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.


5 Responses to “Is India investment constrained or saving constrained?”

  1. Avid reader Says:

    Hi I read your paper. It was very enlightening. I have never seen such a data-rich study of the investment cycle in India. I do not have a background in economics but I was able to grasp the points.

    About your suggestions and conclusions, I am not sure if it is prudent encourage people to invest/speculate in riskier assets. Ordinary people are not in general savvy investors. They will end up losing their savings and lose trust in the financial system. This in turn might lead to social problems.

    A lack of trust in the system in general is a big problem. I recently read that Indians are the people buying up huge amounts of gold. Part of the reason is our affinity for the metal but another big reason is that people have learnt the habit of saving for a rainy day and keeping their savings hidden from the state (and thus the world.) This may have to do with the difficulties our ancestors faced under colonialism and occupations. Changing these deep-rooted cultural notions might be difficult and moving people to risky assets may be counterproductive in the long run as people would clam up even more from their bad experiences.

    One of the ways in which countries like Korea and Taiwan (and now arguably China) have developed is to take the relatively safe savings of ordinary people, pay them sub-par returns and directly lend out the capital at reduced costs to the private sector. This is in a way a transfer of savings. They were applied under what were dictatorships and are not advisable or even possible in India.

    I really don’t have any suggestions for policy remedies except maybe to find a way to harness the hidden savings (in gold, land etc) in financial instruments than be then deployed into investments.

    I think the fact that India oscillates between Saving Constrained and Investment Constrained means that it runs near equilibrium. Am I wrong in assuming that and being happy about it? Will this make RBI’s life easier with no need for letting the rupee rise? If the trend continues, will it mean that the Indian economy will slow down?

    Thanks for the paper

  2. Avid reader Says:

    Oops that was much too long for a comment.

  3. Amol Agrawal Says:

    Hi Avid Reader/Hmm But,

    I thought Avid reader is different but the email id told me they are the same people. I don’t think it matters if you share your name on the web. It hardly matters.

    Anyways, thanks for the comments. I am with you on the fact that it is not right to let poor invest in risky assets. Infact I show how vulnerable they are and invest as index rises and vice-versa whereas finance theories would suggest the opposite. So we need fianncial literacy. But in a country where you do not have basic literacy, financial lietracy is far-off.

    The government did try and convert the gold into financial assets by asking people to depsoite their gold and get interest.

    I dont think we have been near equilibirium. The present capital flows have been so much that we have become an IC and this is posing numerous problems for RBI.

  4. Raghuram Rajan Committee on Financial Sector reforms « Mostly Economics Says:

    […] I am disappointed as there is hardly any empirical evidence. Why can’t the committee add empirical evidence on the Indian experience. (I have some basic idea on capital flows based on Rodrik’s paper here). […]

  5. Capital flows in India: Are they really good? « Mostly Economics Says:

    […] I have written a paper applying the Rodrik-Subramaniam framework on India. I had mentioned in a post earlier on the new framework proposed by the duo. I expanded on the thoughts and put it together on […]

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