- Resource Mobilization, Financial Liberalization, and Investment: The Case of Some African Countries Mohammed Nureldin Hussain, Nadir Mohammed and Elwathig M. Kameir Introduction The role of interest rate in the determination of investment and, hence economic growth, has been a matter of controversy over a long period of time. Yet, what constitutes an appropriate interest rate policy still remains to be a puzzling question. Until the early 1970s, the main line of argument was that because the interest rate represents the cost of capital, low interest rates will encourage the acquisition of physical capital (investment) and promotes economic growth. Thus, during that era, the policy of low real interest rate was adopted by many countries including the developing countries of Africa. This position was, however, challenged by what is now known as the orthodox financial liberalization theory. The orthodox approach to financial liberalization (McKinnon-Kapur and the broader McKinnon-Shaw hypothesis) suggests that high positive real interest rates will encourage saving. This will lead, in turn, to more investment and economic growth, on the classical assumption that prior saving is necessary for investment. The orthodox approach brought into focus not only the relationship between investment and real interest rate, but also the relationship between the real interest rate and saving. It is argued that financial repression which is often associated with negative real deposit rates leads to the withdrawal of funds from the banking sector. The reduction in credit availability, it is argued, would reduce actual investment and hinders growth. Because of this complementarity between saving and investment, the basic teaching of the orthodox approach is to free deposit rates. Positive real interest
- rates will encourage saving; and the increased liabilities of the banking system will oblige financial institutions to lend more resources for productive investment in a more efficient way. Higher loan rates, which follow higher deposits rates, will also discourage investment in low-yielding projects and raise the productivity of investment. This orthodox view became highly influential in the design of IMF – World Bank financial liberalization programmes which were implemented by many African countries under the umbrella of structural adjustment programs. The purpose of this chapter is to provide a theoretical and empirical examination of the question of resource mobilization in the context of African countries as envisaged by the theory of financial liberalization. The chapter begins by developing the conceptual framework for the whole study. This involves the examination of the theory of financial liberalization, and the development of an analytical framework which exposes the theory and its critique. The chapter concentrates on examining the empirical relationship between the real interest rate, saving and investment. It draws a distinction between total saving and financial saving and estimates separate functions with special emphasis on the role of the real interest rate in the determination of each category of saving. For the relationship between the real interest rate and investment, this section employs a 3-equation investment model which tests for the effect of below equilibrium and above equilibrium interest rates on investment. The model also allows the calculation of the net effect of the real interest rate on investment after taking into account the effect of the real interest rate on the provision of credit and the cost of investment. Resource Mobilization and Financial Liberalization Resource Mobilization and Financial liberalization: A Conceptual Framework
- The accumulation of capital stock through sustained investment is indispensable for the process of economic growth. In a closed economy, investment itself can only be financed from domestic saving. Because the acts of saving and investing are usually conducted by different people, the financial sector is entrusted with the functions of channeling resources from savers to investors. The relationships between domestic saving and economic growth can be examined through the Harrod-Domar Result: g = p(S/Y) = p(I/Y) (1) where g is the rate of growth of real output, p is the productivity of capital and (S/Y) is the ratio of total domestic saving to income which, in equilibrium, is equal to the ratio of investment to income (I/Y). Accordingly, given the productivity of capital, the growth rate should increase the higher the ratio of saving (investment) to income. Conversely, if the ratio of saving (investment) to income is given, the growth rate can be increased by improving the efficiency of investment which will raise the productivity of capital (p). To do this, it is necessary to promote investment that support efficient production in sectors where rapid growth in effective demand can be expected (Okuda 1990). The orthodox approach to financial liberalization suggests that, financial liberalization will both increase saving and improve the efficiency of investment (Shaw 1973). By eliminating controls on interest rates, credit ceilings and direct credit allocation, financial liberalization is said to lead to the establishment of positive interest rates on deposit loans. This, in turn, is said to make both savers and investors appreciate the true scarcity price of capital, leading to a reduced dispersion in profits rates among different economic sectors, improved allocative efficiency and higher output growth (Villanueva & Mirakhor 1990).
- Figure (1) provides a diagrammatic illustration of the theory backing financial liberalization programs. The figure exhibits the behavior of savings (S) and investment (I) in relation to the real rate of interest (r). The savings schedule slopes upwards from left to right on the (classical) assumption that the rate of interest is the reward for foregoing present consumption. The investment schedule slopes downwards from left to right because it is assumed that the returns to investment decreases as the quantity of investment increases, which means that a lower real rate of interest is therefore necessary to induce more investment as the marginal return to investment falls. If the interest rate is allowed to move freely (i.e., no interest rate controls), the equilibrium rate of interest would be r* and the level of saving and investment would be at I*. If the monetary authorities impose a ceiling on the nominal saving deposit rate, this will give a real interest rate of, say, r1. If this rate is also applicable for loans,1 saving will fall to S1 and investment will be constrained by the availability of saving to I1. At r1 the unsatisfied demand for investment is equal to AB. According to the financial liberalization theory, this will have negative effects on both the quantity and the quality of investment. That is, credit will have to be rationed, consequently many profitable projects will not be financed. There will also be a tendency for the banks to finance less risky projects, with a lower rate of return, than projects with a higher rate of return but with more risk attached. If the ceiling on interest rate is relaxed, so that the real interest rate increases to r3, saving will increase from I1 to I3, and the efficiency of investment also increases because banks are now financing projects with higher expected returns. Unsatisfied investment demand has fallen to A1B1 and credit rationing is reduced. It is argued that savings will be «optimal» and credit rationing will disappear, when the market is fully liberalized and the real rate of interest is at r*.
- Although it appears convincing, the financial liberalization theory suffers from major shortcomings. As it has been argued by Warman & Thirlwall (1994), the financial liberalization theory makes no clear distinction between financial saving and total saving. To be sure, the saving symbol which appears in equation 0) stands for total saving and not financial saving. The relationships suggested by the Harrod-Domer result, between saving, investment and growth, are complicated by the fact that a significant portion of domestic saving may be held in the form of real assets (e.g., real estate, gold and livestock), exported abroad in the form of capital flight, or claimed by informal markets such as the informal credit market, the underground economy and the black market for foreign exchange. The fact that financial saving is only one form of saving, raises many important issues regarding the theory of financial liberalization. In what follows, a simple conceptual framework is developed to restructure the debate on financial liberalization and to articulate the arguments against the financial liberalization theory. It puts into focus some of the worries, criticisms and limitations of the financial liberalization theory which are important to bear in mind when evaluating the implementation of policies in the context of African countries. Total Saving, Financial Saving, and the Leakage The flow of total national saving can be decomposed into public saving and private (household and enterprise) saving: ST = SG + SP (2) Where ST, SG and SP are total, public, and private savings respectively. The flow of private saving can be divided into two major components: private financial saving which comprise the portion of private saving that is kept in the form of financial assets in the formal financial sector (FP) and private saving residue which
- comprises the portion of private saving which is kept in non-financial forms or put into other uses (L). That is: SP = FP + L (3) Substituting equation (3) into (2), we get: ST = SG + FP + L (4) The flow of total financial saving (FT) comprise public financial saving (FG) and private financial saving (FP). That is: FT = FP + FG (5) On the assumption that all government saving is kept in the form of financial assets (so that FG = SG) and substituting equation (5) in (4), and rearranging we have: L = ST — (FG + FP) (6) and, FT = ST – L (7) Dividing equation (6) by ST, we obtain: FT/ST = 1 – s (8) Where, s = L/ST, which measures the proportion of total saving that is leaked out of, or not captured by the formal financial sector. If equations (6), (7) and (8) are expressed in stock rather than flow terms, they can be interpreted as giving the condition for the case of what can be called full financial deepening where the whole stock of total saving is kept in financial forms and the leakage, L, is zero.
- The degree of financial deepening at any point in time, can be measured by equation (8), where the smaller, s, the higher will be the degree of financial deepening. The equations can also be used to clarify the confusion in the literature between total saving and financial saving. Total saving and financial saving are identical only in the case of a zero leakage (i.e., L=0). In their flow forms the equations can be interpreted as giving the ‘dynamics’ of the process of financial deepening. The case of a zero leakage with L = s = 0, corresponds to what can be called full financial augmentation where all the additions to total saving are kept in the form of financial vessels (so that ST = FG + FP in equation (6) and FT/ST=1 in equation (8)). A reduction in the leakage (i.e., s L0) implies an increase in the process of financial shallowing. The equations also illustrate the important result that even though total saving might be stagnant (i.e., s ST=0) financial saving can increase if sL
- is stagnant (i.e., s ST=0), financial saving can still increase — keeping other things constant — by reducing the stock of saving which is kept in real assets (i.e., sR
- positive increases in working capital and output. This depends on which component of the leakage is reduced and on whether the reduced component will cause an offsetting reduction in output. Two basic reasons (assumptions) are usually given to explain the position of the new structuralist: first, the intermediation of the informal credit market is said to be complete while that of the formal market is not and; second, the informal credit market is assumed to support equally productive and efficient activities, while the other components of the leakage do not. As for the first reason, the funds in the informal market are said to be transmitted, in full, to production entities with no holding of reserves, while in the formal sector the transmission is less than full. The required reserve ratio and the holding of excess reserves constitute another leakage in the flow of funds between savers and investors. This can be illustrated by assuming that financial savings are equal to bank time deposits. The relationship between financial saving and the supply of bank loans may be written as: BC = (1 – T) FT (10) where BC is the supply of bank loans, T is the required and excess reserves ratio held by banks and FT is financial saving. Thus, while reductions in any of the components of the leakage in equation (9), keeping all other parameters constant, will bring about an equal increase in financial saving, the supply of bank loans will not increase by the same amount because of the leakage caused by banks’ holdings of reserves. As for the second reason, according to Van Wijnbergen’s (1983) new structuralist model, if the increase in financial saving occurs through the reduction in hoarded cash balances [-H in equation (9)] and other intrinsic unproductive assets, then it will have a positive effect on output. If, however, it is at the cost of informal credit market (-N) it will lead to a fall in total private sector credit, working capital and output. The loss of informal sector credit without an equal compensating increase
- in formal sector lending, is said to bid up the informal sector lending rate and reduce net working capital causing a decline in output. The new structuralist argument rests, therefore, on the contentions that the intermediation of the formal sector is not full and that informal sector resources, and not the other components of the leakage in equation (9), are likely to be the closest substitute for time deposits. However, it has been argued by Serieux (1993), that less than full intermediation can only occur if we assume away the money creation capacity of banks. That is, most informal sector loans are essentially cash loans. It follows that a shift from informal sector resources to bank resources would imply a surrender of cash to the formal banking sector. This, will increase banks’ reserves and hence their credit creation capacity. Accordingly, bank intermediation might be complete or even multiplicative. Also, an increase in bank deposit rates, may lead to shifts among the components of the leakage such that the available informal credit remains intact. The Real Interest Rate and the Determinants of Saving and Investment in Africa As outlined in the conceptual framework, the financial liberalization theory, is based crucially on three postulates concerning the relationship between the real interest rate, saving and investment: 1. that saving is positively related to the real rate of interest; 2. that investment is determined by prior saving; and 3. that the effect of the real rate of interest on investment will depend on whether the real interest rate is below or above the equilibrium rate.
- Although the financial liberalization theory places more emphasis on the desirable effects of raising the real interest rate towards equilibrium, it also postulates that the impact of the change in the real interest rate on investment depends on whether the actual interest rate is below or above equilibrium. Below the equilibrium interest rate, investment is constrained by saving. An increase in the real interest rate towards equilibrium, will increase saving and investment. Hence, as long as the equilibrium interest rate is not reached, investment is positively related to the real interest rate (see Figure 1). Beyond this equilibrium, an increase in real interest rate will have a negative effect on investment as the economy moves along the negatively-sloped investment demand curve. The relationship between the real interest rate and investment as postulated by the financial liberalization theory is depicted by Figure (2). Against this theory which is based on classical notions, we have the Keynesian framework which postulates that saving is positively related to income and investment is negatively related to the price of credit for which the interest rate stands as a proxy. However, the proponents of this Keynesian view concede that the real interest rate might also have a positive effect on investment through the provision of credit. That is, as financial saving and the rate of interest are positively related, interest rate may also have a positive effect on investment through the process of financial deepening and the provision of credit to the private sector (Warman & Thirlwall 1994). Thus the net effect of the real interest rate on investment will depend on the relative strength of its negative effect through the cost of investment and its positive effect through the provision of credit. In what follows, we discuss the empirical models that we are going to use to examine the validity of the postulates of the financial liberalization theory. Total Saving and Financial Saving: Empirical Models
- The financial liberalization theory postulates that saving is positively related to the real interest rate. The theory, however, does not make clear distinction between total savings and financial saving. Total domestic saving consists of private and public savings of which financial savings is a part. While financial saving is the portion of total saving that is channeled through financial assets which comprise short and long-term banking instruments, non-bank financial instruments such as treasury bills and other government bonds and commercial paper. It is prudent, therefore, to examine the role of the real interest rate in the determination of both total saving and financial saving. To this end, the following two equations for total saving and financial saving are specified: TS = s0 + s1 + s2Y (12) FS = T 0 + T 1+ T 2 Y + T 3 (C/M1) (13) It is hypothesized that, total real domestic saving (TS is a function of real income (Y) and the real interest rate (r). It is expected that total saving is positively related to real income (Y). Whether the total saving is positively or negatively related to the real interest rate, will depend on the relative strength of the income and substitution effects of changes in the rate of interest [see Warman & Thirlwall (1994)]. The substitution effect of a higher interest rate is to encourage agents to sacrifice current consumption for future consumption, but the income effect is to discourage current saving by giving agents more income in the present, and the two effects may cancel each other out. As saving is a flow concept, financial saving is measured by the change in the stock of such financial assets. It is hypothesized that real financial saving (FS is positively related to real income (Y), and also positively related to the real rate of interest (r) as postulated by the financial liberalization theory. Also, because of the important role played by the informal credit market in many African countries, an
- attempt is made to capture its effect on formal financial saving. This is done by including as an independent variable, the ratio of currency outside banks to narrow money M1. The proportion of narrow money (M1) held as currency is commonly accepted as a measure of the size of the informal credit market (see Shaw 1973 and Serieux 1993), on the grounds that the higher this ratio the larger will be the size of the informal credit market. An Investment Model As it has been noted before, the financial liberalization theory suggests a differing effect of the real interest rate on investment, depending on whether the real interest rate is below or above the equilibrium rate. It is also noted that, on Keynesian grounds, the real interest rate might affect investment negatively through the cost of investment and positively through the provision of credit. The foregoing arguments suggest the use of a switching regime model which differentiate between the effect of above and below equilibrium real interest rates. They also suggest that attempts should be made to separate the positive and negative impact of the interest rate on investment. To this end, we use a switching investment model: I = a0 + a1BC + a2r+ a3 [(r-r*)D] + a4s Y (14) BC = O0 + O1FS (15) FS = T 0 + T 1r+ T2Y + T3 (C/M1) (16) where I is real gross fixed investment; r is the real interest rate; r* is the real equilibrium interest rate; Be is the supply of bank credit; D is the switching-point dummy variable which takes the value of zero when the interest rate is below equilibrium (i.e., r < r*) and the value of unity when the interest rate is above equilibrium; and s Y is the change in real income as a measure of the income
- accelerator effect on investment. Substituting equation (16) into equation (15) and the result in (14), and by totally differentiating equation (14) with respect to the real rate of interest and rearranging, the investment/interest rate (dI/dr) multiplier will be given as follows: dI/dr = a2 + a1T 1O1 + a3D (17) In the case where the interest rate is above the equilibrium with D=l, the negative effect of interest on investment is assumed to be at work and the effect of the real interest rate on investment will be given a2 + a1T 1O1 + a3. While below the equilibrium rate of interest, with D=0, the impact of a3 will disappear and there will remain only the impact measured by a2 + a1T 1O1. The product (a1 ?T 1 ?O1) represents the chain effect that goes from the real interest rate to investment, through the supply of credit. An increase in interest rate is expected to stimulate saving in financial forms (O1), which is expected to increase the supply of credit (T 1), which is expected, in turn, to increase investment (a1). The question of whether the final effect of interest rate on investment is negative or positive, depends on the relative magnitude of the parameters a2, a3, T 1, O1 and a1. Empirical Results: Saving Equations The saving equations (12) and (13) are estimated for 25 African countries over the period 1972–1992. A single equation OLS procedure is employed and in the case of the presence of autocorrelation in OLS estimates, a General Autoregressive and Moving Average Error Correction Process (GAMAECP), with a first-order autoregressive and/or first-order moving average is used. Different experiments with time lags on the real interest rate variable were conducted. Tables 11.1 and 11.2 give a summary of the results for the total saving and financial saving respectively.
- Table 11.1: Summary of the results of total domestic savings equation in 25 African countries, 1970–1992 Table 11.2. Summary of the results of the financial savings equation (FS) in 25 African countries, 1970–1992 It can be observed from Table (11.1) that of the 25 countries in the sample, the real interest rate has a positive impact on total saving in the case of 15 countries (60 percent of the total). The coefficient on the real interest rate is, however, positive and statistically significant, at the 10 percent level of confidence, in only 8 cases (32 percent of the total), these are Burkina Faso, Gabon, Mauritius, Nigeria, Swaziland, Zaire, Zambia, and Zimbabwe. This positive and significant relationship between the real interest rate and total saving, indicates that in the case of these countries the positive substitution effect of real interest rates outbalances the negative income effect. This also implies that, in the case of these countries, there is a strong substitution effect between present and future consumption. The real interest rate has a negative and significant effect on total saving in five cases (28 percent of the total). These are Benin, Côte d’Ivoire, South Africa, Togo, and Tunisia. Thus, in these five countries the implication with
- regard to the substitution and income effects is exactly the opposite to that of the eight cases above. In conformity with Keynesian theory, real income proved to be the most important determinant of saving. The coefficient on income has the expected positive sign in all cases with the exception of Tanzania, and it is positive and statistically significant in 18 cases. For some African countries (e.g., Ghana, Senegal, and Swaziland) the estimated propensity to save is very small not exceeding 0.01 for one unit of income. The largest propensities to save are recorded by Gabon (0.92) and Mali (0.61). In the majority of all the other countries, the estimated propensity to save ranges between 0.10 and 0.35. Contrary to expectations, the interest rate plays no significant role in the determination of financial saving (Table 11.2). The real interest rate and financial saving are positively related in 11 cases. However, this positive relationship is statistically significant in one case, Mauritius. The relationship between the real interest rate and financial saving is negative and significant in four cases, namely Tanzania, Tunisia, Zaire and Zimbabwe. Similarly, the impact of gross domestic income on financial savings is statistically insignificant in three quarters of the countries in the sample. It is positive and statistically significant in four cases (Kenya, Mali, Mauritius, and Togo) and negative and statistically significant in Gambia and Madagascar. The activities of the informal credit market as proxied by the ratio of currency outside banks to narrow money, proved to be the most important determinant of financial saving. The relationship between financial saving and (C/M1) ratio is negative in 18 cases. This indicates that as this ratio increases (indicating an increase in the activities of the informal credit market) financial saving decreases. This negative relationship between financial saving and the activities of the informal credit market is statistically significant in eight cases.
- These are Burkina Faso, Côte d’Ivoire, Ghana, Kenya, Mali, Mauritius, Morocco, and Nigeria. Thus, in so far as the relationship between the real interest rate and saving is concerned, these results give no strong support to the financial liberalization theory. The real interest rate does not playa significant role in the determination of neither financial saving nor total saving. Real income is found to be the most important determinant of total saving while the activities of the informal market is found to be the most important determinant of financial saving. Empirical Results: Investment Model The investment model [equations (14) to (16)] is estimated for the 25 African countries in the sample over the period 1971–1992. As in the case of saving equations, a single equation OLS procedure is employed correcting for the presence of autocorrelation through the use of a GAMAECP with a first-order autoregressive and/or a first-order moving average. All the annual data used in the estimation are obtained from World Bank World Tables with the exception of data on nominal interest rate which are obtained from the IMF International Financial Statistics. For the basic investment equation, a similar OLS procedure is used. Preliminary experiments have also shown that investment in some African countries is volatile during years of armed conflicts. To capture this effect, we include in the basic investment equation a War dummy which takes a value of zero in peace years and a value of unity in the years of armed conflicts.3 Since the equilibrium interest rate (r*) is unknown, it is necessary to search for the equilibrium rate which minimizes the sum of square residuals using a trial and error process. That is, different hypothetical values of the real rate of interest that range from +30 percent to -30 percent are initially assumed. Each value is used to calculate the switch variable on the assumption that it represents the equilibrium
- rate of interest. Each of these variables are then used, together with the other explanatory variables to estimate equation (3). The hypothetical real interest value that yields the estimate with the smallest sum of square residuals is considered as the true equilibrium real interest rate (see Rittenberg 1991). Table 11.3 shows the values of the real interest rate arrived at in each country’s case. The Table reveals that there is a large variations in real interest rate experienced by the African countries in the sample. In 12 countries, the estimated equilibrium real interest rate is positive ranging from a rate of 2.0 percent per annum in the case of Mauritius to a rate of 17 percent in Senegal. In 12 countries, it is negative ranging from a rate of -0.5 percent for Kenya, Gabon, Madagascar, and Zambia and a rate of -27.0 percent for Sierra Leone. This variation is evident even in countries with similar monetary arrangements such as the CFA Franc Zone. For instance, the estimated real interest rate for Côte d’Ivoire is negative amounting to about -7.5 percent, while in Burkina Faso it is positive amounting to 9.0 percent. Table 11.3. Equilibrium interest rates in 25 African countries, 1970–1992
- Table 11.4. Summary of the results of the basic investment (1) in 25 African countries, 1970–1992 It can also be observed that there is no apparent correlation between high inflation rates and negative equilibrium real interest rate. For instance, the equilibrium rate in Zaire ( a country with high inflation rates) is 3.0 percent while in Côte d’Ivoire (a country with low inflation rates) is -7.5 percent. The equilibrium interest rates in Table 11.3 are used to estimate the basic investment equation and the complete results are reported in Table 11.4. Table 11.5, provides a summary of these results and reveals that the supply of bank credit to the private sector is a very important determinant of investment. The coefficient on the supply of credit has the expected positive sign in 19 cases and it is positive and statistically significant in 16 cases. For most of these countries the size of this coefficient is large (in the cases of both elasticity and propensity estimates) indicating a large effect of changes in bank credit on investment. In the case of South Africa and Zimbabwe, for instance a one percent increase in the supply of credit leads to about 0.97 percent increase in investment. In Benin, Burkina Faso, and Côte d’Ivoire a one unit increase in bank credit leads to an increase in investment of about 5 to 7 units.
- However, in certain countries, namely, Gabon, Senegal, Tanzania, and Zaire, the coefficient on the supply of credit is negative and highly significant. Although this result is puzzling, but some “African” observations might help to resolve this puzzle. Because of macroeconomic instability, it is observed that in some African countries, investors opt to use the funds supplied by banks for the purchase of foreign exchange which is usually exported and deposited abroad (a form of capital flight) awaiting a large currency devaluation. After devaluation, part of the funds deposited abroad is imported and converted into domestic currency to repay the bank loan and the “profit” is kept abroad. Some investors simply default on the bank loan. If such an operation is in process for sometime and the level of investment is generally falling because of the very macroeconomic instability, it will not be surprising to find a negative and statistically significant relation between the supply of bank credit to the private sector and the level of investment. Demand factors as approximated by the income accelerator effect proved to be as important as the credit supply factor in the determination of investment. The impact of the change in income on investment is positive in 20 cases and it is positive and significant in 12 cases. However, the impact of real change in income is negative and statistically significant in Rwanda only. Out of the five countries affected by armed conflicts in the sample, the WAR dummy is negative and statistically significant in the case of Kenya and Rwanda. It is negative but not significant in the case of Zimbabwe, positive and statistically insignificant in the cases of Morocco and Tanzania. We turn now to the subject of primary interest to this study, namely, the effect of the real interest rate on investment. Table 11.5 shows that the effect of the real interest rate on investment has the expected positive sign in 13 cases (52 percent of the total) but it is positive and statistically significant in only 8 cases (32 percent of the total).