SAVINGS

AND THE FINANCIAL SYSTEM

INTRODUCTION
Saving plays a key role in determining growth. It is also important to know how saving behavior
is conditioned in order to explore the implications for the macroeconomic policy and the impact of
changing government policies. Much of the literature on the developing countries deals with how these
models can be used and tested.

Some Saving Models

Total saving is the sum of government, business, and private savings. In developing countries,
most savings is accumulated by private households and the unincorporated business sector.
Government saving has not grown much in the developing countries and corporate saving is relatively
small.

Keynesian and Income Constrained Models

 These models start with the simple observation that consumption may depend upon current
income. This model was overtaken by more plausible theories in the 1960s and 1970s that allow for
consumption and income smoothing overtime – that is, borrowing to smooth consumption so that it
does not depend completely on the current level of income.
 Nevertheless, the simple Keynesian Model featuring the importance of present income has
made a comeback with the work of Deaton (1989,1991, 1992) and Hall (1978).
 Hall argues that expected future income is subject to random changes so that the current
income is the only reliable predictor of current consumption and saving.

Income smoothing does not occur or is weak and this vitiates the life cycle model for several possible
reasons:
 Income smoothing is not possible because of borrowing constraints and imperfect capital
markets.
 Income smoothing is not applicable since many generations live together, weakening the need
for individuals to save.
 Future incomes are uncertain so it is difficult to plan over a lifetime.

Income Smoothing Models: The Permanent Income and Life Cycle Hypotheses

These are models that allow for consumption over some time horizon without constraint.
Families can borrow and save at will in order to smooth their consumption patterns to
compensate for fluctuations in income.
Determinants of Savings

1. Real Interest Rates – Higher real interest rates stimulate saving by offering higher financial returns for
abstaining from consumption through the substitution effect. On the other hand, higher interest rates
result in more income for creditors and this stimulates consumption through the income effect.
Furthermore, a negative income effect could manifest as a decline in pension contributions when
interest rates rise.

2. Role of the Government – if the government raises taxes (increases government saving), incomes will
decline and private saving can also be expected to diminish, other things being equal.

3. Growth of Income – if workers believe that a change in income is permanent, in a LCH/PIH world,
consumption would be adjusted upward accordingly and current saving rate could fall. The increase in
income could also have an impact on the rate of return on capital and hence the real interest rate.

4. Population Age Structure – the saving rate is expected to decline as the population ages. A country
with a very low dependency rate can be expected to have a higher saving rate in an LCH model.

5. Level of Income – if LCH and PIH are correct, then saving should not be related to current income.
However, several researchers have found that current income is an important explanatory variable.

6. Terms of Trade– the terms of trade effect works through an unanticipated and transitory increase in
income by an improved trade balance. An unexpected improvement in the terms of trade can have a
positive effect on the saving rate because it represents a windfall gain in income and, according to the
life cycle and permanent income models, would be saved.

7. Degree of Financial Liberalization– a general rule of thumb regarding saving would be that financial
stability and liberalization are positively related to the rate of private saving, other things being equal.

 A predictable and stable financial environment that offers a range of financial instruments can
be expected to call forth a higher level of saving from the private sector than a volatile and
capricious financial and economic environment.

Determinants of Saving in Developing Countries and in Asia

 Developing countries, such as those in South Asia and Latin America, generally saved up to
approximately 20-25percent of GDP between the 1960s and 2000s.
 In developing countries, saving rates are higher for the wealthy.
Determinants of Saving in Developing Countries and in Asia
 A careful review led by Harrigan (1998,p.42) conclude that:
“A trinity of fast growth, fiscal rectitude and slowing population growth have been associated
with high savings in Asia. Where one or more of these ingredients have been missing, savings have
suffered.”
Determinants of Saving in Developing Countries and in Asia
 Harrigan (1998) concludes that rapid income growth, selective terms of trade effects, financial
deepening, reduction in young age dependency and a reduction in size of government has boosted
private saving.
 There was also a significant depressing effect on saving caused by the decline in the
agricultural share of income.

Financial System

Introduction
The financial system is an integral component of modern economies. In most Asian countries,
commercial banks constitute the primary component of the financial system. However, informal
financial institutions also play an important role.
Furthermore, in the last decade or so, other financial institutions, including insurance companies and
pension funds, as well as stock and bond markets, have gained greater importance.

Banking and the Financial System

The banking and financial systems in the developing economies in Asia evolved from systems
that were in place during the colonial period. In South Asia, Taiwan, Malaysia, Hong Kong and Singapore,
the British system was adopted, while in East Asia, the Japanese model was adopted in Korea. In cases
such as Thailand and China, which were not colonized to any significant extent, the financial system
were borrowed from the industrial countries.

By the early 1970s, the region as a whole could be characterized by the widespread presence of
financial repression. It is a situation, first described fully by Shaw (1973) and McKinnon(1973), where
government taxes and subsidies distort the domestic capital market (compared with a free and
competitive system where private banks are supervised by a central bank) by imposing interest rate
restrictions and high reserve requirements.

At the same time there are compulsory credit allocations to some sectors and the lack of credit to
others. As a result, loans extended by banks were not thoroughly analyzed in terms of risk or proper
viability.

Competition among banks was also limited, particularly as foreign banks were not allowed to enter the
market or where their presence was highly regulated.

Financial Repression
“Repressed” financial systems were characterized by low or negative real interest rates and a
low and sometimes falling ratio of monetary assets to GDP/GNP.
In a repressed system, the government usually plays a dominant role in controlling the banking system
by imposing these kinds of controls, using banks to serve as the instruments for allocating credit to key
selected sectors. Often, specialized banks were created to address the needs of particular sectors.
Rural banks were often created for this purpose in the early stages of development and were
complemented by banks focusing on key industries later in the development process.

At the same time, credit to other potential borrowers was lacking.

As a result, informal or “kerb” markets developed outside the formal financial system to mobilize and
direct credit to those sectors not effectively serviced by the formal financial and banking system.

The overall impact of these developments was a fragmented banking system where the
organized banking system serviced only a small part of the total capital market while informal finance
emerged to serve the needs of other borrowers.

Financial Liberalization
Designed to remove all the restrictions that characterize financial repression.
These include the:
1. lowering of reserve requirements,
2. freeing up interest rates,
3. and allowing them to respond to market forces.

Managed credit allocations to key sectors should be reduced or eliminated, and loan officers should be
required to evaluate potential borrowers on the merits of the project and not to give loans
indiscriminately based on other economic criteria.

Competitive forces should be allowed to operate in the banking system to improve economic efficiency
through the relaxation of entry requirements, both domestically and for international banks.

The Financial Crisis of 1997

The Asian financial crisis of 1997 refers to a macroeconomic shock experienced by several Asian
economies – including Thailand, Philippines, Malaysia, South Korea and Indonesia.

Typically countries experienced rapid devaluation and capital outflows as investor confidence turned
from over-exuberance to contagious pessimism as the structural imbalances in the economy became
more apparent.

The crisis of ’97-99 followed several years of rapid economic growth, capital inflows and build up
of debt, which led to an unbalanced economy. In the years preceding the crisis, government borrowing
rose, and firms overstretched themselves in a ‘dash for growth.’

When market sentiment changed foreign investors sought to reduce their stake in these Asian
economies causing destabilishing capital outflows, which caused rapid devaluation and further loss of
confidence.
Long-term causes of the Asian Financial Crisis
1. Foreign debt-to-GDP ratios rose from 100% to 167% in the four large ASEAN economies in 1993-96.
Foreign companies were attracting capital inflows from the developed world. Investors in the West
were seeking better rates of return, and the “Asian economic miracle’ seemed to offer better rates
of return than lower growth economies in the West.

2. Current account deficits. Countries like Thailand, Indonesia, South Korea had large current account
deficits; this meant they were importing more goods and services than they were exporting – it was
a reflection of very high rates of economic growth and consumption. The current account deficits
were financed by hot money flows (on capital account). Hot money flows were accumulated
because of higher interest rates in the East

3. Fixed or semi-fixed exchange rates. This made currencies vulnerable to speculation. Also, interest
rates were used to maintain the value of a currency. Causing relatively high-interest rates in S.E. Asia
which caused hot money flows.

4. Financial deregulation encouraged more loans and helped to create asset bubbles. But, the
regulatory framework and structure of banking and firms meant loans were often made without
sufficient scrutiny of profitability and rates of return.

5. Moral Hazard. With a strong political desire for rapid economic growth, governments often gave
implicit guarantees to private sector projects. This was magnified by the close relationships between
large firms, banks and the government.
This closeness encouraged private firms to place less emphasis on the costs of projects and an
assumption expansion plans would be supported by the government

6. Over-exuberance. The booming economy and booming property markets encouraged expansive
borrowing by firms. It also encouraged international investors to move the capital to these fast-
growing economies.
There was an element of irrational exuberance – the idea that Asian economies were undergoing an
economic miracle where high returns were guaranteed.
Informal Finance
Informal finance is defined as contracts or agreements conducted without reference or recourse to the
legal system to exchange cash in the present for promises of cash in the future.

Informal Financial Sector

1. The informal financial sector provides savings and credit facilities for small farmers in
rural areas, and for lower— income households and small—scale enterprises in urban
areas.

2. The procedures of informal schemes are usually simple and straightforward; as they
emanate from local cultures and customs, they are easily understood by the population

3. The informal sector mobilises rural savings and small savings from Iow- income urban
househod.

4. Informal groups operates at times and on days which are convenient for their members.

5. Informal sector associations accept any amount of regular savings, even the most modest
sums which a saver can aford to set aside. The financial techniques on which such
informal groups are based lend themselves to the management of a large number of
small accounts.

6. Access to credit is simple, nonbureaucratic, and little based on writtern documents.

Literacy is not a requisite.

7. The simple and direct processing of loan requests allows for their prompt approval and a
minimum delay in disbursement. Rejections are rare; but the level of risk is reflected in
the interest rate charged .

8. Collateral requirements on loans are to local conditions and borrowers capacity.

The conditions may be based either on regular contributions to ROSCAs or on precise

knowledge of farm size and/or to so as to determine the borrower's capacity to repay a
loan.

9. Transaction costs are low

10. Repayment rates rates are high