Determinants of household savings in lam dong province

INSTITUTE OF SOCIAL STUDIES
THE HAGUE
THE NETHERLANDS

UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

VIETNAMESE-NETHERLANDS PROJECT ON DEVELOPMENT ECONOMICS

DETERMINANTS OF HOUSEHOLD SAVINGS
IN LAM DONG PROVINCE

A Thesis Submitted In Partial Fulfillment of the Requirement for the Degree of
MASTER OF ART IN ECONOMICS OF DEVELOPMENT

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CERTIFICATION

I certify that this thesis has not already been submitted for any degree and is not being
submitted for any other degree.
I certify that to the best of my know ledge any help received in this thesis and all sources used
have been acknoledged in this thesis.

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NGUYENTHJNAMPHUONG
Date ........................... .

1


ABSTRACT
The current empirical study is to examine the detenninants of household savings in Lam
Dong province. The methodology of the paper is the estimating the saving function of
households in Lam Dong province by employing Integrated Model with special focus on the
influence of financial development on household savings. The econometric analysis in this
empirical study is based on the data from household survey in Lam Dong province. From the
total sample size of 203 observations, the regression results show that among variables
considered, financial development proxied by the distance to the nearest financial institution,
has no significant effect on the volume of household savings. However, six social economic

variables, which are educational level, occupation, gender of household head, family size,
land size, household income, are found to be strong detenninants of household savings in
Lam Dong province.

11


CONTENTS
ACKNOWLEDGMENT
ABSTRACT
CONTENT
LIST OF TABLES
LIST OF FIGURES
CHAPTER 1: INTRODUCTION ............................................................................................. 1
1. Problem Statement ............................................................................................ 1
2. Objectives of the Study .................................................................................... 3
3. Research Methodology and Data Sources ......................................................... .4
4. The Structure of the study ................................................................................ .4
CHAPTER 2: THEORETICAL FRAMEWORK. ..................................................................... 5
I.

IMPORTANT CONCEPTS .................................................................................... 5

II.

THEORETICAL REVIEW .................................................................................... 7
1.

Household Savings .............................•............................................................ 7
1. 1. The Classical Theory .................................................................................. 7

1.2. Theory of Keynes ...................................................................................... 7
1.3. The Relative Income Hypothesis ................................................................ 8
1.4. The Permanent Income Model and Life Cycle Hypothesis .......................... 9
1.5. Integrated Theory of Savings ..................................................................... 9

2. Financial Development and Household Savings ................................................. 10
2.1. Impact on Opportunities to Save ................................................................. 10
2.2. Impact on the Incentive to Save .................................................................. 14
III.

FINANCIAL DEVELOPMENT AND SAVINGS: EMPIRICAL EVIDENCE ....... 16

CHAPTER 3: FINANCIAL DEVELOPMENT AND HOUSEHOLD SAVINGS IN
VIETNAM ................................................................................................................................ 21
I.

FINANCIAL SYSTEM BEFORE FINANCIAL REFORM ..................................... 21
1. Impact on the Incentive to Save ............................................................................. 21
2. Impact on the Opportunities to Save ...................................................................... 23

II.

FINANCIAL SYSTEM AFTER REFORM ............................................................... 24
1. The First Round of Financial Reform, 1988-1991.. ................................................ 25
2. The Second Round of Financial Reform, 1992- ONWARD .................................... 26
2.1. Impact on Incentive to Save ........................................................................... 27

iii

2.2. Impact on Opportunities to Save ................................................................... 29
CHAPTER 4: EMPIRICAL ANALYSIS .................................................................................... 35
I.

MODEL SPECIFICATION AND SAMPLING METHOD ............................... ."........ 35
1.1. Model Justification ........................................................................................ 35
1.2. Model Specification....................................................................................... 36
1.3. Sampling Design ............................................................................................ 40
1.4. Sampling Method .......................................................................................... 41
1.5 Method of Data Collection............................................................................. .42

II.

DATAANALYSIS .................................................................................................... 42
1. Findings from the Sample Survey ......................................................................... .43
1.1 The Ability to Save........................................................................................ .43
1.2. Using Financial Institution by Households in Lam Dong province ................ .43
1.3. Change in Using Financial Institutions by Households .................................. .44
1.4. The Use of Financial Institutions and Some Selected Indicators of
Household Savings .............................................................................................. 46
1.5. Analysis from the Preferred Saving Forms .................................................... .48
1. 6. The Structure
of Financial Savings ......................... .'..................................... .49
,
2. Model and Results ................................................................................................ 51
2.1. Regression Results ......................................................................................... 51
2.2. Hypothesis Testing, Explanations of the Empirical Results ............................ 53

CHAPTER 5: EMPIRICAL FINDINGS AND POLICY RECOMMENDATIONS ..................... 56
I.

SUMMARY OF MAIN EMPIRICAL FINDINGS ................................................................ 56

II. POLICY RECOMMENDATIONS ........................................................................................ 57
1. Reducing Transaction cost and Creating More Chance For Households To
Access To Financial Services ............................................................................. .57
2. Other Policies Aim at Increasing Household Savings ........................................... 58
REFERENCE LIST .................................................................................................................... 60
APPENDIX 1.............................................................................................................................. 63
APPENDIX 2 .............................................................................................................................. 64

IV


LIST OF TABLES AND APPENDICES:

Table 1: Financial Indicators and Domestic Saving in Vietnam before 1988 ................................... 22
Table 2: Financial Development in Vietnam, 1988-1999 ................................................................ 29
Table 3: Change in Composition of Household Savings, 1993-1998 ............................................... 30
Table 4: Saving ratios ofhouseholds in Vietnam, 1993-1998 ......................................................... 33
Table 5: Distribution of Household Sample,(% households) .......................................................... 42
Table 6: Changes in the Use of Financial Institutions by households, 1993-2002 ............................ 45
Table 7: The Use of Financial Institutions and Some Selected Indicators of Household Savings .... .46
Table 8: Distribution of the Most Preferred Savings Forms(% of survey Sample) ......................... .48
Table 9: Structure of Households' Financial Savings ...................................................................... 50
Table 10: Results of Least Square Model ....................................................................................... 52
Table 11: Results after Dropping Insignificant Variables ................................................................ 52
Appendix 1: The Increase in Mechanization in Vietnam ................................................................ 64
Appendix 2: Diagnostic testing of the Models ................................................................................ 65

v


LIST OF FIGURES:

Figure 1: Real Three-month Deposit annual Interest Rate, (1986-1999) ....................................... 25
Figure 2: Interest Rate Spread, Credit to Private Sector and the Broad Money Ratio, 1993-1997.28
Figure 3: Poverty Profile in Lam Dong Province ........................................................................ 41
Figure 4: Structure of Household Savings(% of the sample) ...................................................... .43
Figure 5: Using Financial Institutions(% ofhouseholds) ............................................................ .44
Figure 6: Savings and Loans in Lam Dong province .................................................................. .47

VI


ACRONYMS
GDP: Gross Domestic Products
GSO: General Static Office
OLS: Ordinary Least Square
USD: United States Dollar
VBARD: Vietnam Bank for Agriculture and Rural Development
VBP: Vietnam Bank for the Poor
VLSS: Vietnam Living Standard Survey
VND: Vietnam Dong
WB: World Bank
IMF: International Monetary Fund

vii

ACKNOWLEDGEMENTS
To complete this MDE program as well as this thesis I have been indebted to so many
people that I could not mention them all here. Hereinafter, I would like to express my thanks
to those who have helped me in some important ways.
First of all, I would like to thank all the staff of Vietnamese-Dutch project for Master
in Economic Development for their help during my study time and the Ho Chi Minh Political
Academy, where I have worked, for its support and providing the opportunity for me to take
this course.
I would like to express my gratitude to Pr. Dr. Karen Jansen who is the course leader

of Banking and Finance. During his course, not only I can achieve the knowledge about the
Finance and banking but also I have the opportunity to discuss household saving behavior
with him.
I would like to thank Dr. Nguyen Trong Hoai, my supervisor, for his helpful

comments. Especially, during the time of supervising my thesis, he has also given me useful
documents, which are hard to find in Vietnam. Without these documents, the thesis would
have taken a longer time to finish.
I am much in debt to Dr. Gabrielle Berman and Dr. Youdhi Schipper who corrected

my thesis and guided me into the right way of doing the thesis. The fulfillment of this thesis
perhaps is an end of my study in this program, but the image of Dr. Youdhi Schipper going
with us into every single household in Hoi An to guide us on how to conduct a household
survey as well as to show us how to analyze the collected data is definitely everlasting in my
memory.
I am much in debt to Dr. Haroon Akram Lodhi, the Project Leader. During the M.A

study course, he has taught me not only the methodology but also the honest intellectual ways
of doing a thesis. Without his contribution, the thesis could not have been successful.
Finally, I would like to thank to my mother, late father, sisters and brothers for their love,

support and encouragement.

viii


CHAPTER I

INTRODUCTION
1. Problem Statement
Interest in the study of household savings is increasing, especially in developing countries where
thousands of people live in poverty and the problem of capital shortage is severe. According to
Waheed (1996), a low level of household income reflecting low productivity caused by the lack
of capital investment, will result in low saving rates. Low saving rates, as a culprit of scarce
investment capital, in turn will lead to a low level of income and therefore poverty and low
savings again. That is how the cycle of household poverty works. For Vietnam, the study about
determinants of household savings is important for following reasons:
First, from the perspective of savings-investment gap, with the objective to tum the Vietnamese
economy to industrialized and modernized country by the year 2020, Vietnam needs a huge
amount of capital for investment. However, most of the rural enterprises in Vietnam have long
been facing a serious capital shortage: only 12-15 percent of rural enterprises can access capital
from formal financial institutions. Three quarters of enterprises claim that they desire to bonow
capital to expand and maintain their business. More than half of Vietnam's population has not
been served by the financial system (World Bank, 1998).
There are two ways that Vietnam can solve the problem of lack investment capital, either by
increasing domestic savings or by increasing foreign savings. However, there is general
agreement thaTin the early stages of economic development, developing countries can rely on
foreign savings to reduce their savings-investment gap in order to develop their economies. The
purpose of using foreign savings to increase domestic income (and therefore to increase domestic
savings) after all is to achieve sustainable development and to reduce the dependence on foreign
countries. Therefore, to achieve sustainable development, domestic savings sources play a

decisive role. The important role of domestic savings in achieving stable economic growth is
obvious for the case of Vietnam The practical experience from previous years showed that a
sharp reduction of foreign direct investment as a consequence of the Asian crises caused the
problem of capital shortage in Vietnam to be more severe, widened budget deficit and resulted in
slowing the Vietnamese economic growth rate (World Bank, 1997; O'Connor, 2000; AkramLodhi and Sepehri, 2002). Financing investment by borrowing foreign capital is also not easy for
Vietnam because Vietnam is considered as one of the severely indebted low-income countries
with limited debt service capacity (World Bank, 1997). Accessing foreign aid is not easy too
because in order to receive aid, Vietnam should meet many conditions set by its donors.
1


Domestic savings sources include government savings and private savings (Qian, 1988).
However, it is difficult to increase government savings because most of State owned enterprises
in Vietnam operate inefficiently (World Bank, 1997). Private savings include household savings
and corporate (business) savings. However, in Vietnam most of eighty- percent private businesses
are household-based (Leung and Riedel, 2002). In the context of the Vietnamese economy, the
increasing household income would lead to the stable and permanent increase in domestic
savings, which will supply a stable source of investment capital to achieve sustainable economic
growth (World Bank, 1997). Therefore, from the perspective of the savings-investment gap and
from the context of a capital-scarce economy like Vietnam, the study about determinants of
household savings in order to fmd solutions for increasing savings is important.
Second, from the perspective of poverty alleviation, the study about determinants of household
savings is important. The justification for this argument is based on ground that the lack of capital
due to low savings has prevented rural households from adopting modem agricultural technology
and engaging in income generating activities. This results in a vicious cycle of low productivity,
low income, and then low savings of the rural households (Hung, 1999). Therefore, high savings
allows households to insure against uncertain income, unforeseen risks such as natural disasters,
sickness, and volatile agricultural prices in order to break out of the vicious cycle of poverty
(Asian Development Bank, 1996).
It is worth noting that, an increase in the volume of household savings is only a necessary

condition to achieve economic growth. The sufficient condition to achieve economic growth is
how to channel savings into investment to generate economic growth and to reduce proportion of
idle savings. For Vietnam, channeling household savings into investment is extremely important
to resolve the contradiction that the economy is capital scarce while households keep their
savings in idle holdings and unproductive assets. This justification is based on the previous
findings of many economists doing research in Vietnam For example, according to Dapice
(1994) there is high potential for Vietnam to increase domestic savings rate in order to resolve the
problem of lack of investment capital, especially in the short run. "In the short run, much of
household level savings held in the forms of gold and USD could be converted into bonds, bank
accounts or direct investment" (Dapice, 1994: 15). Because at the National Income Account level,
gold is considered consumption good, therefore, according to his estimation, only by shifting
from household savings in gold and USD into fmancial savings, could the Vietnamese national
savings rate increase over ten percent holding the level of household savings constant (Dapice,
1994). From this perspective, the necessary and sufficient condition to achieve sustainable
economic growth is not only to increase volume of household savings but also to channel savings
2


into productive investment. There is general agreement that by intermediating saving sources
from savers to investors, financial development influences not only the volume but also the forms
of household savings. However, whether the net effect of financial development on household
savings is positive or negative remains inconclusive (Jansen, 1990; Adams 1983). Therefore, in
this study of determinants of household savings, the special focus is placed on financial
development to see how financial development influences household savings in Vietnam.
This study takes Lam Dong province for empirical study on the ground that Lam Dong belongs
to the Central Highlands region, one of the three poorest regions of Vietnam The estimation by
Lam Dong Statistics Office based on per capita income criteria shows that up to 11.64 percent of
households in Lam Dong province are still living in poverty (Lam Dong Statistic Office: 2002).
However, this does not mean that poor households in Lam Dong province cannot save. In fact, to
deal with survival needs such as income fluctuations due to the volatile prices of agricultural

products, natural disaster, sickness, poor households need to save and do save. Therefore, the
study aims at finding what factors determining household savings in order to find solutions for
increasing the volume of household savings and for channeling savings into productive assets is
important to help the poor households in this province improve living standards and move out of
poverty.
2. Objectives of the Study
This empirical study aims at analyzing what factors determine household savings with special
focus on financial development to see how financial development influencing household savings.
The central concerns of the current empirical study are what are determinants of household
savings in Lam Dong province? Does financial development have a positive impact on household
savings? These main concerns pose two hypotheses that need to be tested in the current empirical
study:
The first hypothesis is" Household savings is determined not by one factor but by a set of
socioeconomic factors". To be specific, a set of socioeconomic factors in the current study is
household income, land size, gender of household head, education, occupation, dependency ratio,
family size, age of household head and financial development proxied by the distance from the
household to the nearest financial institution.
The second hypothesis is "there is a negative relationship between the volume of household
savings and the distance from the household to the nearest financial institution".

3


3. Research Methodology and Data Sources
The study about determinants of household savings can be carried out by two approaches: a
macro approach and a micro approach. However, for Vietnam, data about household savings as
well as data suitable to test the mentioned hypotheses at macro level is not enough. Alternatively,
the micro approach is employed in this empirical study. To test the hypotheses, quantitative
method applying ordinary least square (OLS) technique is employed.
To conduct this empirical study, primary data, secondary data and tertiary data are all employed.

The primary data is mostly from VLSS 1993, VLSS 1998 and household survey conducted in the
year 2002 in Lam Dong province. Secondary data and tertiary data come from other previous
empirical studies, newspapers, GSO, IMP, World Bank, etc. Among these sources of data, the
emphasis is placed on primary data from a household survey conducted in Lam Dong province.
4. Structure of the Study
The rest of the study is arranged by following structure: Chapter 2 is a theoretical review. In order
to understand the theoretical review and to form an empirical framework, at first some important
concepts are presented in this chapter. Then various theories about determinants of household
savings from different schools of thought, theoretical and empirical reviews about the impact of
financial development on household savings are presented to draw framework for the empirical
analysis. Chapter 3 provides an overview of financial development in Vietnam and its impact on
household savings in_ terms of saving opportunities and saving incentive. Chapter 4 presents
model specification, sampling method, data collection and data analysis including regression
analysis and statistical descriptive analysis. Then based on the
results, policy recommendations are suggested in chapter 5.

4

dat~

findings and regression


CHAPTER2

THEORETICAL FRAMEWORK
Introduction

The objectives of this chapter are firstly to provide some important concepts that will be used in
the theoretical review and empirical study. Secondly, after understanding the main concepts,

various theories about determinants of household savings from different schools of thought as
well as the theoretical review of the impact of financial development on household savings are
presented to draw a theoretical and conceptual framework for the empirical analysis in the
following chapters. Finally, a review of empirical studies is presented to show the impact of
financial de:velopment on savings in reality.
I. IMPORtANT CONCEPTS

In order to investigate what factors determine household savings and how financial development
influences household savings, the current study will take each household as a unit of analysis.
The following concepts will pave the way into the theoretical review and empirical analysis:
Savings is defined as income that is not consumed (Newman, et al., 1997). That is:
Household savings =household current disposable income -household consumption. The total
savings includes financial savings and physical savings. Disposable income is measured by
deducting the household income and tax.
Financial development is defined as "the process by which the role of indirect finance in
financing capital formation increases. It implies an increased separation of the acts of saving and
investing, or an increased division of labor in the economy between the saving and investment
unit." (Jansen, 1990: xii). The term "indirect fmance" means that the saver allocates his savings
into a financial institution, and then the financial institution uses this savings fund to lend to the
investor (Jansen, 1990; Kitchen, 1995). Therefore, on the supply side, financial development also
means that there is an increase in the use of financial institutions by economic units in allocating
their saving resources. At the macroeconomic level, the quantitative measures of financial
development are usually the ratio of M2 to GDP or M3 to GDP (Jansen, 1990; Kishi, 1995;
Husain, 1996). The components of M2 are currency in circulation, demand deposits and savings
deposits in the banking system The components of M3 are currency in circulation plus the
demand deposits and savings deposits both in banking and non-banking fmancial institutions
(Jansen, 1990). As the volume of currency in circulation is controlled by the Central Bank, any
5

increase in financial savings will lead to an increase in the ratios of M2 or M3 to GDP in the
economy (Kitchen, 1995; Nam, 1996). The proportion of household financial savings depends on
the return on financial savings, which includes interest rate and transaction cost. Financial
development leads to an expansion of financial institutions i.e. an increase in density of financial
institutions and the improvement in financial services, which results in reducing transaction cost.
At a given rate of interest, the reduction of transaction cost will lead to the increase in return on
financial savings, which in turn will cause substitution effect and income effect on the total
volume of household savings. Therefore, by employing cross sectional data at micro approach,
the current empirical study employs the distance from household to the nearest financial
institution as a proxy for financial development to capture the impact of financial development on
the total volume of household savings.
Based on VLSS 1997-1998, the concept "the use of financial institutions by households in
allocating savings" consists of household savings in state bank, other types of bank, Credit
Corporation, government bonds, informal credit system In the current empirical study, savings
that belong to above categories are considered as fmancial savings. Savings allocated outside
financial institutions or "non-use fmancial institutions" consists of savings in cash, USD, gold,
gemstones and other physical assets. Savings that belong to these categories are considered as
physical savings.
The term "financial repression" is understood as the situation when the Government controls and
sets the interest rate, which is lower than that determined by the forces of demand and supply of
free market (Kitchen, 1995; McCarty, 2001). The low interest rates discourage households from
using financial institutions to allocate their savings and to save in financial assets (Kitchen, 1995).
Therefore, in the current empirical study, the term "financial repression" also is roughly
understood as opposite to the term "financial development".
In summary, the meanings and the defmitions of some key concepts such as household savings,
financial repression, financial development and the use of financial institutions by households in
allocating savings are presented. These concepts will pave the road for understanding the
theoretical review and empirical analysis in the following sections.

6

II. THEORETICAL REVIEW
The objectives of this part are at frrst to present theories of determinants of household savings and
then theory of how financial development influences household saving behavior.

1. Household Savings
The theories about household savings can be classified into two schools of thought. The frrst is
the classical school and the second is Keynes and other modern economists such as Franco
Modiglian and Milton Friedman. The main difference between the classical theory and the rest is
that in the classical viewpoint, savings is determined mainly by interest rates. In contrast, Keynes
and other modern economists emphasize the role of household income as the main determinant of
household savings (Wai, 1972; Qian, 1988; Thirdwall and Warman, 1994). Now the theories
about household savings are summarized systematically on time order.
1.1. The Classical Theory

The typical representatives of the classical school are Alfred Marshall, Knut Wicksell, and Irving
Fisher. According to this school of thought, interest rates are the most important factors in
detemlli1ing household savings. With the viewpoint, "interest rate is a reward for waiting", an
increase in interest rates will lead to the larger reward for savings and therefore a larger volume of
household savings (Wai, 1972). In addition, in this theory, an increase in savings also means an
increase in investment (Wai, 1972; Waheed, 1996). This viewpoint is attacked by Keynes.
Keynes argues that the volume of savings depends on the volume of investment, which is
influenced by interest rates. An increase in interest rates will lower the volume of investment,
which in turn will reduce savings (Waheed, 1996). Based on this argument, Keynes developed his
savings model called "Absolute Income Hypothesis".
1.2. Keynesian Theory

Under Keynesian theory named "Absolute Income Hypothesis", the savings model simply is a
function of crnTent disposable income.

S =a+ b.Yt

(Jansen, 1990)

Where a is intercept term, which is negative. b is propensity to save which is greater than zero but
less than one. Yt is current disposable income which equals income minus tax (Qian, 1988;
Jansen, 1990; Gillis et al, 1996). According to Keynes, an increase in household income will lead
to an increase in household consumption. However, the increase in household consumption is at
7


lower speed than the increase in household income. Therefore, the increase in household income
will lead to the increase in household savings (Waheed, 1996). Keynes also pointed out eight
motivations for household savings, such as precaution, foresight, calculation, improvement,
independence, enterprise, pride, and avarice (Wai, 1972; Tin, 2000).
In contrary to the classical viewpoint, Keynes argues that interest rates have negative effect on
savings. An increase in interest rates leads to a decrease in investment, which in turn will result in
a larger decrease in income and therefore a decrease in savings. This phenomenon is called the
"paradox of savings". From this perspective, Keynesian model is attacked by the theory of
"financial liberalization" ofMcKinon and Shaw. According to Shaw (1973), developing countries
face the problem of shortage of capital investment rather than the problem of shortage of
productive investment projects. Therefore, the increase in interest rates does not lead to the
reduction in investment and in the volume of savings. Besides, Keynesian model is attacked by
the empirical studies such as those of Kunezts et al in 1946, Brady and Friedman in 1947
(Modigliani, 1998). According to their findings, the saving behavior of households is influenced
by long-term factors such as the expectation of lifetime income rather than short-term factors
such as current income. From these mentioned shortcomings, the new three models of household
savings have been developed. They are "Relative Income Hypothesis" developed by
Duesenberry, 'The Permanent Income Model" developed by Milton Friedman and the ''Life
Cycle Hypothesis" developed by Duesenberry and Modigliani. All of these three models will be

discussed in the next section.
1.3. The Relative Income Hypothesis

According to the Relative Income Hypothesis, household savings depends "not only on the
current income but also on previous levels of income and past consumption habits" (Gillis et al,
1996:313). That is, when household income increases over the long term, household consumption
also increases. However, it takes time to change household consumption habits. Therefore, in the
short term, any increase in household income does not lead to the change in household
expenditure immediately. This leads to an increase in the volume of household savings (Waheed,
1996; Gillis et al, 1996)

8


1.4. The Permanent Income Hypothesis and Life Cycle Hypothesis

According to the Permanent Income Hypothesis, the saving decisions of households depend on
permanent income, defmed as "the return on wealth including both human capital and physical
asset accumulated by the household" (Jansen, 1990:82) and transitory income, defined as
unpredictable income such as lottery winning, gifts, inheritance and other unpredictable windfall
(Gillis et al, 1996). The general form of savings fimction in the permanent income hypothesis is:
(Jansen, 1990; Qian, 1988)
Where: Y1 is transitory income. The parameter a1 equals one indicating that any increase in
transitory income will lead to an increase in household savings by the same amount. YP is
permanent income. In reality, it is very difficult to estimate permanent income as above defined.
Therefore, empirical studies usually estimate permanent income by taking a weighted average of
the observed income values in the past (Jansen, 1990).
The Life Cycle Model was developed by Modigliani and Bromberg in 1954, almost at the same
time as the "Permanent Income Hypothesis". In the Life Cycle Hypothesis, the household saving
decisions also depend on permanent income rather than current income. The age profile also

affects household saving behavior. People are unable to save when young, increase savings in
their middle age, reduce their savings at retirement and reach the break-even point at death.
Besides income factor and age profile, other factors such as the dependency ratio, the fluctuations
in income also affect household savings (Gersovitz, 1988; Modigliani, 1988; Asian Development
Bank, 1996). The two models have common assumptions, for example perfect capital market and
perfect foresight. The assumption about perfect capital market means that households do not face
any borrowing constraints. They can borrow to finance consumption at their will. The assumption
about perfect foresight means that households can estimate their lifetime income. The main
difference between the two models lies at the point that the Permanent Income Hypothesis
focuses on the income fluctuation, meanwhile the Life Cycle Model focuses on the fitness of life
and the plan for retirement (Wai, 1972; Aryeetey and Urdry, 2000).
1.5. Integrated Theory of Savings

There is general agreement that no single theory can fully explain reality. Every single theory
mentioned above has its own strengths in dealing with household saving behavior, so they cannot
be ignored all together. Therefore, Wai (1972) and other economists have developed an Integrated
theory to capture economic and non-economic factors that influence household savings. In the
9


Integrated model, decisions to save are determined by the so-called ability to save, the willingness
to save and the opportunity to save:

S =f(W, A, 0)

(Wai, 1972: 96)

Where W is the willingness to save; A is the ability to save; and 0 is the financial variables. In
this function, each factor is a function of socioeconomic variables. For example, willingness to
save is a function of age profile and occupation of household head. The ability to save is a

function of income, dependency ratio, and wealth. The two W and A functions are inherited from
the previous mentioned saving models. The only difference between the integrated model and
previous models is financial variables (0). According to Wai (1972), financial development is
one of determinants of household savings. Particularly, the availability of financial institutions
and the quality of the staff of financial institutions are expected to have a positive impact on the
volume of household savings. The marginal efficiency of capital reflects the choice of households
in allocating their savings between fmancial assets and physical assets. If the rate of return on
financial assets provided by financial institutions is higher than that on physical assets,
households will shift their savings into financial assets. This leads to an increase in the share of
financial savings to the total volume of savings. According to Wai (1972), any improvement in
financial institutions and rate of return on savings will lead to an increase in volume of savings.
Though the model of Wai is not perfectly developed, it can shed a light on empirical study of
determinants of household savings and on the influence of fmancial development on household
savings. Many economists have built their empirical studies based on the Integrated model with
some modifications to study the impact of financial development on savings such as the study of
Fry (1988, 1998), Thirdwall, (1999) etc., which will be discussed deeply in the empirical
evidence section.
2. Financial Development and Household Savings

The effects of financial development on household savings can work through two channels: the
opportunities to save and the incentive to save.
2.1. Impacts on Opportunities to Save

The opportunities to save of households are determined by the availability of financial
institutions, financial services and financial products offering to households (Adams, 1983). In
theory, the impact of financial development on the volume of household savings through the
channel of saving opportunities is inconclusive.
10

Financial development leads to an increase in competition between financial institutions, which
provide more opportunities for households to save. That is, in process of financial development,
more and more financial institutions are established. The coexistence of many types of financial
institutions leads to increasing competition between financial institutions and reducing their
monopoly characteristics. Operating in a competitive environment, each financial institution has
to improve its quality of services, diversify saving products in order to maximize profit. All of
these factors contribute to reducing transaction cost, creating more convenience for households to
save, therefore influence both the volume and the composition of household savings (Wai, 1972;
Mauri, 1983; Gillis et al, 1996; Hanahan, 1999; Adams 1983; Robinson 2001).
Financial development influences the volume of household savings in that, to dealt with income
fluctuation due to natural disaster, crop failure, sickness, children's education, volatile
agricultural prices, and other survival uncertainties, rural households need to save and do save
though the volume of their savings at each time may be very small. They save whenever possible
and in whatever form, which is convenient and secure for them (Rutherford, 2000). By providing
better saving services and wider range of financial products, financial development can exploit
the capacity to save of rural households and helps them to turn many small savings into larger
lump sums enough to smooth their consumption, deal with emergencies and engage in productive
activities. This leads to an increase in the volume of household savings as well as an
improvement in the living standards of rural households. In addition, financial institutions (in this
case usually insurance companies) can take small savings from various households into lump
sums then return to those households who suffered from losses. This action helps households to
cope with risk, disasters and insures their production activities in any circumstances. From this
perspective, fmancial development has positive impact on the volume of household savings
(Rutherford, 2000; Robinson, 2001).
Financial development also leads to an increase in liquidity, defined as "the speed at which assets
can be converted in purchasing power at agreed price" (lsaksson, 2000:4), which has positive
effect on household savings. That is, rural households are involved in many different activities
such as production, consumption, and savings-investment. The savings-investment activities of
rural households are unstable due to unstable income caused by objective factors such as weather
uncertainty, crop failure, natural disaster and volatile prices of agricultural products, so that they

usually need liquidity to deal with such uncertainties (Adams, 1983; Haughton, 1994). By
diversifying financial products, financial development allows households to choose the financial
assets that suit their needs to restore temporary accesses in agricultural income. When households
need cash to due with emergencies in their production, they can convert these financial assets into
11


cash by selling these financial assets to financial institutions. This can help rural households
manage their agricultural production better and therefore leads to an increase in income and
savings (Husain, 1996). Besides, the increase in liquidity also allows households to reduce the
proportion of precautionary savings, which is high liquid form but at a low rate of return to
increase the proportion of other assets that can provide a higher rate of return (Rutherford, 2000).
This improvement in saving allocation together with the earnings on savings leads to higher
income and higher volume of household savings (Wai, 1972; Fry, 1988; Schmidt-Hebbel et al,
1996).
Financial development leads to an increase in allocating efficiency of resources, therefore
generates higher income and savings. This is because, firstly, in the economy, investors and
savers are usually not the same agents. Households may not be good at accessing risk and may
not want to take risk by making investment. However, lending their savings directly to investors
to earn interest is not easy because it is costly and difficult for households to evaluate
creditworthiness of investors. Households will not lend their savings to investors with unreliable
information. Financial institutions, as specialists in lending, are better at selecting the most
promising investment projects based on profitability and risk assessment (Kitchen, 1995). They
can obtain economies of scale in lending and reduce the transaction cost such as the cost of
information, the cost of exchanging savings resources between savers and investors as well as the
opportunity cost of holding idle money. Therefore, at any level of risk financial institutions· can
provide households higher rates of returi:l on their savings and offer investors lower rates charged
on loans. This stimulates households to save more and to save more in the form of financial assets
and investors to invest more (Fry, 1988; Jansen, 1990; Haughton, 1994; Kitchen, 1995;
Thirdwall, 1999). Secondly, the maturity mismatch between savers and investors is also a

problem that could be an obstacle for both households and investors. Sometimes, investors want
to borrow to finance high return investment projects that require a long term cornmi.tment of
capital while households do not want to lend their savings for investors with long commitment
because the longer time the households lend their savings to the investors, the higher risk and
higher loss of liquidity they will face (Kitchen, 1995). Financial institutions can resolve this
problem by using the law of large number to receive short-term savings from savers to lend to the
investors with long-term loans (Kitchen, 1995). In addition, by diversifying fmancial products,
financial development can provide both households and investors the financial instruments that
suit their needs. This is convenient for both households and investors. As a result, the indirect
finance in the economy will increase. In other words, financial development stimulates

12


households to save more and to save more in the form of financial assets (Nwanna, 1995;
Kitchen, 1995).
Financial development leads to relaxation of borrowing constraints, which influences saving
behavior of households in two opposite directions. The relaxation of borrowing constraints allows
households to borrow from fmancial institutions to engage in income generating activities and
expand their production. This leads to an increase in household income and therefore the volume
of household savings through the mechanism: "low-income, credit, investment, then higher
income, higher savings and higher investment" (Nwanna, 1995; Hoai, 2001 :36). However, the
relaxation of borrowing constraints also encourages households borrowing and reduces the
volume of precautionary savings (Rogg, 2000). From this perspective, the relaxation of
borrowing constraints due to financial development has negative effect on the volume of
household savings (Gersovitz, 1988; Schmidt-Hebbel et al, 1996; Fry, 1998; Rogg, 2000).
Financial development influences the composition of rural household savings in the way that if
financial

institutions could provide "combination of security,

convenience,

liquidity,

confidentially, service and return" (Robinson, 2001: 228) for households then the ratio of
financial savings of households will be high and vise versa. To be more specific, if the financial
services are good, then the increase in density of fmancial institutions leading to the reduction of
transaction cost will have positive impact on the proportion of financial savings of rural
households. Therefore, according to Robinson (2001) the low or high proportion of financial
savings of households in rural areas depends on the financial institutions themselves not on the
households.
In summary, there is general agreement that financial development is one of determinants of
household savings. However, the net effect of financial development on household savings
remains inconclusive. Financial development accompanied by an increase in the density of
financial institutions, providing a wider range of saving products and better fmancial services,
encourages households to save more and to shift their savings into the form of financial assets.
Consequently, this leads to an increase in the proportion of financial savings. The relaxation of
borrowing constraints creates opportunities for households to engage in income generating
activities and therefore leads to higher income and savings. On the other hand, relaxation of
borrowing constraints encourages households to borrow for consumption. This leads to a
reduction of precautionary savings. As a result, the overall effect of financial development on the
volume of household savings remains inconclusive.

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2.2. Impacts on the Incentive to Save
The saving incentive of households is mostly determined by interest rate (Adams, 1983). As
noted in the previous section, financial development leads to an increase in the rates of return on

household savings due to the increase in the efficiency in allocating saving resources (Jansen,
1990; Wai, 1972; Thirlwall, 1999). However, an increase in interest rates creates two opposite
effects on the volume of household savings (Jansen, 1990; Husain, 1996; Rogg, 2000).
The first effect is called the substitution effect. Under the substitution effect, an increase m
interest rates has positive effect on the volume of household savings. According to Shaw and
McKinnon (1973), in developing countries, an increase in interest rates leads to an increase in
savings. This is because developing countries face the problem of lack of capital rather than the
problem of lack of productive investment projects. Thus, an increase in interest rates due to
financial development does not lead to a reduction of investment. Instead, an increase in the
interest rates creates pressure on investors to search for high yield investment projects and to
consider the efficiency of investment projects carefully before making their investment decisions
because if they invest in low yield investments, the profits earned from these projects is not
enough to cover interest payment to financial institutions. As a result, the efficiency of investment
of the country will increase. Therefore, this leads to an increase in savings (Shaw, 1973; Fry,
1998). Fry (1988) also argues that the less fmancial development the country faces, the stronger
ability to increase its savings by increasing interest rates the country has.
The increase in interest rate also makes opportunity cost of consumption and idle holdings
increase. Households react to the increase in opportunity cost by reducing current consumption
and by shifting their savings into financial assets to earn interest. This leads to the increase in the
volume of household savings and the share of financial savings (Kitchen, 1995; Fry, 1998). In
addition, an increase in interest rates prevents households from investing in low yield projects
because if households could not find high yield investment projects, they can allocate their
savings into financial institutions to earn return instead of investing in low yield projects (Fry,
1988; 1998). From this perspective, an increase in interest rate has positive effect on the volume
of household savings and on the share ofhousehold financial savings.
The second effect is called the income effect. Under the income effect, an increase in interest
rates has negative impact on the volume of household savings. This is because an increase in
interest rates leads to an increase in household wealth. Then the increase in household wealth in
tum will encourage households to consume more. As a result, the volume of household savings
will be reduced (Rogg, 2000). Therefore, the overall effect of an increase in interest rates on the

14


volume of household savings, i.e. the combination between the income effect and the substitute
effect, is inconclusive (Clarke, 1996; Jansen, 1990; Rogg, 2000).
To sum up, financial development influences household savings through two channels, the
incentive and the opportunity to save. From the perspective of opportunity to save, by providing
wider range of saving products at lower transaction cost, financial development encourages
households to save more and to save more in the form of financial assets. However, fmancial
development is also accompanied by relaxation of borrowing constraints, which causes both
positive and negative effects on the volume of household savings. Therefore, the net impact of
financial development on household savings through saving opportunities is inconclusive. From
the perspective of incentive to save, financial development leads to an increase in interest rates,
which cause the substitution effect and the income effect on household savings. If the substitution
effect is greater than the income effect, then the increase in interest rates will lead to an increase
in the volume of household savings and vice versa. Therefore, the effect of financial development
on the composition of household savings is obvious but the overall effect of fmancial
development on the volume of household savings is so far inconclusive. However, there is
general agreement that by expanding financial system, providing better fmancial products and
reducing transaction cost, financial development leads to an increase in the use of fmancial
institutions by households and other economic units in the economy. On the other hand, an
increase in the use of fmancial institutions by households and by other economic units stimulates
financial development. Perhaps there are no better words to reveal this relationship than what
Jansen (1990) has written:
The crucial causes and effects of financial development lie at micro level, where an
individual economic unit that saves more than it can or wishes to invest decides to
deposit its savings with a banks; and where another unit that wishes to invest more than
it can save obtains that credit from that bank (Jansen, 1990: xi).
In brief, during the process of financial development, there is increasing density of financial
institutions and they work more efficiently leading to the reduction of transaction cost. As the

return on financial savings equals interest rate earned minus transaction cost, the reduction of
transaction cost will result in an increase in return on financial savings, which influences the
volume of household savings. Therefore, to capture the impact of financial development on the
volume of household savings at micro approach, the current empirical study will employ the
distance measured by kilometer traveled from the household to the nearest fi11ancial institution as
a proxy.
Over the past years, economists have tried to test the relationship between financial development
and household savi11gs. Their empirical results show that the relationship between fi11ancial
15


development and household savings is inconclusive and remains an ongoing debate. For the
current empirical study, to provide practical evidence about the relationship between financial
development and savings, some prominent empirical studies are presented in following section.
III. FINANCIAL DEVELOPMENT AND SAVINGS: EMPIRICAL EVIDENCE

Empirical studies about determinants of household savings with special focus on financial
development factor have increased in recent years in both developed and developing countries.
Especially, in developing countries where investment capital is scarce, there is strong hope
financial development could create incentive for savings, provide more opportunities to save and
allocate saving resources efficiently. Therefore, it contributes to reducing the gap of savinginvestment in order to generate economic growth. Some significant empirical studies about the
impact of financial development on savings are summarized bellow:
At the macro level approach, by using the time series data from 1950 to 1969 of 43 developing
countries including Latin American, African, and Asian countries, the empirical study of Wai
(1972) shows that there is positive relationship between national savings and financial
development proxied by the interest rate and the ratio of financial savings (Wai, 1972).
Another study to test the impact of financial development on the volume of savings was carried
out by Fry. With the belief financial development leads to an increase in real interest rates and
therefore stimulates savings, Fry (1988) used the real deposit rate and rural population per bank
branch as proxies for financial development and data of Asian countries to test the impact of

financial development on savings rates at the macro level. His empirical study showed that there
was a significant positive effect of fmancial development on savings (Fry, 1988). However, for
different countries, the increase in density of bank branches resulted in an increase in savings
differently. For example, a reduction of 10 percent of population per bank branch could increase
national savings 4.7 percentage points in India, 4.1 percentage points in Korea, 8.6 percentage
points in Sri Lanka but only 0.8 percentage points in Thailand (Fry, 1988).
In contrast, the empirical study of Jansen (1990) in Thailand during the period 1960-1977 showed
that financial development, measured by financial intermediation ratio, had a negative impact on
savings (Jansen, 1990:99).
The study of Jappelli and Pagano (1992) was also consistent with the finding of Jansen. Jappelli
and Pagano argued that financial development would lead to a relaxation of the liquidity
constraint, and therefore reduced the volume of household savings. To support the argument, they
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