8. Capital Formation, Savings and Investment – Business Environment

8

CAPITAL FORMATION, SAVINGS AND INVESTMENT

After reading this chapter, you will be able to understand and appreciate all that you need to know of savings, capital formation and investment and relate them to Indian economy. In this chapter, we study capital, savings and investment, how savings are the sources of capital formation, and why are they comparatively low in developing countries.

WHAT COMPRISES CAPITAL?

In ordinary language, capital is used in the sense of money. But in economics, we use the term capital in a variety of senses. Machines, tools and instruments, factories, canals, dams, trucks, raw materials, etc. would all constitute capital in economics. Capital is defined as “produced means of production” (Böhm-Bawerk). This definition distinguishes capital from land and labour. Land and labour are original factors of production while capital is a man-made factor. Capital is the result of man's efforts to produce income from the resources found in nature. When he saves a part of the income to invest in future income-yielding activities, it is called capital. Therefore, capital is a man-made instrument of production. It consists of physical goods which are saved to be used in future production. All of them are produced by man to help him in the production of further goods.

Capital plays a crucial role in the modern economy. Without capital, economic systems and organizations will collapse. Without capital, land will be uncultivated, labour unemployed and organization stranded. The modern economic system relies so much on capital that it is known as capitalistic. We would not have been in a position to enjoy all the comforts and luxuries of modern life if some people in the past had not saved enough and invested in the field of production. Greater achievements in this economic sphere were possible in USA, Germany and Japan because of capital. Whether it is a free-enterprise or a socialist economy, capital is essential for economic development. Without it, there could not be industrial development, agricultural revolution, or growth in transport and communication. Capital is a prerequisite for the laying of infrastructure, economic and social overheads without which economic growth is impossible. Capital is required for working capital, for funding production-based activities, and for building a system of marketing of goods and services. Production itself cannot take place without capital for investment in plant and machinery, technology and expertise of all kinds and for employment of other factors of production such as labour and organization. The economy would simply stagnate in the absence of capital. In fact, an underdeveloped economy remains underdeveloped because it does not have sufficient capital to effect a break-through. Capital also is very necessary if the country requires more employment opportunities. Employment will increase in that economy where the capital formation is stepped up sufficiently.

CAPITAL FORMATION

According to Ragnar Nurkse, capital formation refers to that part of the country's productive activity that is being directed to the “making of capital goods, tools and instruments, machines and transport facilities, plant and equipment—all the forms of real capital that can so greatly increase the efficacy of productive effort. The essence of the process then is the diversion of society's currently available resources to the purpose of increasing the stock of capital goods, so as to make possible an expansion of consumable output in the future.” 1 However, Nurkse's definition is incomplete in that it takes into account only physical side of capital ignoring human capital, the investment on which is very important to usher in and accelerate economic development in a poor country. Simon Kuznets stressed the need to include human capital in capital formation, which according to him “contributes to economic growth by increasing the efficiency of a complex productive system.”2

Singer's definition of capital formation is also broad-based. To him, “capital formation consists of both tangible goods like plants, tools and machinery and intangible goods like high standards of education, health, scientific tradition and research.”3

To carry the discussion further, while modern economists like Nurkse emphasized only the physical aspects of capital, their predecessors, the classical economists were aware of the existence and usefulness of human capital. However, many modern economists did not take the discussion on capital formation to include investment in human beings. It was only T. W. Schultz, who called upon economists to seriously consider the importance of human capital. He argued: “The failure to include the acquired abilities of man that augment his economic productivity as a form of capital, as a produced means of production, as a product of investment, has fostered the retention of the patently wrong notion that labour is capital free and it is only the number of man-hours worked that matters.”4 Schultz further argued that in today's world, workers have become capitalists in that the work related knowledge and many skills they have acquired have definite economic value. Therefore, if one has to have an all inclusive concept of capital, one would have to include in it the concept of human capital.

Capital—both human and man-made—is one of the most important factors of production and without it land will be barren, labour idle and organization rudderless. In other words, no economic activity is possible without capital. Capital is a sine qua non for economic growth. If a country has to acquire faster economic growth, it has to acquire adequate capital for this purpose. It is quite necessary to determine the rate of capital formation that is required for a country's economic growth and also to identify the process of capital accumulation. How can a country achieve a high rate of capital formation, which is what you invest in the economy? Economists have identified three important variables for accelerating capital accumulation as given below.

  1. An increase in the volume of real domestic savings which would imply that the resources that would have been otherwise consumed is now being diverted for investment.
  2. The establishment of adequate banking and financial institutions with view to channelling the community's savings.
  3. The existence of a community of entrepreneurs and businessmen who can use the realized savings for productive investment purposes, or alternately, the state exercising the responsibility to carry on the entrepreneurial functions in lieu of private entrepreneurs in critical areas.

However, for a poor, capital deficient economy like that of India, domestic savings alone may not be enough for planned investment. A part of investment may come out of import of foreign capital, which can be only a temporary arrangement. In the final analysis, the country's financial burden of economic growth has to be borne by the domestic savers and investors alone.

In the Indian context, conventional estimate of capital formation included in it only additions to the stock of producer goods such as machines, tools, equipment, transport facilities and so on. It is only in recent times that attempts have been made to include in the calculation of capital formation, the outcomes of human capital. It is, therefore, necessary and appropriate to define capital formation broadly and study as part of it both the components of capital formation namely, physical and human. In India, though a large percentage of investment on economic growth came out of domestic savings, there was considerable reliance on foreign capital initially, especially during the Second and Third Five Year Plans. But since foreign capital was grossly inadequate and unreliable and came tied with conditions, our planners charted a different course of investment. From the Fourth Five Year Plan onwards, they planned to reduce progressively the dependence on foreign aid and to enable the economy become self-reliant and self-sustaining through a series of measures of domestic capital formation.

Growth in Capital Formation

Capital formation means making an addition to the existing stock of real capital in a country over a period of time. Normally, capital formation would indicate the amount of savings available in a country and the grants available from outside which can be used to invest on instruments of future production. In other words, capital formation involves the making of more capital goods such as machines, tools, factory and office buildings, trucks and motors, various kinds of raw materials and electricity, which are all used for future production of goods. For increasing the capital, savings and investments are essential.

Capital grows out of savings. It represents a surplus of production over consumption. It is the surplus that is set aside for the future by sacrificing or postponing some part of the present consumption. If an individual spends all his income on consumption, he cannot buy property. Likewise, if a community spends all its current output, it cannot accumulate real capital for future production.

Capital formation in a modern society takes place in three stages: (1) creation of savings, i.e., making a surplus of income over consumption; (2) mobilization of these savings (achieved by such institutions as commercial banks, financial institutions, insurance companies, etc); and (3) conversion of money savings into capital assets such as machines. This is not done by the savers themselves. The investors are generally people who borrow money directly or indirectly from savers and invest it for productive purposes.

Sources of Capital Formation

We have already seen that capital formation involves three steps, namely: (i) increase in the volume of real savings; (ii) mobilization of savings through banking and financial institutions and (iii) investing of what has been saved. With regard to underdeveloped countries, there are two important issues that have to be addressed; one, enhancing the propensity to save of low income groups of the people; and two, using most gainfully the current savings for capital formation. With regard to the first issue, it is necessary to identify the sources of capital formation, both from the domestic and foreign sources.

Domestic Sources of Capital Formation

Domestically, several measures can be conceived and executed with the view to enhancing capital formation internally. These include, among other things (i) efforts at increasing national income; (ii) efforts at reduction in consumption; (iii) savings drives through concerted efforts in the form of propaganda and social education; (iv) establishing banking and financial institutions to mobilize savings and capital formation, especially with the aim of tapping them from rural areas; (v) promoting new and innovative commercial and financial products such as bonds, debentures and depositories; (vi) tapping rural savings; (vii) issuing gold bonds and certificates; (viii) enabling businessmen to increase profits through tax rebates and providing supply of raw materials at subsidized prices as suggested by Lewis and practised by the Chinese for the purpose of promoting exports; (ix) devising fiscal and monetary measures such as creation of budgetary surplus through increased taxation, reduced government expenditure, public borrowing, expansion of the public sector, resorting to deficit financing and so on; (x) creating inflation, which is considered as a hidden or invisible tax. Inflation by contributing to the reduction in consumption can divert resources to investment; (xi) using disguised unemployment to bring out the concealed savings potential contained in rural underemployment in primary sector-oriented underdeveloped countries; and (xii) resorting to compulsory savings by compelling people by law to deposit part of their wages or salary increases in what was known as in 1960s and 1970s as compulsory deposit schemes. However, measures such as inflation, deficit finance and compulsory savings should be handled extremely carefully and with moderation as otherwise, it may lead to corruption, tax evasion and even social tension. Besides, economic growth implies enhancing people's capacity to consume more and enjoy a life of prosperity, while these measures have opposite effect.

Foreign Aid

Since domestic sources of capital formation are inadequate to meet the compulsions of rising investment needs in developing countries, they have to be supplemented by external sources such as foreign aid and other administrative measures.

In the absence of adequate increase in the supply of capital from domestic sources, a developing country can obtain capital from foreign countries apart from borrowing from international financial institutions. Most of these countries prefer “international borrowing at government level rather than import of equity capital. Two precautions, however, are to be taken by a country if it decides to go in for foreign aid. In the first place, the size of aid should never be so large that the borrowing country falls in a debt trap. Secondly, foreign aid should not carry strings to it.”5 In the opinion of Nurkse, neither foreign aid nor foreign private investment would help a developing country in the long run. The best option perhaps is to encourage joint ventures, which would not only bring into a developing country foreign capital but also technical know-how. The foreign firms also would train local labour, apart from enabling local partners to learn modern managerial skills. There is, however, a limitation in this process of capital formation from external sources. The import of capital strengthens the ties between developed and underdeveloped countries leading to a situation of people of the latter trying to imitate the consumption pattern of the former. Such demonstration effect leads to the draining of the poor country's savings and capital formation.

There are other administrative measures a low income country can initiate, which though not as direct as foreign aid will have the same impact on the country's capital formation as non-domestic channels. These are: (i) restriction of consumption imports, wherein all luxury imports could be restricted and the forex so saved utilized to import capital goods with a view to producing the very same consumption goods people wanted to import; and (ii) ensuring favourable terms of trade by adopting economic policies that would enable the developing country earn large export earnings. Table 8.1 provides data on the rate of saving and capital formation in India including data on foreign capital.

 

Table 8.1 Rate of Saving and Capital Formation

 

Note: Figures for 2006–07 are Provisional and Quick Estimates. *Gross/Net Domestic Product at Current market prices. †Figures are deduced.

Source: Tata Services Limited: Statistical Outline of India, Mumbai: Tata Services Limited, July 2009.

Capital Formation in India

There is a low capital formation or capital accumulation in India. While the gross domestic capital formation of China was 44 per cent, as we have seen it was only 33 per cent for India in 2007–08. The low capital formation is due to a combination of several factors. It is not possible for Indians to save as their per capita income is very low. Almost 350 million of Indians live in utter poverty. The rest of the population too enjoys no affluence except the five per cent at the top who control most of our industries. Besides, in the past the institutional facilities such as banking and insurance had not developed much and were unable to siphon off the excess incomes especially in rural areas. Now, the position has slightly improved in this regard. The government's taxation policy with its high and steep rate of taxation discourages those who could save. Again, rising prices have deprived many would-be savers of any incentive to save. Moreover, as a developing economy, India suffers from all other factors other poor countries suffer from such as low productivity, lack of enterprise, lack of economic overheads, lack of capital equipment, inequalities in income distribution, excessive population coupled with low growth, small size of the market, economic backwardness, technical backwardness, high taxes, unchecked practice of deficit finance in budgeting uncontrolled inflation and demonstration effect eating away the country's savings. There is widespread corruption in administration which also siphons away a large amount of incomes that would have legitimately swelled savings and capital formation in the country. These factors are responsible for the low capital formation in India. But it is expected that with higher economic growth, the saving capacity of the country would show a definite improvement as it has been demonstrated in India over the past one and a half decades after the adoption of the New Economic Policy.

CAPITAL ACCUMULATION

Savings in a society depend upon (i) the ability to save and (ii) the willingness to save. The ability to save in an economy depends upon the average level and the mode of distribution of national income.

Factors Affecting Capital Accumulation

The higher the level of national income, the greater will be the ability of people to save. Also, the more equitable is the distribution of income, the greater is the ability to save. The will to save depends on the individual, family and other factors. People often save in order to provide against old age and unforeseen emergencies. People also save with the objectives to educate, marry and start a business for their children. Some people save in order to start their own business or to expand the existing business. The ability to save and the will to save are governed by the following considerations:

  1. Level of income and its distribution: If the level of income of a community is large, its capacity to save is also large. The rich people save without any difficulty. They save because they earn more than they can spend. Every addition to their incomes adds to their ability to save. Besides, if the income is more equitably distributed among all the sections of the community, their saving capacity increases as a whole.
  2. Psychological motives to save: People save out of a variety of motives. They save because the future is uncertain and they have to provide for future emergencies. They save to meet conditions of old age and sickness. A man may save to provide for his family. The love of children and the provision for their better future strengthens one's will to save. Some may save out of the desire to obtain political and social status. Some may accumulate capital out of a sheer miserliness. A few may save because they cannot spend all that they earn. Thus, various motives help in the accumulation of capital.
  3. Institutional facilities: The amount of saving would depend to a great extent upon the encouragement people receive from banks and other financial institutions which assure safety of funds and offer high rates of interest. Again, if people have confidence in banks, they will be induced to save and deposit their money with them.
  4. Social and political factors: Savings are greatly promoted by an orderly social system which protects life and property. Savings are encouraged in society where there is political stability, tranquillity, peace and order.
  5. Rate of interest: The supply of savings, like the supply of any commodity, depends mainly on their price, i.e., the rate of interest. The payment of interest offers an inducement to savers to save as much as possible. Therefore, other things being equal, people will save more when the rate of interest is higher.
  6. Economic policy of the state: Taxation and other policies of the state affect the savings of people. High personal taxation prevents people from saving. Income tax, for example, reduces the margin of income available for saving. Also, if the government is unable to maintain the stability of the currency, savings would dry up as in a period of continued inflationary rise in prices. Again, if a government often threatens to nationalize business concerns, private investors and savers would be very cautious and would like to spend rather than to save and invest. These are some of the factors that would affect the saving capacity of a community.
  7. Corporate savings: Sizeable parts of the savings of the modern community are made by companies. Out of their total profits, companies distribute a part as dividend and plough back the rest into their business.

Capital Accumulation in Developing Countries

Low-income economies have low savings due to a variety of reasons. Though the savings rate in India has been increasing to a sizable extent of late, it has still not matched the level required under conditions of rising population and the need for heavy investment to achieve faster economic development. For instance, the gross domestic savings in India as a percentage to GDP amounted to 32 per cent in 2007–08 whereas this was 51 per cent in China. Likewise, gross domestic capital formation as a percentage to GDP was 33 per cent in India while it is 44 per cent in China. Thus, China, though a developing nation like India, has acquired the status of fast-developing economy.

The reasons for low rate of capital formation are as follows:

  1. Low income: The average income of an Indian is low when compared to other countries. For instance, India's per capita gross national income (GNI) was only USD 820 in 2006 whereas it was USD 36,620 for Germany, USD 36,410 for Japan and USD 40,180 for United Kingdom and USD 44,970 for the United States of America.6 As a result, the per capita saving is also low whereas the propensity is to consume is very high. In such a case, the entire income of the vast majority of people is spent on consumption. This obviously leads to low savings and poor capital formation.
  2. Low productivity: The level of productivity in low-income countries is miserably low leading to low growth rates of national income, and savings. Even though countries like India have abundant natural resources, they are not exploited adequately for want of capital, up-to-date technology and trained labour. As a result, the resources remain unutilized and the owners of resources are not in a position to gain much income. Naturally, therefore, they are unable to save or invest in industries and other sectors of the economy.
  3. Lack of enterprise: Low-income countries are characterized by lack of entrepreneurial skills and ability. Even if these countries have adequate number of potential entrepreneurs, they are not exposed to training and entrepreneurial development. Besides, the small size of the market, low capital availability and the innate aversion of people to take risk, inter alia, retard enterprise and initiative, all of which lead to low capital formation.
  4. Lack of economic overheads: For bringing about faster industrialization and economic development, a country should have adequate economic overheads such as banking, insurance, financial institutions, electricity, water, and transport and communication facilities. Many developing countries have inadequate and poor quality economic overheads which make it difficult for people to decide to invest in enterprises. Though many countries like India have plenty of manpower and increasing opportunities of a captive and growing market, entrepreneurs from abroad do not get attracted to invest in these countries due to lack of economic overheads. This results in low capital formation.
  5. Lack of capital equipment: In many poor countries including India, the rate of growth of capital formation remains low due to the lack of capital equipment. Besides, the total capital investments in these countries are only a fraction of what are invested in them in developed countries. Due to paucity of capital, it is not possible to replace the existing capital equipment and even to cover its depreciation in these countries. This is one of the reasons for low capital formation in developing countries.
  6. Inequalities in income distribution: Developing countries such as India are characterized by extreme inequalities in income distribution, which in turn keeps the vast majority of population in these countries in abysmal poverty. When the income inequalities are very high, these adversely impact savings. The top earners in the country who may constitute a very small percentage of say, 5–10 per cent of the country's population, spend the surplus income they have in conspicuous consumption and invest in unproductive channels such as costly ornaments, real estate, foreign cars and so on, while the vast majority of people can hardly save anything. Thus, inequalities in income distribution distort real investment and consequently the rate of capital formation tends to be low.
  7. Demographic factors: Low-income countries are characterized by excessive growth in population and low growth in per capita income. As the number of people added annually to the population of each of these countries is very large, the entire income of these communities is spent on feeding and maintaining the additional mouths with little saving and capital formation. Moreover, the rapid increase in population aggravates the shortage of capital as some amount of resources has to be spent to equip the labour force. Besides, bringing up a large number of children costs the parents enormous amount of money and as such they can hardly save. We have already seen that there is a high dependency ratio in these countries which again makes it difficult for the poor income earners to save.
  8. Small size of the market: The developing countries have smaller markets compared to the advanced economies. A small market which is the result of poor capacity of people to buy due to low income does not attract enterprise or initiative. With a low demand for goods which is the result of low incomes, the small size of the domestic market cannot absorb the supply of new products. These factors, too, keep the rate of capital formation at a lower level.
  9. Lack of financial institutions: Another factor that stands in the way of a high growth of capital formation in poor countries is the lack of adequate financial institutions to mobilize funds for investment. The demand for faster industrialization calls for larger capital expenditures but inadequate number and underdeveloped nature of banking and financial institutions, capital and stock markets, money and credit markets make it very difficult for savings to be collected and purveyed to investors. Moreover, there may not be sufficient number and variety of saving and investment products. All these deficiencies make it difficult to mobilize sufficient savings and capital for investment purposes and as such the rate of capital formation remains low.
  10. Economic backwardness: The economic backwardness of poor countries is responsible for low income, savings and capital formation, which in turn, cause poor investment and economic backwardness. This is a vicious circle in poor countries. Further, low labour efficiency, factor immobility, lack of occupational specialization, ignorance of economic issues, traditional values and lack of scientific and rational attitude combine together to cause low savings, capital accumulation and investment.
  11. Technical backwardness: One of the primary obstacles to economic growth in poor countries is the outdated and antiquated technology they invariably possess in all sectors of the economy. Obsolete technology leads to low production and poor productivity, both in labour and capital. Technology which is a critical input to generate marketable surpluses and cost-effective products in developed countries is very archaic in poor nations. Such a situation keeps the national output and income low, and the rate of capital formation too remains low.
  12. High taxes: Governments can play an adversarial role to reduce savings and capital formation by imposing very high and unsustainable taxes as a means of forced savings. This obviously reduces consumers' real incomes. High direct taxes such as income tax reduce incomes directly, whereas indirect taxes such as sales tax reduce real incomes by raising prices of products and services. Very steep taxes, as were imposed in India in 1960s and 1970s, not only curtail capital accumulation but also breed corruption.
  13. Deficit finance: Finance ministers in poor countries use deficit finance as a magic wand to create capital through uncovered deficit in the budget. But when deficit finance is used excessively and imprudently, it leads to an inflationary spiral. When prices rise, people would divert money they would normally save to buy the same quantum of essential commodities whose prices have risen. Savings and capital formation will, thus, be reduced substantially.
  14. Unchecked inflation: Economists argue that the process of economic development creates inflation when poor countries resort to deficit finance to meet development expenditures. Inflation, in turn, reduces people's capacity to save and invest. Almost all developing countries have gone through this situation.
  15. Demonstration effect: Ragnar Nurkse points out that the demonstration effect is one of the primary causes of low capital formation in low-income countries. People always have an urge to imitate the living styles of the rich and the affluent, be their own neighbours or those who are abroad. This tendency is fuelled by films, glossy magazines or visits abroad. As a result, the rise in the income of people of poor countries goes into imported products, if they are not produced locally. If that is not possible, they may patronize even smuggled products. Either way, the demonstration effect leads to conspicuous consumption and curtailment of savings and capital formation.

Table 8.2 gives the gross domestic savings and the gross domestic capital formation, as a percentage of the GDP at the current market prices.

 

Table 8.2 Gross Domestic Savings and Capital Formation

  Economic Indicators  
Period Gross domestic savings as percentage to GDP at current market prices Gross domestic capital formation as percentage to GDP at current market prices
1950–51
8.6
8.4
1960–61
11.2
14.0
1970–71
14.2
15.1
1980–81
18.5
19.9
1990–91
22.8
26.0
2000–01
23.7
24.3
2002–03
26.4
25.2
2003–04
29.8
28.2
2004–05
31.8
32.2
2005–06
34.3P
35.5P
2006–07
34.8Q
35.9Q

Source: Central Statistical Organization and the Economic Survey 2007–2008.

SAVINGS

Savings are the backbone for investments in the sense that higher savings lead to higher investments and vice versa. Savings in an economy can be of different kinds such as (i) household financial savings which, by and large, form the largest chunk in aggregate domestic savings. These household financial savings include currency and bank deposits, shares and debentures, life insurance, provident and pension funds, etc; (ii) household physical savings. These include construction of houses, equipment and assets in possession of households; (iii) private corporate sector savings; (iv) public sector savings; and (v) foreign savings as measured by the magnitude of the current account balance in the balance of payment statement.

Savings are estimated by dividing the community of savers into the categories mentioned above. Savings of the household sector are estimated in two parts; in the first part, household financial savings are calculated by using data on the assets and liabilities of the financial sector adjusted for its outstanding positions with the public and private corporate sector. In the second part, household savings in physical assets are estimated as the excess of aggregate of capital formation through the product flow method that takes into account the availability of items such as machinery, equipment and construction material that have generally been accounted for in capital formation. Public sector saving is estimated from the budgetary data and contains the excess of expenditure over revenue, both of the central and state governments. Savings in the private corporate sector are estimated in the form of retained earnings and available from the data obtained from the balance sheets of companies. Table 8.3 provides the composition of India's gross domestic saving drawn from diverse sources such as household and corporate constituting the private sector and the public sector.

 

Table 8.3 The Composition of Gross Domestic Saving (as % of GDP)

 

Note: Figures are at current prices. Upto 1999–00 relate to old series (1993–94) and are not strictly comparable with the latter figures. * Provisional. † Quick estimates.

Source: Tata Services Limited: Statistical Outline of India, Mumbai: Tata Services Limited, July 2009.

Sources of Savings

It is well known that a vast majority of people in developing countries have low incomes and with a high propensity to consume, their savings are low. However, even in these countries there are some affluent sections of society such as merchants, contractors, landlords and speculators who receive sumptuous incomes. But these upper crusts of society indulge in conspicuous consumption and save very little.

  1. Land-owning farmers who constitute a bulk of the population of these poor nations are generally thrifty and are given to savings for the rainy, or rather for the rainless day! The rural community also has a small team of money lenders who have the habit of saving, both as a habit and as to augment their business. The rural people also are recipients of inward remittances from their children or siblings settled in towns or employed in the armed forces and non-resident Indians who send their savings for safe-keeping or to meet common family commitment.
  2. The middle-income group of people is another source of savings, though a very limited source. In the early days, people of this class earned less; they spent most of it on educating their children, constructing a house or acquiring articles of comfort/luxury such as cars, air conditioners, music systems and expensive furniture. However, in recent times, their incomes have risen and many of them have developed the habit of saving and investing in stocks, bonds, debentures and securities.
  3. Business and corporate savings constitute yet another source which in the form of distributed and undistributed profits adds to the total savings of the country. This profit-making group saves and invests in productive enterprises. By and large, the expansion of business and corporate savings has been fairly adequate to meet the needs of business and industry, or at least to supplement loans and grants received from government and financial institutions.
  4. Governments too contribute to the domestic savings of the country. In most developing countries, economic growth brings about direct participation of government in various sectors of the economy and consequently an increasing share for it in national income which, according to Lewis, might vary between 5 and 10 per cent, but in reality it might be much more as it was in India prior to 1991. Apart from the use of real resources for industrial activities, government may use them for military purposes and for effecting transfer payments such as pensions, interest payments and insurance payments. In this manner, governments too contribute to domestic savings and capital formation.

Domestic Savings in India (1951–2008)

Mobilization of domestic savings to finance economic growth of the country became the primary task of planners in the early stages of economic planning. It was not an easy task given the fact that the country was poor, resources were untapped and growth painfully slow. Planners learnt a bitter lesson during the Second and Third Five Year Plans that dependence on foreign capital could cause problems of inadequate amount, lack of serious commitment, arm-twisting, tied-up assistance and worse, it mostly came with strings attached. The situation was so bad that the Fourth Plan had to be postponed due to paucity of resources. Moreover, imported foreign capitals were to be returned with interest over a period, making future generations liable to repay foreign debts. Under these circumstances, the planners decided to depend more on internal resources than relying on foreign capital. They devised policy measures to restrain domestic consumption and bring about a sort of compulsory domestic savings. The second half of the previous century,1950–2000, witnessed a mixed trend with regard to savings; it can be divided into six distinct phases, described here.

  1. 1950–1968 (The early phase): This phase witnessed low-saving phase due to low rate of growth in national as well as per capita incomes. At the same time, the period was also marked by the establishment of financial infrastructure. Earlier in 1948, the Industrial Finance Corporation of India (IFCI) was established and in 1949, the Reserve Bank of India had been nationalized to perform the functions of the Central Bank of the country. In 1955, the State Bank of India became the first public sector commercial bank. In quick succession, other state-owned financial institutions came to be established. Insurance companies were taken over by the government and became the Life Insurance Corporation of India (LIC) in 1956 with the objective of mobilizing contractual savings. The Unit Trust of India (UTI), the country's first and largest mutual fund company was established in 1964 with a view to mobilizing the savings of middle class households, with the launching of unit 1964 scheme. The rate of savings during this period was very low. It was only 10.4 per cent of GDP in 1950–51.

    Economists were of the opinion that two major factors accounted for this phenomenon: “First, the propensity to save in agriculture was comparatively lower than in the non-agriculture sector during this period in contrast to the outcome in the following periods. Secondly, there exists a comparatively higher share of agriculture in GDP during this period than in the subsequent periods.”7 However, despite these adverse factors, there was a marginal increase in the saving rate. By 1967–68, the saving rate went up to 13 per cent. The setting up of various financial institutions could have helped the growth.

  2. 1968–1976 (The gradual rise in savings): This period witnessed a revolutionary government move to nationalize 14 privately owned commercial banks in 1969 with a view to enlarging their operational areas in rural and semi-urban areas. The period since nationalization of banks is of great significance from the point of view of the growth and reach of the banking system, both of which had registered spectacular progress during this period. Opening of rural branches has improved mobilization of savings from the rural sector. Between 1969 and 1976, the number of branches of commercial banks increased more than two and a half times from 4,168 to 11,000. Besides, on the basis of recommendations of the Narasimham Committee, several regional rural banks (RRBs) were established under an act of 1976 as a part of a multi-agency approach to credit. An RRB is established with assistance from a public sector bank which subscribes to its share capital and provides managerial personnel also. With rapid expansion of branch networks, banks were able to mop up increased incomes of farmers, many of whom were enjoying the benefits of Green Revolution. All these factors helped to increase substantially the country's gross saving rate to 19 per cent.
  3. 1976–1980 (A high-saving phase): This period of about four years was characterized by high domestic savings. There were a few factors that were responsible for the appreciable increase in gross domestic savings (GDS). These were: (a) the impact of expansion of bank branches in rural and semi-urban areas; (b) a sharp increase in foreign remittances; (c) increased money supply with the public caused by large public sector food procurements; and (d) improvement in household physical saving. All these factors worked together to push up the savings rate to 21.8 per cent.
  4. 1980–1985 (The stagnation phase): This five year period was marked by stagnation in savings. The factors that were responsible for the stagnation in savings were: (a) decline in the public sector savings because of the increase in government expenditure; (b) fall in household savings due to the gradual spread of consumerism; and (c) the corporate sector depended more on borrowed funds having an adverse impact in generating internal savings
  5. 1985–1993 (The recovery phase): This phase witnessed a number of pro-saving measures initiated by the government such as (a) liberalization of economic policies that helped in boosting the capital market; (b) expansion of mutual funds (c) increasing public investment in shares and debentures; and (d) increasing savings in corporate sector. As a result of these combined factors, the GDS grew to 22.4 per cent in 1989–90, but it declined to 22.1 per cent in 1993–94 due to negative savings in government departments as a result of their spending large amounts on defence, servicing of interest payments and subsidies.
  6. 1993–1996 (A high-saving phase): This period witnessed a high rate of savings going up to 24.5 per cent between 1993–94 and 1995–96. These high savings could be easily attributed to the economic reforms undertaken by the government which had the positive impact on household financial saving and private corporate sector saving. This high rate of saving could have been better but for the continued negative savings experienced by public authorities for the reasons already mentioned.
  7. 1996–2002 (A low-saving phase): This four-year period experienced a decline in domestic savings to 22.7 per cent of GDP, the share of the household sector being the highest. During this period, the share of the public sector to domestic saving was practically nil. Between 1996–97 and 2001–02, the savings of the public enterprises were 3.47 per cent of the GDP but dissaving of public authorities were –4.29 per cent. As a result, the public sector showed a dissaving of 0.82 per cent of the GDP. The high saving rate of the seventies was due to temporary factors such as heavy foreign inward remittances and, therefore, could not be sustained. But the nineties witnessed the best performance of the economy in terms of domestic savings up to 1995–96, but subsequent years witnessed a decline in saving.8
  8. 2002–2007 (A high-saving phase): During the Tenth Five Year Plan (2002–07), “both private and public savings contributed to higher overall savings. The savings from the private corporate sector were particularly buoyant, while the turn around in public sector savings from negative to positive from 2003–04 onwards is heartening.” Likewise, “The domestic savings rate or the ratio of gross savings to GDP is estimated by the CSO to have touched a record level of 29.1 per cent in 2004–05. This implies an increase of 5.5 percentage points since 2001–02, before which the rate had remained stagnant and even declined since the mid 1990s.”9 Savings of the household sector averaged a robust 23.7 per cent during the Tenth Five Year Plan.10 A significant development of the post liberalization GDP growth has been an appreciable rise in GDS, which rose by 11.3 per cent of GDP over the five years till 2006–07. The average saving rate during the Tenth Five Year Plan was 31.4 per cent of GDP which was higher than the average ratio of 23.6 per cent during the Ninth Five Year Plan. “Both private and public savings have contributed to higher over all savings. Private savings have risen by 6.1 per cent points of GDP over the Tenth Five Year Plan while public sector savings increased by 5.2 per cent of GDP. Both have increased steadily over this period, though private savings appear to have reached a plateau in 2005–06.”11 During this period, savings of the household sector were stable between 23 and 24 per cent of GDP and average 23.7 per cent during the Tenth Five Year Plan period. It was also observed that the physical and financial components of the household savings remained more or less stable as a result of a substantial increase in the savings of both the private and the public sector, there was a decline in the share of the household sector in GDS from 94.3 per cent in 2001–02 to 68.4 per cent in 2006–07.12 Table 8.4 gives the savings and investment details in India during the Ninth and Tenth Five Year Plans.

 

Table 8.4 Savings and Investment Between Ninth and Tenth Five Year Plans

 

Source: Ministry of Finance, Government of India, Economic Survey 07–08, Delhi: Ministry of Finance, Government of India, 29 February 2008.

INVESTMENT

As per The Penguin Dictionary of Economics, “Strictly defined, investment is expenditure on real capital goods… In this sense, investment is the amount by which the stock of capital of a firm or economy changes, once we have allowed for replacement of capital which is scrapped.” Real capital goods could refer to construction of a new railway system or erection of new factory buildings. However, in a layman's language, it may be taken to mean purchase of any asset or even an undertaking of any commitment involving initially a sacrifice which may have some subsequent benefits. Thus, investment as a financial term refers to the purchase of stock exchange securities or government securities… or the deposit of money in building societies, banks, or other financial institutions, with the aim of either securing an income or the refund of a greater sum at some future date. In fact, investment refers to domestic capital formation. The size of both depends on domestic savings and capital inflow. Having reviewed the meanings of savings and capital formation, we should understand the trends in investments in the country after independence. The rate of domestic capital formation in India is now estimated as a percentage of gross domestic product.

Rate of Investment and Capital Formation

Even cursory glances at the statistical tables suggest that the gross domestic capital formation (GDCF) of the economy since the commencement of planned economic development in 1951 has shown a secular upward trend. The overall GDCF has shot up from a mere INR 10.37 billion (Base 1990–2000) in 1950–51 to an astonishing INR 14,923.13 billion in 2006–07 (quick estimate). The rate of investment as a proportion of GDP went up from 10.00 per cent in 1950–51 to 35.9 per cent in 2006–07. However, the increase in the rate of investment has been neither steady nor firm. Over the years, the rate of investment has more than doubled of what it was in the early years of economic planning.

  1. Investment during the initial period of planning: During the first year of the First Five Year Plan, the investment was estimated to be 10.2 per cent per annum. Though this was 1.2 per cent higher than what was invested in the economy during the British regime, ruling out the possibility of any increase in national or per capita income, but in the next 15 years, as a result of several pro-saving and pro-investment measures initiated by the government, the rate of investment began to climb up gradually to 18.4 per cent of the GDP by 1966–67. However, though this higher growth rate in investment was commendable considering the fact that the country, impoverished as it was during the British colonial rule, had to battle several obstacles to come out of the rut in which it was placed, and to push investment still higher for the economy to achieve accelerated growth.
  2. The declining phase of investment (1961–1969): Poor economic performance during the Third Five Year Plan pushed down the rate of investment after 1966–67. Problems such as defective economic planning, ineffective implementation of projects and policies and uncertainty over foreign aid were compounded by successive droughts and wars with Pakistan and China. The overall economic conditions deteriorated so badly that the government postponed the launch of the Fourth Five Year Plan by three years, and followed it with what was then known as “Plan Holidays” or Rolling Plan. It was not surprising, therefore, that the rate of investment slumped to a mere 13.9 per cent in 1968–69.
  3. The recovery phase of investment: The years after 1969–70 saw the recovery of the rate of investment, though it was not a wholesome improvement in the situation. During the Fourth Five Year Plan (1969–74), the rate of GDCF was only 19.1 per cent. During the Fifth Five Year Plan (1974–79), the rate of investment hovered around 19.0 per cent of the GDP. The years 1978–79 saw a remarkable turn around, when the rate of investment peaked to an impressive 23.3 per cent, even though it fell short of our requirements for massive investment. “Under the Seventh plan (1985–90), the investment rate as a percentage of the GDP at market prices was projected to rise to 25.8 per cent in 1989–90. As against this, in 1989–90, the rate of gross domestic capital formation was 25.1 per cent. It rose further to 27.7 per cent in 1990–91.”13
  4. Post liberalization phase in investment: Severe macroeconomic imbalances, double digit inflation, unfavourable balance of payments, lowest quantity foreign exchange and hesitation of advanced economies to provide aid necessitated drastic changes in the economic policies of the government in 1991. The government faced with a severe economic crisis had adopted macroeconomic stabilization measures and introduced comprehensive structural reforms. However, the hope that the new economic policy would bring about an improvement in the performance of the economy quite early was belied and the rate of capital formation remained depressed and hovered around 23.5 per cent. It was only after 1994–95 that a set of policy initiatives of the government resulted in the recovery process and the rate of capital formation went up to 26.9 per cent. The ascending phase of recovery continued in subsequent years and the rate of capital formation increased to 27.3 per cent in 1996–97. While prior to the reforms it was the public investment that gave a lead for private investment, in the post reforms period it was the other way around; it was private investment that lifted the total investment to higher level even though the public investment remained stagnant. In contrast to the increase in savings, the increase in investment has been driven especially by private corporate investment. Private investment was 10.3 per cent of GDP over the five years of the Tenth Five Year Plan. Private corporate sector investment improved from 5.4 per cent of GDP in 2001–02 to 14.5 per cent in 2006–07.

The upsurge in private corporate investment has been visible even to the public as a “capex” boom, and that is still continuing. Household investment remained close to the plan average of 12.7 per cent of GDP throughout the period while the public sector investment increased by less than 1 per cent of GDP over the plan period.14

The National Accounts provide the data of the gross domestic capital formation at constant 1999–2000 prices also. In terms of constant prices, the ratio of gross investment to GDP is estimated to have increased from 25 per cent in 2002–03 to 33.8 per cent in 2006–07. The gross fixed capital formation accounted for more than 90 per cent of the investment. The ratio of fixed capital formation to GDP is estimated to have increased to 30.6 per cent in 2006–07.15

Reasons for the Low Level of Investment in India

It is a fact that after the liberalization of economy in 1991, the rate of investment has gone up considerably, but considering the need and potential of the country to have faster economic development it fell far short. This is so for the following reasons: (i) Except during the First Five Year Plan, the level of investment has been much lesser than the targets fixed to maintain at least minimum 5 per cent increase in GDP per annum. We needed a rate of investment of 22 per cent or more of the GDP to achieve such a rate of growth. This could not be achieved till the middle of 1980s and the actual rate of investment was much lower. This is the reason why we were unable to realize the growth targets under the various five year plans; (ii) The targets in respect of investment had also not been achieved. The First plan document anticipated that the rate of investment would increase to 20 per cent of the net national product by 1967–68. When during the mid-term appraisal of the Third plan it was found that it could not be achieved, it was hoped that it would be achieved at least at the end of the Fifth plan. Even then the target could not be achieved; and (iii) Compared to India, the investment rates of several Third World countries are at present much higher. These countries such as South Korea, Malaysia, Thailand, Hong Kong, Indonesia and China have all raised their investment rates to more than 30 per cent which has enabled them to achieve faster economic growth over the past decades. India is still lagging behind in this respect.

The reasons for the lower rate of investment or the gaps between the desired and actual rate of investment are as follows:

  1. Inadequate increase in the rate of savings: This is one of the basic reasons why the investment rate in India was pretty low. This is because of the poor performance of the household sector to raise more savings and equally poor performance of the public sector to mobilize more capital formation. Corruption and misuse of public funds in the government and increased cost of public administration have all consumed unproductively large saving potential available in public sector.
  2. Poor performance of public sector enterprises: Indian public sector enterprises have failed to deliver the goods even though public investment in them has been raised steadily over the years. Due to problems such as low efficiency, underutilization of capacity, administrative incompetence and longer gestation period, these enterprises have been incurring heavy losses and have to be propped up by the public exchequer, though in recent times some of the social monopolies amongst them have been generating surpluses on their gross domestic savings; overall it was a measly 3.2 per cent for the year 2006–07 and worse still it averaged only 1.7 per cent during the Tenth Five Year Plan against the averages of private corporate sector which were 7.8 per cent and 6.0 per cent, respectively. In terms of gross capital investment, public sector performance was better – 7.8 per cent in 2006–07 and 6.9 per cent as an average of Tenth Plan. Here again the private corporate sector did almost twice better.
  3. Defective economic planning: It is often said that Indian economic planning has been very poorly implemented. It has also been noted that the growth in some of the leading sectors of the economy lagged behind other sectors often so much that their underdevelopment became a serious roadblock to the development of the latter. For instance, the energy sector and infrastructure industries have not been able to cope with the demand for their services and have contributed to a large extent to the industrial stagnation.
  4. Inadequate and defective resource mobilization: In India, as elsewhere in other developing countries, quite a large scale of the aggregate saving comes from the household sector. These savings have to be mobilized effectively and invested efficiently. However, this does not take place in India where resource mobilization is not only inadequate but also defective. Likewise, government also is not able to mobilize savings for its investments. Moreover, due to political and other reasons government is not able to levy taxes on incomes from agriculture, fisheries and plantations even though there is a vast scope for taxing in these sectors.

Investment Commission

The Government of India established the Investment Commission on December 2004, to interact with the Indian industry and big MNCs, especially in sectors where there is a severe need for high investment, but which has not been forthcoming. The Investment Commission was expected to secure annually a certain amount of investment. It would also recommend to the government to work out policies and procedures with a view to facilitating greater inflow of foreign direct investment (FDI). The Investment Commission submitted a report to the government on 7 July, 2006. In the report, the Commission said that it has set up a FDI target of USD15 billion by 2007–08. It also suggested that the government allow 49 per cent FDI in retail, contract labour in all areas and automatic route for all investments within certain limits fixed for each sector.

Another recommendation made by the Commission to the government was to promote special economic zones (SEZ) in such areas as textiles, chemicals, electronics and auto components. “It has also mooted a level playing field in sectors where public sector dominates and creating a special high level fast track mechanism for priority sector projects.”16

SUMMARY
  • Capital is “produced means of production”. 1t is a man-made factor and consists of physical goods and money which can be used to further production.
  • Capital is very important to a modem economy. Modern production itself is called capitalistic. Industrial development, agricultural improvements, development of transport and communications— all these are possible only because of capital. It is necessary in production to meet the various costs incurred in the production of goods and services. Capital investment is necessary in distributive trades and in various modes of consumption. Capital grows out of savings.
  • Formation of capital follows three stages: (i) creation of savings, i.e., a surplus of income over consumption, (ii) mobilization of savings, and (iii) investment of what is saved. The following factors affect capital formation: (i) Level of income and its distribution, (ii) Psychological motives to save, (iii) Institutional facilities such as banking and insurance, (iv) Social and political factors, (v) Rate of Interest, and (vi) Economic policy of the state. There is low capital formation in India because of the unfavourable conditions in which the above-mentioned factors operate.
  • The reasons for low rate of capital formation are as follows: (i) low income; (ii) low productivity; (iii) lack of enterprise; (iv) lack of economic overheads; (v) lack of capital equipment; (vi) inequalities in income distribution; (vii) demographic factors; (viii) small size of the market; (ix) lack of financial institutions; (x) economic backwardness; (xi) technical backwardness; (xii) high taxes; (xiii) deficit finance; (xiv) unchecked inflation; and (xv) demonstration effect.
  • Economists have identified three important variables for capital accumulation: (1) an increase in the volume of real domestic savings; (2) the establishment of adequate banking and financial institutions; and (3) the existence of a community of entrepreneurs and businessmen. Capital formation means making an addition to the existing stock of real capital in a country over a period of time. Capital grows out of savings. It represents a surplus of production over consumption.
  • Domestically, several measures can be executed with the view to enhancing capital formation. These include (i) efforts at increasing national income; (ii) efforts at reduction in consumption; (iii) savings drives through concerted efforts; (iv) establishment of banking and financial institutions to mobilize savings; (v) promoting new and innovative commercial and financial products such as bonds, debentures and depositories; (vi) tapping rural savings; (vii) issuing gold bonds and certificates; (viii) enabling businessmen to increase profits through tax rebates; (ix) devising fiscal and monetary measures; (x) creating inflation, which is considered as a hidden or invisible tax; (xi) using disguised unemployment to bring out the concealed savings potential; and (xii) resorting to compulsory savings.
  • In the absence of adequate increase in the supply of capital from domestic sources, a developing country can obtain capital from foreign countries; there are other administrative measures a low income country can initiate. These are (i) restriction of consumption imports; and (ii) ensuring favourable terms of trade. Mobilization of domestic savings to finance economic growth of the country became the primary task of planners in the early stages of economic planning. They devised policy measures to restrain domestic consumption and bring about a sort of compulsory domestic savings.
  • There is a low capital formation or capital accumulation in India as a developing economy, India suffers from all factors other poor countries suffer from such as low productivity and lack of enterprise.
  • Savings are the backbone for investments. Different kinds of savings include (i) household financial savings; (ii) household physical savings; (iii) private corporate sector savings; (iv) public sector savings; and (v) foreign savings as measured.
  • Savings in a society depend upon (a) ability to save, and (b) willingness to save. The ability to save and the will to save are governed by the following considerations: (i) Level of income and its distribution; (ii) Psychological motives to save; (iii) Institutional facilities; (iv) Social and political factors; (v) Rate of interest; (vi) Economic policy of the State; (vii) Corporate savings.
  • A vast majority of people in developing countries have low incomes and with a high propensity to consume, their savings are low. However, the sources of savings in poor countries are: (i) Land owning farmers who constitute a bulk of the population of these poor nations; (ii) The middle income group of people is another source of savings; (iii) Business and corporate savings constitute yet another source; (iv) Governments too contribute to domestic savings of the country. It is necessary to identify the sources of capital formation.
  • Investment is expenditure on real capital goods; it may mean purchase of any asset or even an undertaking of any commitment involving initially a sacrifice which may have some subsequent benefits. Several statistical studies suggest that the gross domestic capital formation of the economy has shown a secular upward trend, the increase in the rate of investment has been neither steady nor firm.
  • The reasons for the lower rate of investment or the gaps between the desired and actual rate of investment are as follows: (i) Inadequate increase in the rate of saving; (ii) Poor performance of public sector enterprises; (iii) Defective economic planning; (iv) Inadequate and defective resource mobilization.
  • The Government of India has established the Investment Commission on December 2004 with a view to interacting with Indian industry and big MNCs.
KEY WORDS
capital equipment capital investment corporate sector
economic policy entrepreneurs and businessmen inequalities in income
investment commission level of income man-made factor
modern economy savings social and political factors
special economic zones tapping rural savings willingness to save
DISCUSSION QUESTIONS
  1. Define capital. Give some examples. What is the importance of capital in a modern economy?
  2. What are the factors that contribute to the capital formation of a country?
  3. Why is capital formation in India low? Suggest ways and means of improving the position.
  4. What were the factors which caused a rise in the gross savings and investment rates in India, especially since mid 1970s? Do you think that the growth of savings and investment rate since 1991 is adequate to support the programme of rapid industrialization in the post reform liberalized environment?
  5. What have been the basic constraints, which have prevented India from realizing its growth potential in spite of high rate of savings and investment? Do you agree with the view that the higher growth achieved recently is due to the new economic policies followed since 1991? Give reasons in support of your answer.
  6. Assess the magnitude of inequality in the distribution of national income in India. What are the main causes of this inequality?
  7. “While India has achieved high rate of saving and investment, the basic constraints in realizing the growth potential remain.” Do you agree? Give reasons for your answer.
  8. “High rate of saving is a sufficient condition for rapid economic growth.” Comment
  9. Discuss various problems of capital formation in India. Suggest various ways to augment its rate.
  10. “Stagnant domestic saving is the only major constraint on investment in the Indian economy presently.” Comment.
SUGGESTED READINGS

Acharya, S. “The Savings-Investment Miracle”. Business Standard, 27 March, 2008.

Centre for Monitoring Indian Economy, Basic Statistics Relating to the Indian Economy, All-India: Centre for Monitoring Indian Economy, Vol. I., August 1994.

Chaudhuri, D. P. and P. Rao. Private and Social Return to Higher Education-A case study of Delhi Graduates (Mimeo).

C.S.O. National Accounts Statistics, 1960–61, 1970–71 to 1981–82, 1995, 1998, 2001 and 2005.

Government of India. Economic Survey 2001–2002, 2002–03, 2003–04, 2004–05 and 2005–06.

Institute of Applied Manpower, Manpower Profile in India: Yearbook (2004).

Johansen, S. “Statistical Analysis of Co-integrating Vector”. Journal of Economic Dynamics and Control, 12: 231–254.

Mohan, Rakesh. “The Growth Record of the Indian Economy, 1950–2008: A Story of Sustained Savings and Investment”. Reserve Bank of India Bulletin, March 2008.

Oura, H. “Financial Development and Growth in India”. International Monetary Fund: IMF Working Paper No. 08/79, March 2008.

Planning Commission. Sixth Five Year Plan (1980–85).

Reserve Bank of India. Report on Currency and Finance. 1975–76 and 1999–2000.

Reserve Bank of India. Capital Formation and Saving in India (1950–51 to 1979–80). Report of the Working Group on Savings, February 1983.