Determinants of domestic savings in asean developing countries in the period 1986 2000, the case of VN

.

'

UNI,rVERSITY OF ECONOMICS
·rt

INSTITUTE OF SOCIAL STUDIES

· HO CHI MINH CITY

THE HAGUE

VIETNAM

THE NETHERLANDS

·;

VIET NAM- THE NETHERLANDS PROJECT FOR M.A. ON DEVELOPMENT ECONOMICS

DETERMINANTS OF DOMESTIC SAVINGS IN ASEAN
DEVELOPING COUNTRIES IN THE PERIOD 1986-2000,
THE CASE OF VIET NAM

A thesis submitted in partial fulfillment of the requirements for the degree of
MASTER OF ARTS IN ECONOMICS OF DEVELOPMENT

'
~,

Academic Supervisor: Dr. NGUYEN TRQNG HOAI

HOCHIMINH CITY, NOVEMBER 2003


CERTIFICATION

"I ,certifY that the substance of this dissertation has not already been submitted for
any degree and is not being currently submitted for any other degree.

I certifY that to the best of my knowledge any help received in preparing this
dissertation, and all source used, have been acknowledgement in this thesis."

Ph~;tm

Dinh Long

Date: November 51\ 2003


ACKNOWLEDGMENTS

First of all, I would like to express my sincere thanks to all teachers and the st~ff in Viet
Nam - the Netherlands Project for M.A. on Development Economics, especially Mr.
Tran Yo Hung Son, Mr. Nguyen Huu Dung and Ms. Tran Thi Ben. They have created an
excellent environment for our study. Many thanks are also released to Ms. Dinh Anh
Nguyet, the project secretary and Ms. Dang Kim Chi, the project librarian for their
assistance during the whole course.

I am grateful to Dr. Karel Jansen, Dr. Youdi Schipper and Dr. Joost Buurman for their

comments on the thesis proposal. Especially, I am indebted to the knowledge got from
Dr. Karel Jansen in the field Money and Banking, his useful and interesting lecture as
well as works relating to finance dropped a hint for me to follow this research.

,I am so fortunate to be guided by Dr. Nguyen Trang Hoai. His deep understanding on
Econometrics and Savings is

invaluable for my thesis.

His enthusiasm and

encouragement made me more confident in the difficult times. I hope my result is not a
disappointment to him.

I would like to thank all my classmates, friends and colleagues at Labor and social ·
Affairs School HCM city for their support in my study process.

Last but not least, God bless my parents and lovely relatives. There is no word to reveal
my love to them. I hope they would consider this thesis as one of worthy gifts from me.


ABSTRACT

A savings rate of a country has been considered as one of the most crucial sources for capital
formation that can be translated to improve its

ec~nomic

growth rate.

For the past decades, selected ASEAN developing countries (Indonesia, Malaysia, the
Philippines, Thailand and VietNam) have attained miracle in economic development. They
are all in the process of regional integration with greater overall openness of economies and
an ongoing liberalization of their finance, trade and investment regime. However, from the
1997 financial crisis and its consequences for ASEAN countries' economies, one of the
lessons withdrawn is that these countries passively depended much on foreign capital.
Therefore, realizing the determinants of domestic savings in these countries is necessary to
mobilize and well use the available resource for high and sustainable economic growth.
Basing on the integrated theory of savings and previous empirical works, this study also
found income growth, demographics, financial liberalization and financial development are
main factors explain for the domestic savings in Southeast Asian countries. The regression
result gave out the positive impacts of income growth on domestic savings in VietNam and
Indonesia; the positive effects of financial development on domestic savings in Viet Nam
and Malaysia. Furthermore, the negative impacts of age dependency ratio and real interest
rate on domestic savings are revealed in all five countries.

In order to mobilize domestic savings for modernization and industrialization, Vietnamese
government should try to stabilize socio-economic problems, control inflation, reform stateowned enterprises and encourage the development of private sectors, continue to improve
the effectiveness of financial and banking sectors as well as birth-control and family
pla'nning programme.


ABBREVIATIONS

ADB: Asian Development Bank
A SEAN: Association of Southeast Asian Nation
DEP: Age Dependency Ratio
FDI: Foreign Direct Investment
GOP: Gross Domestic Product
GDS: Gross Domestic Savings

GSO: General Statistics Office
IMF: International Monetary Fund
M2: Broad Money

;:-;,

ODA: Official Development Assistance
RIR: Real Interest Rate
USD: United State Dollar
VND: VietNam Dong
WDI: World Development Indicators

ii


TABLE OF CONTENTS
ABSTRACT ...................................................................................................,............. 1

ABBREVIATIONS .....................................................................................................11
LIST OF TABLES ..................................................................................................... V
LIST OF FIGURES .................................................................................................... V
CHAPTER 1:

INTRODUCTION ..............................................................................1

1.1. PROBLEM STATEMENT ............................................................................................. 1
1.2. OBJECTIVES OF THE STUDY .................................................................................... 2
1.3. DATA AND RESEARCH METHODOLOGY ............................................................. 3
1.4. STRUCTURE OF THESIS ............................................................................................. 3
CHAPTER 2:

LITERATURE REVIEW .................................................................... 5

2.1. DEFINITIONS ................................................................................................................. 5
2.2. SELECTIVE THEORIES OF SAVINGS ..................................................................... 6
2.2.1.
2.2.2.
2.2.3.
2.2.4.
2.2.5.

KEYNESIAN SAVINGS FUNCTION ....................................................... ."........ 6
THE PERMANENT INCOME HYPOTHESIS ................................................... 7
THE LIFE CYCLE HYPOTHESIS ...................................................................... 9
THE McKINNON- SHAW'S FINANCIAL LIBERALIZATION .................. 14
INTEGRATED SAVINGS THEORY ............................................................... 21

2.3. EMPERICAL STUDIES OF DETERMINANTS OF SAVINGS ............................. 22
2.3.1.
2.3.2.
2.3 .3.
2.3.4.
2.3.5

INCOME AND ECONOMIC GROWTH .......................................................... 22 ·
DEMOGRAPHICS ............................................................................................. 24
REAL INTEREST RATE ................................................................................... 25
FINANCIAL DEVELOPMENT ........................................................................ 28
THE STUDY OF VIETNAM INSTITUTE OF FINANCE ............................. 29

I

2.4. SUMMARY ..................................................................................................................... 29
CHAPTER 3: DETERMINANTS OF DOMESTIC SAVINGS IN ASEAN
COUNTRIES: AN OVERVIEW ...........................................................................·..... 31

3.1. SIMILARITIES OF THE FIVE ASEAN COUNTRIES ........................................... 31

iii


3.2. GROWTH, DEMOGRAPHICS AND FINANCIAL LIBERALIZATION ............. 31
3.2.1.
3.2.2.
3.2.3.

A SEAN ECONOMIC GROWTH ...................................................................... 31
ASEAN POPULATION BOOM, HIGH DEPENDENCY RA TJO ................... 33
FINANCIAL LIBERALIZATION IN ASEAN COUNTRIES ......................... 36

3.3. SITUATION AND POLICIES ENCOURAGING SAVINGS IN VIETNAM ....... 41
3.3.1.
3.3.2.
l3.3.

OVERVIEW OF ECONOMY AND ACCUMULATION BEFORE 1988 ....... 41
STABILIZATION, REFORM AND CONSOLIDATION AFTER 1988 ........ .43
IMPACTS OF ECONOMIC REFORM ON SA VINGS .................................... 45

3.4. SUMMARY ..................................................................................................................... 52

CHAPTER 4: DETERMINANTS OF DOMESTIC SAVINGS IN ASEAN
DEVELOPING COUNTRIES, THE CASE OF VIET NAM ....................................... 55

4.1. MODEL SPECIFICATION AND ESTIMATION METHOD ........................... ~ ..... 55
4.2. DATA SOURCES ........................................................................................................... 60
4.3. ESTIMATION RESULTS ............................................................................................ 60
4.4. MAIN FINDINGS .......................................................................................................... 68
CHAPTER 5:

CONCLUSIONS AND RECOMMENDATIONS .............................. 73

5.1. CONCLUSIONS OF THE THESIS ............................................................................. 73
5.2. POLICY IMPLICATIONS ........................................................................................... 74
5.3. SUGGESTIONS FOR FURTHER STUDY ................................................................ 77
APPENDIX 1: DATA SET (0/o) .................................................................................. 78
APPENDIX 2: DESCRIPTIONS OF HYPOTHESES TESTING .............................. 79
APPENDIX 3: REGRESSION RESUL TS ................................................................ 81
REFERENCES ........................................................................................................84

iv


LIST OF TABLES

Table 3.1

GDP Growth Rates in Selected Asean Developing Countries

32

Table 3.2

The Size of Population, 1975 and 1998

33

Table 3.3

Average Population Growth per Annum during 1980-1997

34

Table 3.4

Public Savings and GovernmenJ Compensation for Losses(%)

43

Table 3.5

Investment and Saving (% GDP), 1990-2000

45

Table 3.6

Savings Portfolio by Vietnamese Households 1992-93 and 1997-98 48

Table 3.7

Structure of Invested Capital, 1986 - 2000 (Billion VND)

Table 3.8

Capital Mobilization of Banking Sector (Billion VND)

51

Table 4.1

Data Matrix

57

Table 4.2

Financial Deeping, End-1997 (%)

71

. 48

LIST OF FIGURES

Figure 2.1

Schematic Life-Cycle Profiles of Earnings and Consumption

11

Figure 2.2

Savings and Investment under Interest Rate Ceilings

16

Figure 3.1

ASEAN GDP Growth Rate Per Capita during 1986-2000

35

Figure 3.2

Economic Growth and Inflation during 1990- 2000

44

Figure 3.3

Government Savings in the Period 1986- 2000

47

Figure 3.4

Saving Trend of VietNam Compared with Asean-4 Countries

54

v


CHAPTER 1:

INTRODUCTION

1.1. PROBLEM STATEMENT

A main problem in economic development theory is how to increase the resources available
for capital formation, or how to control consumption and increase savings (Jansen 1990,
p.8I).

The allocation of resources between present and future consumption (savings) is one of the
most fundamental economic choices facing any economy. This choice affects not only the
rate of economic growth a country can enjoy, but also the standards of living for future
generations jet unborn (Gillis, Perkins, Roemer and Snodgrass I 996, p.304).

Traditional development theories have put much emphasis on the importance of savings in
determining economic growth rate in developing countries.

According to Jansen (1990), the resources available for investment and economic growth in
any country can be increased through more domestic savings or through a larger capital
inflqw from abroad. Although many developing countries relied heavily on foreign savings
as a source of investment finance, the rise in investment ratios was accompanied by aroughly commensurate

increa~e

in the share of gross domestic savings in GOP (Gillis, ,

Perkins, Roemer and Snodgrass I 996, p.305).

The high ratios of domestic savings and investment are one of the striking features of East
Asian and Southeast Asian economies. ln reality, these high ratios have been reliable
foundation for the higher economic growth rate of these countries (Le et all2002, p. I 00). In
general, there are many evidences showing the same trend in which domestic savings and


economic growth rates go in the same direction. Basing on this, many governments in
developing countries attempt to raise savings rate in order to achieve high and sustainable
growth rates. Therefore, it would be necessary to deeply understand what determine
'

domestic savings so that policy makers can effectively employ the suitable solutions to
booster this kind of resource.

For the past decades, ASEAN developing countries have spent the dynamic period of
economic development. As a member of ASEAN, VietNam gradually proves its position in
the region. Viet Nam's economic reforms and 'open-door' policy since 1986 have
restructured the economy from a 'highly centralized planned economy' to a 'market-oriented
economy' regulated by the government (Kashiwaghi 1999, p.l33). This country achieved a
remarkably high average growth rate of 6.53% percent per annum during tlie period 1986 2000 (WDI, 2002). However, according to Le (1997), it is able to see that VietNam is in the

'
group of low level of domestic savings countries such as the Philippines, Laos, Myanmar,
Cambodia and relatively far distance from the rest of ASEAN countries.

VietNam is in the process of industrialization and modernization. The demand for capital to
meet the development need is quite high (Nguyen, 2001) and savings are encouraged to
increase so as to finance for that process. Therefore, this thesis focuses on the topic

'Determinants of domestic savings in ASEAN developing countries in the period 1986 -2000, the case of VietNam'.

1.2. OBJECTIVES OF THE STUDY

Basing on the integrated theory of savings and previous empirical studies on determinants of
savings in developing countries, this thesis aims to view the impacts of some main factors
such as income growth, age dependency ratio, real interest rate and financial development
2


on domestic savings in selected ASEAN countries (Indonesia, Malaysia, the Philippines,
Thailand and VietNam) in general and especially for the case of VietNam. This research is
therefore designed to investigate and answer the following key research questions:

•

Whether are there positive impacts of income growth, real interest rate and financial
development on domestic savings?

•

Is there negative relationship between age dependency ratio and domestic savings?

1.3. DATA AND RESEARCH METHODOLOGY

To investigate the relationship between domestic savings and income growth, age
dependency ratio, real interest rate and financial development in selected ASEAN countries
in general and VietNam in particular, this research uses time-series and cross-section data
(panel data) for the period 1986 - 2000. In the thesis, all data are secondary and taken from

2002 World Development Indicators CD-ROM of the World Bank, Asian Development
Outlook 2002 of the Asian Development Bank, and the Viet Nam Statistical Yearbooks of
GSO as well as data from update researches of VietNam Institute of Finance.

In this thesis, both qualitative and quantitative methods are applied, however the regression
econometric analysis is considered as the main methodology. From the collected data, we
can examine the relationship between domestic savings and other variables by making the '
regression so that we are able to explore the effects of each factor on domestic savings.

1.4. STRUCTURE OF THESIS

The thesis is composed of five chapters. Following the introduction, chapter two presents the
literature review and empirical studies. Because no single theory can completely explain the

3


determinants of savings in developing countries, the integrated theory of savings is applied
as the analytical framework of the research. Chapter three provides a brief overview of
determinants of savings in five ASEAN developing countries in general and Viet Nam in
'

particular in order to provide the background for understanding the situation and solutions
encouraging domestic savings in these countries. Chapter four covers the core study of the
thesis. It discusses the model specification and estimation method, gives the basic findings
of the regression results and answers the research questions. Finally, chapter five
summarizes the main findings of the thesis. This chapter also presents policy implications
drawn from the main findings and offers some suggestions for further study.

4

CHAPTER 2:

LITERATURE REVIEW

This chapter will give definition of the key concepts relating to savings, theory review and .
the empirical evidences. The clear definition will help the taxonomy of savings more
favorable for testing its determinants. The theory review focuses on some main theories used
to explain determinants of savings such as Keynesian savings hypothesis, Permanent income
hypothesis, Life cycle hypothesis, McKinnon and Shaw approach relating to financial
liberalization that is expected to encourage savings and then the integrated theory of savings.
The last one will present some empirical studies, which examine the relationship between
savings and its determinants.

2.1. DEFINITIONS

According to Gillis, Perkins, Roemer and Snodgrass (1996), for a country, total supply of
available savings is simply the sum of domestic savings and foreign savings.

Refer to gross domestic savings, they include government savings and private domestic
savings.

Government, or public sector, savings consists primarily of budgetary savings that arises
from any excess of government revenues over govern.nent consumption, where public
consumption is defined as all current government expenditure plus all capital outlays for'
mi)itary hardware (Gillis, Perkins, Roemer and Snodgrass, 1996).

Private domestic savings also arise from two sources: corporate savings and household
savings. Corporate savings is defined as the retained earnings of corporate ·enterprises

(corporate income after taxes minus dividends paid to shareholders). Household savings is

5


simply that part of household income not consumed. Household savings includes savings
from

unincorporated

enterprises

(single

proprietorships,

partnerships,

and

other

noncorporate forms of business enterprise) (Gillis, Perkins, Roemer and Snodgrass, 1996).
.

I

In this thesis, for regression, I base on World Development Indicators (2002) that the gross
domestic savings are calculated as GOP less final consumption expenditure.· Final
consumption expenditure is the sum of household final consumption expenditure (private

consumption) and general government final consumption expenditure (general government
consumption). I consider the gross domestic savings in form of percentage of GOP.

2.2. SELECTIVE THEORIES OF SAVINGS

2.2.1.

KEYNESIAN SAVINGS FUNCTION

Mikesell and Zinser (1973) presented the Keynesian savings (consumption) function is
linear with a constant marginal propensity to save. This function was formulated in the
context of a short-term model in which macroeconomic fluctuations occurred (Jansen 1990,
p.82). Hence savings, a residual of income and consumption, is mainly affected by current
income. But it is observed that the savings ratio is relatively constant in the long run but
shows considerable fluctuations in the short run (Jansen 1990, p.83). The research of
Mikesell and Zinser (1973) relating savings to. current income suggested two general
tendencies. First, as moving from gross domestic savings to private and personal savings,
the relationship between savings and income becomes more proportional for different levels
of per capita income, and over time the gap between marginal and average savings rates
tends to disappear. Second, the results of cross-sectional analysis tend to show a higher
marginal propensity to save and a larger divergence between marginal and average savings
propensities than do results derived from time series regressions. One explanation of these

6


findings is that savings behavior is determined not only by current income but also by past
income levels, the rate of income growth and the age distribution of households of the
community.

Determinants of Savings Derived from Keynesian Approach

•

Income

The Keynesian theories establish a close linkage between the level of savings and the level
of current income. As income rise, consumption also rise but less proportionately.
Additional income part would be saved. From this simple perspective, one would expect that
there is positive relationship between the level of savings and the level of income (Mikesell
and Zinser, 1973).

Rather than linking savings to current income, as in Keynesian approach that can face these
paradoxes above, the Permanent income hypothesis relates them to permanent income and
tht:( Life cycle hypothesis to life-time income (Jansen 1990, p.83).

2.2.2.

THE PERMANENT INCOME HYPOTHESIS

Friedman's 'Permanent income hypothesis' is the starting point for a variety of
specifications of saving-income relationship (Mikesell and Zinser, 1973). In its most simple
form, the linear equation is:

(Gillis, Perkins, Roemer and Snodgrass 1996, p.313)

Where Yt is transitory income and Yp is permanent income. Permanent income is defined in
terms of a long-run expectation over a planning period, and transitory income is the

7

'

..


difference between current income (Y) and permanent income. Friedman's hypothesis. is that
individuals consume virtually no transitory income. This implies a heavy reliance on past
behavior as a determinant of consumption spending; but changes in transitory income will
I

immediately leads to changes in the level of saving.

Because savmgs m this theory is defined as a difference between current income and
permanent income so it equals transitory income. This means that any increase in transitory
income will lead to an increase in household savings by the same amount. As transitory
(unexpected) income can be positive or negative depend on the values of current and
permanent income, hence, so does savings.

An interesting aspect of the Permanent income hypothesis is that it may help to explain the
saving behavior of difference income groups. Self-employed persons generally have a
greater transitory component in their income than wage and salary workers, and hence they
are likely to show a higher ratio of savings to observed income (Jansen 1990, p.85).

Determinants of Savings Derived from the Permanent Income Hypothesis

•

Income (permanent income)

In Permanent income hypothesis, income variable is introduced as a key determinant of
savings. Consumption decisions and thus savings decisions are made on a basic of,
permanent income which is viewed as a stream of income derived from total wealth.

•

Interest Rate

This theory assumes that household's consumption decisions depend on permanent income
while keeping their total wealth intact. Hence, if the interest rate increases, the present value
8


of total wealth will decline, thus permanent income, therefore, transitory income or savings
will increase.

•

Export

Among theories of savings, the Permanent income hypothesis helps us to explain the
positive impact of exports on savings in developing countries. These countries mainly expot1
primary goods. These export earnings suffer from great instability and fluctuation, however.
As a result, export earnings have a larger transitory component and thus most of them are
saved. This leads one to expect that countries with higher share of export sector would have
higher saving ratios.
'
The Permanent income hypothesis has in common with the Life cycle hypothesis the
property that long-term income is assumed to be the primary determinant of consumption
and savings. However, the main different between the two theories is that the Permanent

income hypothesis focuses on income fluctuation, while the Life cycle hypothesis on the ·
fitness of life and the plan for retirement (Wai, 1972).

2.2.3. THE LIFE CYCLE HYPOTHESIS

The Life cycle hypothesis associated with the writings of Modigliani, Brumberg and Ando ·
postulates that individuals adopt a planning horizon for their life-time consumption. It is ,
assumed that individuals plan no net life-time saving but attempt to spread their life-time
consumption evenly over their lives by accumulating enough savings during their earning
years to maintain the consumption standard during retirement (Mikesell and Zinser, 1973,
p.ll ). It also means that they set their life-time patterns of consumption and savings so as to
maximize utility subject to life-time budget constraint.

9


According to the Life cycle hypothesis, households' income fluctuates systematically during
their life-time. In the period of nonworking age, because of the individuals' low earnings,
most of expenditures are financed by available wealth or borrowing lead to negative savings
rate for this age group. In other hand, thanks to the relatively high earnings during the
working age (15 - 64) compared with other stages, savings are indispensable in

o~der

to

maintain their consumption standard during the life-time.

This model, therefore, shows that age composition of households and their current incomes
have important effects on savings. For more detail, in a society with a growing population

and/or growing per capita income, aggregate net personal savings is positive because the
working population tends to be larger than the retired one, and the higher the level of current
capita income the larger will be the amount of saving necessary to maintain an individual's
consumption level in retirement (Mikesell, and Zinser 1973, p.ll ).

Briefly, the level of savings will depend on the structure of population in each stage. If
population rapidly grows, savings tend to decrease because the amount of minors rises faster
than the increase of population in working age. The decrease of savings in this case is
relatively large because the earnings of infants are often zero while the expenditures for
them are not small. However, if population growth rate decreases, savings are able to
increase strongly because the population in the minor age rises slower than the increase of
population in working age and despite the raise of population in retirement age, the decrease ,
of savings in this age group is not too large owing to the demand for consumption tends to

'
reduce
when income decreases and individuals face the last stage of their life-time.
Furthermore, this age group often has income from accumulated wealth during the working
age.

10


Figure 2.1

Schematic Life-Cycle Profiles of Earnings and Consumption

earnings
....

------

Work-related consumption

/,

consumption

borrow;ng
and dissaving

~

I

1

retirement

death

Age

Source: Figure 3.1, Deaton, A (1999)

Determinants of savings de1·ived from the Life cycle hypothesis

•

Income (Life-time income)

Jansen ( 1990) reviewed the researches of Mikesell, Zinser and Modigliani that strongly gave
support to the rate Of growth as a determinant of savings ratio. In short, variables such as
GOP growth rate can be used as a proxy for the income variable which is of a positive
impact on the level of saving in an economy.

•

Demographics

The Life cycle hypothesis predicts a relationship between the age structure and the level of
savings. In other words, it establishes a close link between patterns of savings and pattern of
age composition. For simplicity, the most widely used variable to represent demographic

11


variables is the dependency ratio. The increase in dependency ratio will lead to decrease in
savings ratio.

•

Interest Rate

It is argued that interest rates work in ambiguous directions with respect to savings. An
increase in interest rate may either raise savings. This is because higher interest rates
simultaneously have both substitution effect and income effect (Jansen 1990, p.95). Firstly,
it increases the present value of wealth, which has a positive effect on current consumption.
Secondly, it leads to substitution between current and future consumption, which· has a
negative impact on current consumption. These effects work against each other. That is

exactly the reason why the impact of higher interest rates on saving is unclear.

Summary, we can assess these above saving theories (Keynesian savmgs function,
Permanent income hypothesis and Life cycle hypothesis) like that, to some extents, they are
developed in and for industrialized countries (Jansen 1990, p. 91 ). In applying these theories
to developing countries at least three problems affecting on saving decisions could be faced.
The first of these is that developing countries are going through a process of rapid structural
change. Secondly, most households are primarily production units and not only consumption
units. The third problem is that the assumption of perfect markets, that underlines most of
the saving theories, is not necessary fulfilled (Jansen 1990, p.91 ).

Structural change: The simple Keynesian saving function linking the level of saving to the
level of income is not very meaningful. According to Jansen (1990), the increase in the
savings ratio may be not so much determined by the increase in income as by the long-term
structural changes in the economy that occur with economic development. Such changes
may include the modernization of agriculture, the growing share of the corporate sector and
12


the changing role of government. .. The impact of these processes of structural changes on
the overall savings ratio will be felt only in the long-term and they may dominate any effect
that a higher per capita income may have. The effects of structural change are nor easily .
'

predictable in reality.

Production units: The saving theories above are derived from consumption behavior. But
many, if not most, households in developing countries are simultaneously consumer and
producer (Jansen 1990, p.92). Hence saving decisions and the acquisition of assets are
determined not only by a desired consumption pattern over time but also by the conditions

of production in the household enterprise.

Imperfect markets: The Keynesian saving function, the Permanent income hypothesis and
Life cycle hypothesis assume utility-maximizing households whose behavior is not
constrained by market imperfection. It means that the household can decide on an optimal
saving-consumption pattern over time. However, it seems to be not the case in developing
countries where capital markets and employment condition are quite different from
developed ones. There is no retirement, people work as long as they can; children contribute
to household income after a certain age and often look after their parents in old age. This
makes the pattern of age-earning profile of households unclear. Moreover, capital markets
are far from perfect and often hardly accessible so they make households more difficult iiT
smoothing consumption over their lifetimes.

Generally speaking, they contribute not enough understanding of saving behaviors in
developing countries. Therefore, in order to explain the determinants of domestic savings in
these countries we should apply one more theory relating to savings.

13


2.2.4. THE McKINNON- SHAW'S FINANCIAL LIBERALIZATION

The case for financial liberalization does touch on most aspects of developing countries
'

financial markets. The primary policy prescription arising from McKinnon and Shaw's work
is the general freeing and raising of institutional interest rates and/or a reduction in the rate
of inflation. It would appear the two policies are treated as identical, both policies increasing
the real rate of interest and thereby increasing the savings rate (Sikorski 1996, p.66)

•

Theoretical Foundation: McKinnon (1973)

The first theoretical pillar in the house of financial liberalization is the premise that interest
rates have a positive relationship with economic growth. The formal analysis of McKinnon
adopts the assumption that all economic units are confined to self-finance and that in these
countries, indivisibilities in investment have an important role to play. The first assumption
I

drives McKinnon's model by implying that any potential investor must have accumulated all
the money balances necessary for investment prior to undertaking the project. A higher real
deposit rate of interest makes the opportunity cost of saving real balances to invest lower,
and hence acts as an impetus for firms wanting to finance investment projects.

•

Theoretical Foundation: Shaw (1973)

Shaw's theoretical contribution is on the role financial intermediaries have to play in ,
development. A case for financial liberalization, in terms of increasing interest rates, arises
mainly from expanding the amount of financial intermediations occurring between savers
and investors. By increasing the returns offered to savers, financial intermediaries' capacity
to lend is increased and the banks are able to allocate this larger volume of investment funds.

14


Shaw's model relies on neo-classical market-clearing assumptions, specifically the
assumption that the interest rate functions in an equilibrating manner to ensure equality

between the supply and demand of loanable funds in the financial markets. Given efficient
.

'

financial markets in Shaw's world, the decision to reduce consumption and increase savings
does not reduce demand but, rather, alters its composition from consumption towards
investment expenditure.

In general, one of the main content of McKinnon and Shaw's model is that the real interest
rates have positive effects on the level of savings. Hence financial liberalization that makes
increase in real rate of interest is an effective way to escape from the context of poor capital
accumulation.

Because currency is a central field in the market economy so the government often meddles
in this one. These interventions take various forms such as interest ceilings, reserve
requirements, selective credit programs with subsidies interest rates, of which the most
widely financial instrument used in a financially repressed economy is interest rate that is
usually set below its equilibrium level in order to stimulate economic growth and improve
employment condition. McKinnon and Shaw criticize this way. According to them, the low
real interest rates will lead to the poor level of savings. Hence the level of investment is
limited and the low efficiency of investment is a next consequence of this mechanism.··
Therefore, it should be financial liberalization in order to gradually make interest rate to its
equilibrium level. We can present their assumptions for the model like that:

The supply of deposits equals the supply of savings in the financial market because all kinds
of saving are concentrated on banks in form of bank deposits that are provided to inve~tment
funds by financial intermediaries.

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All expenditures for investment are financed only by bank deposits. It means there ts
equality between the demand for investment and demand for deposit.

'

Both saving and investment are functions of real interest rate. However, there is a positive
relationship between savings and real interest rate meanwhile the relationship between
investment and real interest rate is vice versa. With the expectation that individuals
maximize their utility of consumption, once the real interest rate increases/decreases, the
current expenditure will be relatively expensive/cheap compared with the future one. Hence
current consumption

will

be adjusted

to

reduce/rise,

in

turn,

saving tends

to

increase/decrease. In other hand, investment will be harmed/encouraged when the real rate
of interest increases/decreases owing to the profit maximization.

With the assumptions above, the relationship between saving, investment and interest rate
can be graphically illustrated as the figure below:

Figure 2.2

Savings and Investment under Interest Rate Ceilings

Real
interest
rate

S(Yo)
S(Y1)

ro

So

Savings, I'nvestment

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If institutional interest rates (both deposit and lending rates) are imposed at r 1, then the real
level of savings is at S 1, lower than the possible level of savings (So) at the equilibrium rate

.

of interest, hence the volume of investment is restricted at this level (S 1). It reveals that the .
purpose of maintaining low rates of interest in order to promote investment does not meet
demand. Furthermore, because of the excess demand for credit at r 1 leads to the non-price
rationing of credit occur in the economy. Consequently, the volume of capital supply is low;
the production process is distorted and the financial system is eroded.

In contrast, if the currency management is liberalized (or expanded), the rate of interest will
rise and get the equilibrium level. The volume of savings will shift along the supply curve to
the equilibrium rate, of which lead to the increase of real investment. Hence going with the
increase in quantity, the efficiency of investment is also improved because the low profitable
projects may no longer have change to receive sponsors and the credit allocations be also
constrained to some extent. As a result, there is improvement of economic growth, in turn,
shifts the savings supply curve to the right [S(Yo) => S(Y 1)]. In other word, the level of
saving will increase with unchanged rate of interest. Investment will be better not only in
quantity but in quality with this interest rate. The economic growth in turn will be
strengthened and this process be continued ...

Therefore, increasing the real rate of interest will affect on savings through the two

ch~nnels-

• •

Direct way: rising the real interest rate will raise the level of savings

•

Indirect way: raising the real interest rate will improve the efficiency of investment,

the economic growth and thereby, the level of savings will be better.

17