DURING the last three years, Pakistan’s economy has grown on average at 7.5 per cent. The key to sustaining this growth rate is to increase the level of savings and investment, which, as we shall see later, is well below the desired level.
Investment or capital formation has a two-fold role in the economy. In the short-run, investment affects aggregate demand and thus output and employment. Investment is a component of the aggregate demand or total spending in the economy, and increase in investment steps up total spending raising the level of output and employment in the economy.
In the long-run, investment affects GDP growth. A country’s rate of growth largely depends on how much it sacrifices present consumption to provide for production of capital goods. Investment is in fact the engine of growth. The spectacular economic performance of East-Asian countries can in the main be attributed to their high investment-GDP ratio. Conversely, it is the deficiency of capital or low investment-GDP ratio that is the major weakness of most developing countries.
Investment depends on several factors including savings, costs, revenues and future expectations. The most important factor underlying investment is savings. In case of developing countries, investment falls below the desired level, mainly because of low savings. Though a necessary condition for investment, savings in themselves are not enough to induce investment.
As a matter of principle, businesses undertake investment when expected revenues are greater than estimated costs. Costs depend on interest rates, price of inputs and corporate taxes. Revenue expectations are based on an estimate of the level of demand for the output. In case there is deficiency of potential demand for their goods or services, businesses shy away from investment. As in case of savings, the key determinant of demand is income.
Again, in case of developing countries, since per capita income tends to be low, demand is deficient, which restricts investment. In fact, developing countries are in a Catch-22 situation. Low per capita income restricts capital formation and output, which is responsible for unemployment and underemployment. The higher the level of unemployment, the lower the level of per capita income. Increase in per capita income is thus essential for growth and development.
A number of instruments are available with the government to affect investment level in the economy. These include monetary policy, fiscal policy, trade policy, and investment policy. Monetary policy pertains to money supply and credit conditions in the economy.
Fall in money supply and increase in interest rates increases the cost of doing business and discourages investment. Conversely fall in interest rates decreases the cost of doing business and encourages investment. Fiscal policy deals with government revenue and spending. While higher corporate taxes are a drag on investment, higher government spending can both push up and push down the level of investment.
When demand is depressed and corporate profits are low, the private sector cannot be counted upon to step up investment. The job has to be performed by the government. By borrowing, the government generates the funds necessary for development expenditure.
Government investment increases demand for business goods and services. Businesses respond by increasing output for which they hire additional labour. The income earned by the workers is partly consumed, partly saved, which adds to demand and savings.
Public spending can also help develop the right infrastructure necessary for encouraging the private sector to invest. Increase in government spending or an expansionary fiscal policy is not without its problems. In the first place, if increase in government spending is not accompanied by increase in government revenue, it creates public debt. In the second place, if increase in government spending is not accompanied by proportionate increase in real GDP, the result is inflation. In the third pace, higher public spending may put upward pressure on the interest rates and thus crowd out private sector investment.
A liberal trade policy helps business have access to cheaper intermediate goods — machinery and raw materials — and thus bring down the cost of inputs. A liberal investment policy such as tax breaks and de-regulation of the economy decreases the cost of doing business and thus encourages investment. It is also important that the government create a stable political and economic environment to increase the level of business confidence.
Having outlined the importance of savings and investment in an economy and the factors hindering and promoting them, let’s have a look at the level of savings and investment in the Pakistan economy.
Generally increase in GDP is accompanied by increase in savings-GDP and investment-GDP ratio. However, Pakistan is a different story, where savings-GDP ratio has come down during last three years despite repaid economic growth. In 2000-01, savings-GDP ratio was 17.8 per cent, which increased to 18.1 per cent in 2001-02. But subsequently, the ratio has decreased: 17.6, 15.7, 14.5 and 14.4 in 2002-03, 2003-04, 2004-05 and 2005-06 respectively.
The investment-GDP ratio has a better picture. In 2003-04, investment GDP ratio was 16.6 per cent, which increased to 18.1 per cent in 2004-05 and to 20.0 per cent in 2005-06. However, despite the increase, the investment-GDP ratio is well below the desired level. In India, the investment-GDP ratio exceeds 30 per cent, while in case of Bangladesh and Sri Lanka it is 25 per cent and 24 per cent respectively.
The major reason for low level of savings and the resultant low level of investment is the low level of per capita income. Though per capita income in Pakistan has, according to official statistics, increased to $830 from $655 in 2004, the increase is nominal rather than real thanks to a high inflation rate, which increased from 4.6 per cent in 2003-04 to 9.4 per cent in 2004-05 and was about eight per cent in 2005-06. Two other major causes of high consumption and thus low savings are consumer financing and proliferation of credit cards.
According to the State Bank of Pakistan (SBP) Annual Report for FY06, the government is taking various measures to step up investment including rationalisation of tariffs, improvement in the tax refund process, removal of procedural bottlenecks, review of tax laws and tax machinery, provision of an efficient and reformed banking sector, improved governance and effective contract enforcement.
While all these measures are important, the level of savings and hence, the rate of investment cannot be enhanced to a desirable level without an increase in the real per capita income. This requires on the one hand containing inflation and on the other, human resource development by increasing spending on heath and education.