Practice Exam Questions

Development Economics Essay Plan: Savings and Growth

Level:
A Level, IB
Board:
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 15 Jan 2020

Here is a suggested answer to a past exam question on savings and economic growth in advanced and developing countries.

Question:

In 2014 gross savings as a proportion of GDP were 47% in Singapore but only 16% in Brazil and 10% in Kenya. Assess whether a low savings ratio is the most significant constraint on economic growth in developing countries. (25)

KAA Point 1

One reason why a low gross savings ratio such as the 10% figure in Kenya might be a constraint on economic growth is that domestic savings can play a key role in financing capital investment. Singapore for example is a high-income advanced nation with an ageing population which allows household, corporate and government savings to be much higher (the government for example runs a large budget surplus each year). These savings flow into a sophisticated banking system where there is a high level of trust which can then be reallocated for other agents who need to borrow to fund investment projects (e.g. companies raising money on the Singaporean stock exchange or borrowing from a commercial bank). Thus a surplus of saving keeps down the rate of interest on borrowed money and makes more investment projects viable. Singapore has surplus savings and has established a sovereign wealth fund to invest some of money in domestic and overseas projects. In stark contrast, in Kenya (a lower middle-income country with a per capita GNI of just $3,000), savings are much lower, and businesses might not be able to get the loans they need at a viable rate of interest. This can then hold back planned investment which in turn is a factor influencing labour productivity and - ultimately - gains in real per capita incomes. Kenyan firms and the government might therefore become increasingly reliant on external finance such as debt issued to overseas investors. Given the risks involved in lending to volatile economies such as Kenya; investors will demand a risk premium on the interest rate perhaps making domestic investment even less attractive. The Harrod-Domar model helps to explain why high gross savings can help fund investment which is a key component of aggregate demand and long run aggregate supply.

Evaluation Point 1

However, a low level of gross saving relative to the investment needs of a country can often be overcome by sizeable net inflows of overseas aid and foreign direct investment. In the case of Brazil for example, a period of high global commodity prices caused the terms of trade to move in their favour and stronger growth prospects lead to a sharp rise in inflows of FDI especially in industries such as farming, forestry and tourism. This was helped by Brazil being chosen to host the Olympic Games. In a globalised world, businesses and governments are no longer constrained by the level of savings in their own financial system. Many emerging countries have opted to introduce supply-side reforms to make their economy more attractive to FDI. Countries such as Kenya have attracted sizeable investment from China (to build a new narrow-gauge railway) and the government has also considered issuing Eurobonds (albeit at high interest rates) to finance infrastructure projects.

KAA Point 2

A second reason why low savings can hold back growth is that savings provide an important buffer for when global macroeconomic conditions create negative external shocks. In the case of Kenya for example, a large percentage of their GDP comes from the agricultural sector and this primary sector dependence makes their growers vulnerable to fluctuations in global demand and costs. Kenya is a major net exporter of fresh flowers to the European Union. A recession in the EU or perhaps a steep rise in world fuel prices might damage the profitability of Kenyan growers and threaten large falls in real incomes and employment. If gross savings are low, households may find it difficult to smooth their spending on goods and services in response to this shock, thereby increasing the risk of recession. Many smaller scale producers do not have the savings to tide them over difficult times and the majority may have no insurance. Households with scarce savings might be forced to pull children out of school or become exposed to lenders who charge exorbitant interest rates. Thus, low savings can cause macroeconomic instability and a recession have a negative effect on a country’s trend economic growth rate.

Evaluation Point 2

However the question states that a low savings ratio is the most significant constraint on economic growth. Economic growth in countries such as Brazil and Kenya are usually constrained by a combination of factors and it is difficult to conclude that one is more important than another. For example, the major limit on growth in Brazil might be the endemic corruption which makes their economy much less attractive to overseas investors. Corruption also limits the tax revenues that the Brazilian government can raise to public and merit goods and welfare provision. In Kenya, one might point to the low level of economic diversification as a major barrier allied to the challenges facing Kenyan growers when selling their products to monopsonistic transnational corporations who extract most of the value added from production and often pay little in tax themselves because of shadow pricing and other forms of tax avoidance.

Final Reasoned Comment

As countries grow richer and per capita incomes rise, the absolute level of savings tends to increase too which provides an important flow of funds into a country’s financial system. So in the long run savings are important particularly for countries with very heavy investment needs, perhaps because they lack critical infrastructure. If savings are allocated efficiently, then the capital stock can grow (explained in the traditional Solow Model) and productivity will improve over time. However in a globalised world, countries can look well beyond their national borders if they are experiencing a savings gap. The key is to make effective use of the external debt they accumulate and the inflows of FDI and aid they might attract. For many development economists such as Stiglitz, there is a virtuous cycle between economic growth and saving. Kick-starting faster growth can often generate the extra savings if it successfully raises per capita incomes and lowers the scale of extreme poverty measured by the percentage of the population living on less than $3.10 a day (PPP).

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