A catch-22 situation

Pakistanis need to adopt the culture of savings to induce investment
By Hussain H Zaidi
During the last five years, Pakistan's economy has grown on average by 7 percent. The key to sustaining that high growth rate is to increase the level of savings and investment, which, as we shall see later in the article, is well below the desired level. Investment or capital formation has a two-fold role in the economy. In the short-run, it affects aggregate demand and, thus, output and employment. Investment is a component of the aggregate demand or total spending in the economy; increase in investment steps up total spending and, thus, raises the level of output and employment in the economy.
In the long-run, investment affects gross domestic product (GDP) growth. A country's rate of growth depends largely on how much it sacrifices present consumption to provide for production of capital goods. Investment is, in fact, the engine of growth. The spectacular economic performance of East Asian countries can mainly be attributed to their high investment-GDP ratio. Conversely, deficiency of capital or low investment-GDP ratio is the major failing of most of the developing countries.
Saving is the difference between disposable income -- income minus taxes -- and consumption. It depends on various factors, the most important of which is income. All said and done, saving is a luxury, which increases as income goes up. The poor do not save; rather, they dis-save by borrowing. The same goes for poor countries, which are caught in the debt trap because of low level of national income.
Investment depends on several factors, such as savings, costs, revenues and future expectations. However, savings is the most important factor underlying investment. In the case of developing countries, investment falls below the desired level, mainly because of low savings. Though a necessary condition for investment, savings in themselves are not enough to induce investment.
As a matter of principle, businesses undertake investment when expected revenues are greater than estimated costs. Costs depend on interest rates, price of inputs and corporate taxes. Revenue expectations are based on an estimate of the level of demand for the output. In case there is deficiency of potential demand for their goods or services, businesses shy away from investment. As in the case of savings, the key determinant of demand is income.
Again, in the case of developing countries, since per capita income tends to be low, demand is deficient, which restricts investment. In fact, developing countries are in a catch-22 situation. Low per capita income restricts capital formation and output, which is responsible for unemployment and underemployment. The higher the level of unemployment, the lower the level of per capita income. Increase in per capita income is, thus, essential for growth and development.
A number of instruments are available to the government to affect investment level in the economy. These include monetary, fiscal, trade and investment policies. Monetary policy pertains to money supply and credit conditions in the economy. Fall in money supply and increase in interest rates raise the cost of doing business and, thus, discourage investment. Conversely, fall in interest rates decreases the cost of doing business and encourages investment.
Fiscal policy deals with government revenue and spending. While higher corporate taxes are a drag on investment, higher government spending can both push up and push down the level of investment. When demand is depressed and corporate profits are low, the private sector cannot be counted upon to step up investment; the job has to be performed by the government. By borrowing, the government generates the funds necessary for development expenditure. Government investment increases demand for business goods and services, and businesses respond by increasing output for which they hire additional labour. The income earned by the workers is partly consumed, partly saved, which adds to both demand and savings.
Public spending can also help develop the right infrastructure necessary for encouraging the private sector to invest. Increase in government spending or an expansionary fiscal policy is not without its problems. In the first place, if increase in government spending is not accompanied by increase in government revenue, it creates public debt. In the second place, if increase in government spending is not accompanied by proportionate increase in real GDP, it creates inflation. In the third pace, higher public spending may put upward pressure on the interest rates and, thus, crowd out private sector investment.
A liberal trade policy helps businesses have access to cheaper intermediate goods -- machinery and raw materials -- and, thus, bring down the cost of inputs. A liberal investment policy, such as tax breaks and de-regulation of the economy, decreases the cost of doing business and, thus, encourages investment. It is also important that the government creates a stable political and economic environment to enhance business confidence. Having outlined the importance of savings and investment in an economy, and the factors hindering and promoting them, let us have a look at the level of savings and investment in the Pakistani economy:
Generally, increase in GDP is accompanied by increase in savings-GDP and investment-GDP ratio. However, Pakistan is a different story. In 2000-01, the economy grew at a meager rate of 1.8 percent, while investment-GDP and savings-GDP ratios were fairly reasonable at 17.2 and 16.5 percent, respectively. In 2001-02, the economic growth increased to 3.1 percent, whereas investment-GDP ratio came down to 16.8 percent. Savings-GDP ratio, however, went up to 18.6 percent. In 2002-03, GDP growth increased to 4.8 percent accompanied by increase in both investment-GDP and savings-GDP ratios to 17.2 percent and 20.8 percent, respectively.
In 2003-04, the economy grew at an impressive rate of 7.5 percent; however, both investment-GDP and savings GDP ratios fell to 16.6 percent and 18.7 percent, respectively. GDP growth rate shot up to 8.6 percent in 2004-05. Though investment-GDP ratio increased to 18.1 percent, savings-GDP ratio fell to 15.1 percent. The year 2005-06 saw GDP growth decelerate to 6.6 percent; however, both investment-GDP and savings-GDP ratios went up by 20.0 percent and 16.4 percent, respectively. In 2006-07, the economy grew at 7 percent accompanied by increase in both investment-GDP and savings-GDP ratios to 22.9 percent and 17.8 percent, respectively. The year 2007-08 again saw GDP growth decelerate to 5.8 percent with fall in both investment-GDP and savings-GDP ratios to 21.6 percent and 13.9 percent, respectively.
The major reason for low level of savings and the resultant low level of investment is the low level of per capita income. Though per capita income in Pakistan has, according to official statistics, increased to $1,045 from $655 in 2004, the increase is nominal rather than real – thanks to a high inflation rate, which increased from 4.6 percent in 2003-04 to 12 percent in 2007-08. During the first nine months of the current fiscal year (July 2008-March 2009), average inflation was 24 percent, which is projected to be around 20 percent for the whole 2008-09. Other major causes of high consumption and, thus, low savings are consumer financing and proliferation of credit cards.
The government is adopting various measures to step up investment, such as rationalisation of tariffs, improvement in the tax refund process, removal of procedural bottlenecks, review of tax laws and tax machinery, provision of an efficient and reformed banking sector, improved governance, and effective contract enforcement. While all these measures are important, the level of savings and investment cannot be enhanced to a desirable level without an increase in the real per capita income. This requires, on the one hand, containing inflation and, on the other, developing human resource by increasing spending on heath and education.