrong side of the problem and finally financial globalisation has led to number of indirect benefits – better institutions, financial development etc.

Rodrik reviews all these arguments and says he doesn’t really agree. If the benefits exist it should show. Further, Rodrik points out a different framework for analysing the problem.

He says the research clubs the developing countries as one and analyses whether it has worked or not. Where as most developing countries are in two traps:

1) Saving constrained (SC): in a saving-constrained economy, real interest rates will be high, borrowers will be chasing after lenders, and any (exogenous) increase in resource transfers from abroad will finance mainly investment rather than consumption. If you ask entrepreneurs what they would invest in if you gave them $50 million, you would hear in response a long list of projects.

2) Investment constrained (IC): In economies constrained by investment-demand, by contrast, real interest rates will be low, banks will be sitting on top of mountains of liquidity, and it will be lenders who are running after borrowers. When you query entrepreneurs about investment ideas in such economies, your question will be met by a long silence, followed by the riposte: “do I have to invest the $50 million here?” Any resource windfall will be eaten up by consumption rather than investment.

The paper then goes on to discuss how the 2 economies are different. In an SC the problem is not as much

In a saving-constrained economy, capital-account liberalization works in the conventional fashion: a reduction in domestic interest rates and the increase in the availability of external finance spurs domestic investment, as firms travel down their investment demand schedule. Consumers meanwhile face a change in intertemporal relative prices, inducing them to consumer more and save less. The increase in domestic investment and reduction in saving are financed by capital inflows. The economy grows more rapidly as a consequence of the boost to investment. This is the standard textbook story on capital-account liberalization.

The problems are in an IC:

But in an investment-constrained economy, the investment demand schedule is vertical, so the effect of liberalization is purely to boost consumption. Investment is unaffected because the equilibrium level of investment is determined primarily by the perceived returns, which are presumed to be low. Foreign savings simply substitute for domestic savings, with no net effect on investment or growth.

Further, the capital inflows appreciates the currency in an IC and this excarberates the problem.

Actually IMF has also shown in its research that the investment rates in the world have been lower than previous highs and what was perceived as a saving glut was actually a investment deficit. So, we need to apply the Rodrik framework in other devloping economies to understand whether capital flows can be helpful or not.

What about India?

I have shown in this paper that it is a bit of both. Earlier it was SC and capital inflows led to higher growth. But over a period of time investment opportunities declined and it became IC. With capital inflows continuing,it led to appreciation of the rupee, leading to number of problems (sterlization, inflation) for the supervisors of the economy.

This leads to a question- how come the equity markets continued to rise? (data available in my research is till 2005-06). My best guess is that the industry was busy making profits from speculating in financial markets, commodities, exchange rates etc (Classified as other incomes in the balance sheets). All this now seems to be coming to an end and we keep hearing about some or the other organisation having derivative position going wrong.