Can savings & investment be increased ?

By the Economist

The rate of investment is the most relevant determinant of economic growth in the short run. This is one of the few irrefutable facts of economic theory that has been proven by historical experience. In the Sri Lankan context a higher rate of investment supported primarily by increased domestic savings and supplemented with foreign investment is vital for higher rates of growth. The inability to increase the country's savings ratio, as well as attract higher amounts of foreign investment, has deterred faster growth. Investment has tended to hover around 25 per cent of GDP yielding a growth of around 5 per cent per year. Economists have for quite some time suggested that a growth rate of about 7-10 per cent over a decade was needed to propel the economy to levels that would resolve the country's pressing economic and social problems. Given the current incremental capital output ratio (ICOR) of 5:1, this implies an investment of 35 to 50 per cent of GDP to achieve the desired growth rate.

Once again the security situation and economic developments internationally and domestically make the mobilisation of higher amounts of savings for investment unlikely. In fact several favourable features of last year's economic performance for investment are unlikely to be sustained this year. One of these is the much hoped-for and essential increase in the country's investment ratio. Investment depends on savings. It has been observed for many years that Sri Lanka's domestic savings has not been commensurate with its per capita income level. For instance, India that has a much lower per capita income has a higher domestic savings ratio. Higher income countries in Asia like Singapore and Malaysia have much higher levels of domestic savings. These higher rates of saving are not merely due to their higher incomes. More stable economic conditions, lower inflation, cultural and social values and higher enforced savings through compulsory employer and employee contributions, are among the contributory factors.

The Central Bank Annual Report for 2005 noted that both investment and savings in Sri Lanka increased in 2005. This would have been indeed good news in the long-run interest of the economy, but chances of this development being the beginning of a trend is highly unlikely. The Annual Report noted that investment increased slightly from 25 per cent in 2004 to 25.6 per cent of GDP, while savings increased by around the same extent from 15.9 per cent in 2004 to 16.4 per cent of GDP. However it is noteworthy that private investment declined from 22.8 per cent in 2004 to 22.6 per cent in 2005, while public investment improved from 2.2 per cent of GDP in 2004 to 3.1 per cent of GDP in 2005. The increase in savings last year was due to private domestic savings increasing from 19.8 per cent to 20 per cent of GDP in 2005. The government has been notorious for being a dis-saver for several decades. Last year was no exception. Public dis-savings however declined somewhat from 3.9 per cent of GDP to 3.6 per cent of GDP.

All these somewhat favourable developments are likely to be reversed by the emerging situation of a deteriorating security situation, rising inflation, higher government expenditure on the war and the escalation of oil prices internationally and their repercussions domestically.

The Central Bank observed that the savings and investment gap last year, and indeed in most past years, was financed through increased foreign direct investment, portfolio investment, and loan and grant inflows to the government. Some of the increase last year was no doubt due to tsunami relief funds that are hardly of consequence this year.

The ability to attract foreign direct investment is seriously jeopardised by the deteriorating security conditions, while portfolio investment that still remains robust could under the prevailing conditions get into reverse gear swiftly.

An increment in both domestic savings and foreign investment is dependent on the country's economic, political and security conditions. All these factors are hardly conducive to investment and savings. This is especially so with the weakening security situation. This factor alone is likely to impact heavily on the several components of savings. Therefore last year's somewhat hopeful signs of increased savings and investment may be arrested.

Equally relevant is the continuing rise in prices and inflationary expectations that would erode savings through lesser ability to save as well a lesser willingness to save. Postponing consumption today for consumption tomorrow could be irrational if the real rate of interest (the nominal rate of interest adjusted for inflation) is negative. Increased government expenditure for defence, subsidies for utilities and wasteful expenditure on politicians to keep them within government ranks, would once again increase the fiscal deficit to an extent higher than anticipated in the budget.

It is indeed regrettable that these inexorable laws of economic are either not understood or not cared for by the government. Preoccupation on the war, strengthening its political strength and political base are the main concerns. Meanwhile rapid economic growth remains a distant dream.