Why do Chinese save more than Americans? Why are economists urging China to increase its domestic consumption and turn the economy from an export oriented one to a domestic demand driven one? When does a nation over-consume and create a global imbalance like the way the US did during the consumption binge of the mid-1990s, and when does a nation's overall domestic consumption become so low that the long-term sustainability of its high growth begins to be doubted because of lack of domestic demand as is happening in China?
The savings rate is a key determinant of the overall economic growth of a country. Developed economies (read the US) generally tend to have a low savings rate while developing economies (read China and India) tend to have high savings rate. Because the developing economies need to invest in infrastructure and other capital intensive sectors to generate higher future growth, these economies tend to have a high savings rate. On the other hand, the developed economies already have key infrastructure and capital intensive businesses in place, so they generate future growth via current consumption.
However, this does not imply that all the developing economies have a high savings rate. Neither does it imply that all the developed economies have a high consumption rate. This also does not imply that a country necessarily needs a high savings rate to enable it to invest in infrastructure and capital intensive businesses as it can borrow from outside or attract foreign investments. However, because of the actual or perceived high credit risk, the developing countries generally fail to generate sufficient capital from outside sources and, sans adequate domestic savings, face resource constraints to invest in capital intensive sectors. Hence, for a developing economy, a high savings rate is a critical factor in determining future growth.
In the last decade, the average domestic savings rate in Nepal as a percentage of the total Gross Domestic Product (GDP) stood at a meagre 10 percent. In India, the average savings rate is around 30 percent. In fact, the average savings rate in India has increased from around 14 percent in the 1960s to around 30 percent in 2009. In a recent paper, Kaushik Basu, chief economic advisor to the government of India, identified the rising savings rate from the 1960s as one of the key enabling factors for higher economic growth in India. Similarly, in China, the average savings rate is around 40 percent. The average savings rate in China has been historically high and increased from around 30 percent in the 1970s to around 40 percent in 2009.
Advanced economies like the US and countries in the euro zone, however, have a much lower savings rate. Though there is no optimum savings rate per se, it has been empirically established that emerging and developing countries require high savings to mobilise capital towards productive sectors. With a high savings rate, there is enough capital for investment in productive sectors which propel the economy to a higher growth trajectory. Even in neoclassical growth theory, savings is a key component of long-run, steady state level of output per capita -- an economy with a high savings rate tends to become rich over a period of time compared to those with a low savings rate.
Why then do some economies have a higher savings rate than others? What makes an average person in India vis-à-vis Nepal save more of his personal income? Since it has been empirically established that the developing countries need a high savings rate, why do countries like Nepal consume more when saving for tomorrow can provide higher returns?
From a basic economic theory, a rational individual decides to save when the expected gain from the future payoff from current savings is higher than the utility from the current consumption. If the present value of the expected future payoff provides the agent higher benefits than the current consumption, he will decide to save. So the typical savings decision is an inter-temporal one and hinges on two important things: (1) Expected future payoff and (2) The discount rate used to calculate the present value of the future payoff.
A higher expected future payoff and a lower discount rate leads to higher savings. However, in the case of Nepal, both these factors make savings unfavourable. The expected future payoff is lower because of political instability and an unfriendly business climate. If the probability of getting killed or extorted tomorrow is higher, then the expected future payoff will be lower. Similarly, if the probability of business closures, shutdowns or labour strikes is higher, the expected future payoff will again be lower.
Likewise, the rate used to discount the expected future payoff is high in Nepal. The discount rate generally depends on a nominal interest rate adjusted for time period of the economy. Because of a high inflation rate, the discount rate has been on the higher side making savings less desirable. The discount rate is, to some extent, inversely related to the degree to which the general public perceives that the future will be prosperous and beneficial and trust other participants, especially the policymakers, in the economy to exercise economic prudence. Because of lack of economic prudence as well as perceived direction, or lack of it, of the economy, the discount rate has moved up making saving in Nepal unfavorable in the eyes of the average person.
The savings rate is a key determinant of the overall economic growth of a country. Developed economies (read the US) generally tend to have a low savings rate while developing economies (read China and India) tend to have high savings rate. Because the developing economies need to invest in infrastructure and other capital intensive sectors to generate higher future growth, these economies tend to have a high savings rate. On the other hand, the developed economies already have key infrastructure and capital intensive businesses in place, so they generate future growth via current consumption.
However, this does not imply that all the developing economies have a high savings rate. Neither does it imply that all the developed economies have a high consumption rate. This also does not imply that a country necessarily needs a high savings rate to enable it to invest in infrastructure and capital intensive businesses as it can borrow from outside or attract foreign investments. However, because of the actual or perceived high credit risk, the developing countries generally fail to generate sufficient capital from outside sources and, sans adequate domestic savings, face resource constraints to invest in capital intensive sectors. Hence, for a developing economy, a high savings rate is a critical factor in determining future growth.
In the last decade, the average domestic savings rate in Nepal as a percentage of the total Gross Domestic Product (GDP) stood at a meagre 10 percent. In India, the average savings rate is around 30 percent. In fact, the average savings rate in India has increased from around 14 percent in the 1960s to around 30 percent in 2009. In a recent paper, Kaushik Basu, chief economic advisor to the government of India, identified the rising savings rate from the 1960s as one of the key enabling factors for higher economic growth in India. Similarly, in China, the average savings rate is around 40 percent. The average savings rate in China has been historically high and increased from around 30 percent in the 1970s to around 40 percent in 2009.
Advanced economies like the US and countries in the euro zone, however, have a much lower savings rate. Though there is no optimum savings rate per se, it has been empirically established that emerging and developing countries require high savings to mobilise capital towards productive sectors. With a high savings rate, there is enough capital for investment in productive sectors which propel the economy to a higher growth trajectory. Even in neoclassical growth theory, savings is a key component of long-run, steady state level of output per capita -- an economy with a high savings rate tends to become rich over a period of time compared to those with a low savings rate.
Why then do some economies have a higher savings rate than others? What makes an average person in India vis-à-vis Nepal save more of his personal income? Since it has been empirically established that the developing countries need a high savings rate, why do countries like Nepal consume more when saving for tomorrow can provide higher returns?
From a basic economic theory, a rational individual decides to save when the expected gain from the future payoff from current savings is higher than the utility from the current consumption. If the present value of the expected future payoff provides the agent higher benefits than the current consumption, he will decide to save. So the typical savings decision is an inter-temporal one and hinges on two important things: (1) Expected future payoff and (2) The discount rate used to calculate the present value of the future payoff.
A higher expected future payoff and a lower discount rate leads to higher savings. However, in the case of Nepal, both these factors make savings unfavourable. The expected future payoff is lower because of political instability and an unfriendly business climate. If the probability of getting killed or extorted tomorrow is higher, then the expected future payoff will be lower. Similarly, if the probability of business closures, shutdowns or labour strikes is higher, the expected future payoff will again be lower.
Likewise, the rate used to discount the expected future payoff is high in Nepal. The discount rate generally depends on a nominal interest rate adjusted for time period of the economy. Because of a high inflation rate, the discount rate has been on the higher side making savings less desirable. The discount rate is, to some extent, inversely related to the degree to which the general public perceives that the future will be prosperous and beneficial and trust other participants, especially the policymakers, in the economy to exercise economic prudence. Because of lack of economic prudence as well as perceived direction, or lack of it, of the economy, the discount rate has moved up making saving in Nepal unfavorable in the eyes of the average person.
(This article was first published on the Kathmandu Post on March 29, 2010)
Link: http://www.kantipuronline.com/the-kathmandu-post/2010/03/28/Oped/Spending-or-saving/206604/
