Saving, growth and the current account Daan Steenkamp ERSA / SASI Savings workshop August 2009

Agenda Link between saving, investment and the current account Theoretical relationship between saving and growth The case of a small open economy Macro implications of low saving Sustainability of the current account deficit Implications for macro policy

Accounting identities In an open economy, domestic spending is the absorption of locally produced goods and services plus goods and services from overseas: Gross national product can also be expressed as the sum of expenditures by residents from national income Setting the above equal, the current account balance is the difference between domestic saving and investment (private and public): Current account balance is linked to net international capital flows: Re-arranging: Current account balance = Domestic investment - domestic saving Foreign financing of domestic investment generate claims on domestic assets.

Saving & Growth Theory Exogenous growth models: –Saving supports higher investment and therefore a higher capital stock –Higher saving raises growth per worker only temporarily Endogenous growth models: -Higher saving raises per capita output and growth of per capita output Do savings alone drive growth? –Positive impact of saving has, however, been shown to be contingent on complementary macroeconomic conditions and government policies that help channel savings into productive investment. –E.g. financial sector development, macroeconomic stability, openness to trade, prudent fiscal policies, investment in education, microeconomic reforms that support efficient resource allocation. Can growth drive saving? –Life cycle models with liquidity constraints or endogenous models with habit formation suggest that growth could impact saving.

Open economy setting If the economy is open and capital is mobile, foreign saving can be used to finance higher investment rate than domestic saving would allow. If the return on foreign capital after depreciation > cost of foreign borrowing -Foreign borrowing will raise the level of national income Availability of foreign capital can also lower domestic interest rates Impact of inflows of foreign saving on domestic saving is ambiguous -Lower interest rates reduce opportunity cost of current consumption, lower saving (substitution effect) -Lower interest payments (borrowers) or income (lenders), can increase or decrease saving (income effect) -Interest rate sensitivity of domestic saving an empirical question

6 High levels of domestic saving and investment are associated with high levels of economic growth

7 Saving shortfalls raises growth volatility

8 Impact of increased savings on the economy To increase domestic savings, domestic consumption will have to decrease By substituting current consumption with future consumption, investment can increase, thereby increasing medium and long run productivity The 5% level decrease in consumption initially results in total saving increasing by 20% which then allows investment to increase by 15%

9 Increased investment increases exports and GDP The increase in productivity promotes exports, improving our competitiveness, while imports are driven by the increase in investment. It takes about 1 year for the impact of increased savings and investment to fully flow through to GDP The rebalancing of growth from consumption to investment has a lasting positive impact on GDP

10 Inflows of foreign saving have helped raise domestic investment

Domestic investment requires sustained foreign financing which is dependent on macroeconomic stability Proportion of gross capital formation financed by foreign capital

Low domestic saving relative to investment manifests as a current account deficit

The current account deficit has been comfortably financed

Capital inflows adding to stock of foreign liabilities

15 Relying on foreign savings implies growing claims on the income of domestic assets

An increasing proportion of foreign liabilities are equity liabilities Foreign Portfolio Liabilities: Equity and Debt

17 Volatility is a greater problem if majority share of capital is short term capital

Cost of capital Declining costs of domestic borrowing

Cost of capital Declining costs of foreign borrowing (before crisis)

Sustainability of the current account In the short term, the availability of foreign capital will depend on maintaining investor confidence. This underscores the importance of sound macro management and political stability. In the longer run, the efficiency with which saving is converted into investment is particularly important for the sustainability of the current account deficit and ensuring we benefit from drawing on foreign saving. Servicing our foreign debt requires an increase in future exports or sufficiently high future real returns to domestic capital to service. Microeconomic reforms that address constraints to growth and enhance the economy’s international competitiveness and flexibility are crucial.

Conclusion By investing in resources, rather than consuming them, economies make a trade-off between present and future standards of living. Investment is funded through savings (both domestic and foreign). Fixed investment allows for more sustainable economic growth and improves international competitiveness. In spite of low domestic saving, availability of foreign savings has supported higher domestic investment in South Africa. This has, however, seen the current account deficit widen and foreign liabilities rise. Foreign saving must be used to expand our ability to export and save in future. A higher rate of domestic saving would reduce our vulnerability to the vagaries of investor sentiment. It would help us develop a deeper and more liquid capital market, helping our companies expand. Higher saving would also give South Africans a greater stake in the gains from domestic growth.