Resource Mobilization, Financial Liberalization, and Investment: The Case of Some African Countries Mohammed Nureldin Hussain, Nadir Mohammed and Elwathig M Kameir Introduction The role of interest rate in the determination of investment and, hence economic growth, has been a matter of controversy over a long period of time Yet, what constitutes an appropriate interest rate policy still remains to be a puzzling question Until the early 1970s, the main line of argument was that because the interest rate represents the cost of capital, low interest rates will encourage the acquisition of physical capital (investment) and promotes economic growth Thus, during that era, the policy of low real interest rate was adopted by many countries including the developing countries of Africa This position was, however, challenged by what is now known as the orthodox financial liberalization theory The orthodox approach to financial liberalization (McKinnon-Kapur and the broader McKinnonShaw hypothesis) suggests that high positive real interest rates will encourage saving This will lead, in turn, to more investment and economic growth, on the classical assumption that prior saving is necessary for investment The orthodox approach brought into focus not only the relationship between investment and real interest rate, but also the relationship between the real interest rate and saving It is argued that financial repression which is often associated with negative real deposit rates leads to the withdrawal of funds from the banking sector The reduction in credit availability, it is argued, would reduce actual investment and hinders growth Because of this complementarity between saving and investment, the basic teaching of the orthodox approach is to free deposit rates Positive real interest rates will encourage saving; and the increased liabilities of the banking system will oblige financial institutions to lend more resources for productive investment in a more efficient way Higher loan rates, which follow higher deposits rates, will also discourage investment in low-yielding projects and raise the productivity of investment This orthodox view became highly influential in the design of IMF – World Bank financial liberalization programmes which were implemented by many African countries under the umbrella of structural adjustment programs The purpose of this chapter is to provide a theoretical and empirical examination of the question of resource mobilization in the context of African countries as envisaged by the theory of financial liberalization The chapter begins by developing the conceptual framework for the whole study This involves the examination of the theory of financial liberalization, and the development of an analytical framework which exposes the theory and its critique The chapter concentrates on examining the empirical relationship between the real interest rate, saving and investment It draws a distinction between total saving and financial saving and estimates separate functions with special emphasis on the role of the real interest rate in the determination of each category of saving For the relationship between the real interest rate and investment, this section employs a 3-equation investment model which tests for the effect of below equilibrium and above equilibrium interest rates on investment The model also allows the calculation of the net effect of the real interest rate on investment after taking into account the effect of the real interest rate on the provision of credit and the cost of investment Resource Mobilization and Financial Liberalization Resource Mobilization and Financial liberalization: A Conceptual Framework The accumulation of capital stock through sustained investment is indispensable for the process of economic growth In a closed economy, investment itself can only be financed from domestic saving Because the acts of saving and investing are usually conducted by different people, the financial sector is entrusted with the functions of channeling resources from savers to investors The relationships between domestic saving and economic growth can be examined through the Harrod-Domar Result: g = p(S/Y) = p(I/Y) (1) where g is the rate of growth of real output, p is the productivity of capital and (S/Y) is the ratio of total domestic saving to income which, in equilibrium, is equal to the ratio of investment to income (I/Y) Accordingly, given the productivity of capital, the growth rate should increase the higher the ratio of saving (investment) to income Conversely, if the ratio of saving (investment) to income is given, the growth rate can be increased by improving the efficiency of investment which will raise the productivity of capital (p) To this, it is necessary to promote investment that support efficient production in sectors where rapid growth in effective demand can be expected (Okuda 1990) The orthodox approach to financial liberalization suggests that, financial liberalization will both increase saving and improve the efficiency of investment (Shaw 1973) By eliminating controls on interest rates, credit ceilings and direct credit allocation, financial liberalization is said to lead to the establishment of positive interest rates on deposit loans This, in turn, is said to make both savers and investors appreciate the true scarcity price of capital, leading to a reduced dispersion in profits rates among different economic sectors, improved allocative efficiency and higher output growth (Villanueva & Mirakhor 1990) Figure (1) provides a diagrammatic illustration of the theory backing financial liberalization programs The figure exhibits the behavior of savings (S) and investment (I) in relation to the real rate of interest (r) The savings schedule slopes upwards from left to right on the (classical) assumption that the rate of interest is the reward for foregoing present consumption The investment schedule slopes downwards from left to right because it is assumed that the returns to investment decreases as the quantity of investment increases, which means that a lower real rate of interest is therefore necessary to induce more investment as the marginal return to investment falls If the interest rate is allowed to move freely (i.e., no interest rate controls), the equilibrium rate of interest would be r* and the level of saving and investment would be at I* If the monetary authorities impose a ceiling on the nominal saving deposit rate, this will give a real interest rate of, say, r1 If this rate is also applicable for loans,1 saving will fall to S1 and investment will be constrained by the availability of saving to I1 At r1 the unsatisfied demand for investment is equal to AB According to the financial liberalization theory, this will have negative effects on both the quantity and the quality of investment That is, credit will have to be rationed, consequently many profitable projects will not be financed There will also be a tendency for the banks to finance less risky projects, with a lower rate of return, than projects with a higher rate of return but with more risk attached If the ceiling on interest rate is relaxed, so that the real interest rate increases to r3, saving will increase from I1 to I3, and the efficiency of investment also increases because banks are now financing projects with higher expected returns Unsatisfied investment demand has fallen to A1B1 and credit rationing is reduced It is argued that savings will be «optimal» and credit rationing will disappear, when the market is fully liberalized and the real rate of interest is at r* Although it appears convincing, the financial liberalization theory suffers from major shortcomings As it has been argued by Warman & Thirlwall (1994), the financial liberalization theory makes no clear distinction between financial saving and total saving To be sure, the saving symbol which appears in equation 0) stands for total saving and not financial saving The relationships suggested by the Harrod-Domer result, between saving, investment and growth, are complicated by the fact that a significant portion of domestic saving may be held in the form of real assets (e.g., real estate, gold and livestock), exported abroad in the form of capital flight, or claimed by informal markets such as the informal credit market, the underground economy and the black market for foreign exchange The fact that financial saving is only one form of saving, raises many important issues regarding the theory of financial liberalization In what follows, a simple conceptual framework is developed to restructure the debate on financial liberalization and to articulate the arguments against the financial liberalization theory It puts into focus some of the worries, criticisms and limitations of the financial liberalization theory which are important to bear in mind when evaluating the implementation of policies in the context of African countries Total Saving, Financial Saving, and the Leakage The flow of total national saving can be decomposed into public saving and private (household and enterprise) saving: ST = SG + SP (2) Where ST, SG and SP are total, public, and private savings respectively The flow of private saving can be divided into two major components: private financial saving which comprise the portion of private saving that is kept in the form of financial assets in the formal financial sector (FP) and private saving residue which comprises the portion of private saving which is kept in non-financial forms or put into other uses (L) That is: SP = FP + L (3) Substituting equation (3) into (2), we get: ST = SG + FP + L (4) The flow of total financial saving (FT) comprise public financial saving (FG) and private financial saving (FP) That is: FT = FP + FG (5) On the assumption that all government saving is kept in the form of financial assets (so that FG = SG) and substituting equation (5) in (4), and rearranging we have: L = ST — (FG + FP) (6) and, FT = ST – L (7) Dividing equation (6) by ST, we obtain: FT/ST = – s (8) Where, s = L/ST, which measures the proportion of total saving that is leaked out of, or not captured by the formal financial sector If equations (6), (7) and (8) are expressed in stock rather than flow terms, they can be interpreted as giving the condition for the case of what can be called full financial deepening where the whole stock of total saving is kept in financial forms and the leakage, L, is zero The degree of financial deepening at any point in time, can be measured by equation (8), where the smaller, s, the higher will be the degree of financial deepening The equations can also be used to clarify the confusion in the literature between total saving and financial saving Total saving and financial saving are identical only in the case of a zero leakage (i.e., L=0) In their flow forms the equations can be interpreted as giving the ‘dynamics’ of the process of financial deepening The case of a zero leakage with L = s = 0, corresponds to what can be called full financial augmentation where all the additions to total saving are kept in the form of financial vessels (so that ST = FG + FP in equation (6) and FT/ST=1 in equation (8)) A reduction in the leakage (i.e., s L0) implies an increase in the process of financial shallowing The equations also illustrate the important result that even though total saving might be stagnant (i.e., s ST=0) financial saving can increase if sL