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.

1

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, r

1

. If this rate is also applicable for

loans,

1

saving will fall to S

1

and investment will be constrained by the availability of saving to

I

1

. At r

1

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 r

3

,

saving will increase from I

1

to I

3

, and the efficiency of investment also increases because

banks are now financing projects with higher expected returns. Unsatisfied investment

demand has fallen to A

1

B

1

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

2

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:

S

T

= S

G

+ S

P

(2)

Where S

T

, S

G

and S

P

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 (F

P

) 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:

S

P

= F

P

+ L (3)

Substituting equation (3) into (2), we get:

S

T

= S

G

+ F

P

+ L (4)

The flow of total financial saving (F

T

) comprise public financial saving (F

G

) and

private financial saving (F

P

). That is:

F

T

= F

P

+ F

G

(5)

On the assumption that all government saving is kept in the form of financial assets

(so that F

G

= S

G

) and substituting equation (5) in (4), and rearranging we have:

L = S

T

— (F

G

+ F

P

) (6)

and,

F

T

= S

T

– L (7)

Dividing equation (6) by S

T

, we obtain:

FT/ST = 1 – s (8)

Where, s = L/S

T

, 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).

3

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 S

T

= F

G

+ F

P

in equation (6) and F

T

/S

T

=1 in equation (8)). A

reduction in the leakage (i.e., s L<0) implies an improvement in the process of financial

deepening while an increase in the leakage (i.e., s L>0) 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 S

T

=0) financial saving can increase if sL<O. To elucidate this

result, the leakages of saving outside the formal financial sector may be divided into the

following main components:

2

the portion which is kept in the form of real assets including

livestock and gold (R); the portion which is claimed by the informal financial sector (N), the

proportion which is claimed by the underground economy including the black market for

foreign exchange (U), the portion which goes into capital flight (C) (this is usually kept

abroad in the form of foreign currency deposit accounts, financial assets or physical assets)

and; the portion which is hoarded by households in the form of domestic or foreign currency

holdings (H). Using these definitions in equation (8), we obtain:

F

T

= S

T

— (R + N + U + C + H) (9)

Equation (9) is a restatement of the fact that financial saving is only one type of

saving. The main other types of saving are represented by the components of the leakage on

the right hand side of the equation. According to the equation, if saving is stagnant (i.e., s

S

T

=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<0); by reversing the process of capital

flight (i.e., sC<0); by attracting the resources of the informal sector into the formal sector (i.e.,

sN<0); by reducing the amount of saving claimed by the underground economy and; by

encouraging dishoarding of foreign and domestic currency by households (i.e., sH<0).

Conversely, large additions to total saving might not increase financial saving if they are

offset by an equal increase in any of the components of the leakage, say, capital flight. Also,

substitution among the components of the leakage might occur without affecting financial

saving. An increased dishoarding of domestic and foreign currency, for instance, might be

offset by an equal increase in capital flight (i.e., -sH=sC) leaving financial saving unchanged,

and so on.

The Orthodox Versus the New Structuralist

Equation (9) allows us to reinterpret the controversy between the proponents of the

orthodox financial liberalization theory and their opponents from the New Structuralist

School. In the context of our model, this controversy concentrates mainly on the interactions

between financial saving and the components of the leakages shown by the equation.

According to McKinnon (1973), in most developing countries, a significant proportion of

working capital for the financing of inventories, goods in process, trade credit and advances to

workers is obtained through bank financing. The supply of bank credit determines the level of

available working capital, and thus of net output. An increase in deposit interest rates, is thus

expected to increase holdings of financial assets (broad money) and hence working capital

and output. This increase in financial saving will occur through the reduction in the leakage.

For the new structuralist, an increase in deposit rates is likely to result in an increased

holdings of financial assets, but the outcome will not necessarily be a 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

4

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:

B

C

= (1 – T) F

T

(10)

where B

C

is the supply of bank loans, T is the required and excess reserves ratio held

by banks and F

T

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

5

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:

T

S

= s

0

+ s

1

+ s

2

Y (12)

F

S

= T

0

+ T

1

+ T

2

Y + T

3

(C/M

1

) (13)

It is hypothesized that, total real domestic saving (T

S

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 (F

S

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 M

1

. The proportion of narrow money (M

1

) 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

6

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.

1

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, r

1

. If this rate is also applicable for

loans,

1

saving will fall to S

1

and investment will be constrained by the availability of saving to

I

1

. At r

1

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 r

3

,

saving will increase from I

1

to I

3

, and the efficiency of investment also increases because

banks are now financing projects with higher expected returns. Unsatisfied investment

demand has fallen to A

1

B

1

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

2

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:

S

T

= S

G

+ S

P

(2)

Where S

T

, S

G

and S

P

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 (F

P

) 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:

S

P

= F

P

+ L (3)

Substituting equation (3) into (2), we get:

S

T

= S

G

+ F

P

+ L (4)

The flow of total financial saving (F

T

) comprise public financial saving (F

G

) and

private financial saving (F

P

). That is:

F

T

= F

P

+ F

G

(5)

On the assumption that all government saving is kept in the form of financial assets

(so that F

G

= S

G

) and substituting equation (5) in (4), and rearranging we have:

L = S

T

— (F

G

+ F

P

) (6)

and,

F

T

= S

T

– L (7)

Dividing equation (6) by S

T

, we obtain:

FT/ST = 1 – s (8)

Where, s = L/S

T

, 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).

3

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 S

T

= F

G

+ F

P

in equation (6) and F

T

/S

T

=1 in equation (8)). A

reduction in the leakage (i.e., s L<0) implies an improvement in the process of financial

deepening while an increase in the leakage (i.e., s L>0) 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 S

T

=0) financial saving can increase if sL<O. To elucidate this

result, the leakages of saving outside the formal financial sector may be divided into the

following main components:

2

the portion which is kept in the form of real assets including

livestock and gold (R); the portion which is claimed by the informal financial sector (N), the

proportion which is claimed by the underground economy including the black market for

foreign exchange (U), the portion which goes into capital flight (C) (this is usually kept

abroad in the form of foreign currency deposit accounts, financial assets or physical assets)

and; the portion which is hoarded by households in the form of domestic or foreign currency

holdings (H). Using these definitions in equation (8), we obtain:

F

T

= S

T

— (R + N + U + C + H) (9)

Equation (9) is a restatement of the fact that financial saving is only one type of

saving. The main other types of saving are represented by the components of the leakage on

the right hand side of the equation. According to the equation, if saving is stagnant (i.e., s

S

T

=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<0); by reversing the process of capital

flight (i.e., sC<0); by attracting the resources of the informal sector into the formal sector (i.e.,

sN<0); by reducing the amount of saving claimed by the underground economy and; by

encouraging dishoarding of foreign and domestic currency by households (i.e., sH<0).

Conversely, large additions to total saving might not increase financial saving if they are

offset by an equal increase in any of the components of the leakage, say, capital flight. Also,

substitution among the components of the leakage might occur without affecting financial

saving. An increased dishoarding of domestic and foreign currency, for instance, might be

offset by an equal increase in capital flight (i.e., -sH=sC) leaving financial saving unchanged,

and so on.

The Orthodox Versus the New Structuralist

Equation (9) allows us to reinterpret the controversy between the proponents of the

orthodox financial liberalization theory and their opponents from the New Structuralist

School. In the context of our model, this controversy concentrates mainly on the interactions

between financial saving and the components of the leakages shown by the equation.

According to McKinnon (1973), in most developing countries, a significant proportion of

working capital for the financing of inventories, goods in process, trade credit and advances to

workers is obtained through bank financing. The supply of bank credit determines the level of

available working capital, and thus of net output. An increase in deposit interest rates, is thus

expected to increase holdings of financial assets (broad money) and hence working capital

and output. This increase in financial saving will occur through the reduction in the leakage.

For the new structuralist, an increase in deposit rates is likely to result in an increased

holdings of financial assets, but the outcome will not necessarily be a 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

4

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:

B

C

= (1 – T) F

T

(10)

where B

C

is the supply of bank loans, T is the required and excess reserves ratio held

by banks and F

T

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

5

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:

T

S

= s

0

+ s

1

+ s

2

Y (12)

F

S

= T

0

+ T

1

+ T

2

Y + T

3

(C/M

1

) (13)

It is hypothesized that, total real domestic saving (T

S

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 (F

S

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 M

1

. The proportion of narrow money (M

1

) 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

6

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