Saving, Investment and Economic Growth – Part 2 [Archives:2001/06/Business & Economy]

By: Dr. Alexander Bohrisch
Dr. Alexander Bohrisch is currently with GTZ (German Technical Cooperation), Sanaa Office until June 2001. Before, he has been a senior staff member of the United Nations Conference on Trade and Development (UNCTAD), Geneva, Switzerland. The views expressed in this article are those of the author and do not necessarily reflect those of GTZ. 
Subsequent work on the determinants of economic growth basically confirmed earlier research findings with the principal sources of growth being:
-Physical capital formation
-Human capital
-Technological progress
Physical capital formation means investment in plant, machinery and infrastructure such as roads, railways, etc. Workers output per hour is more today than 50 or 100 years ago because they use more and technologically better equipped machines. Increases in capital per worker have led to increases in output and incomes.
Human capital is the second major source of productivity growth. Good health, a high level of education, extensive training and the long work experience of the labor force matter as much as their age structure for increasing productivity. An increasing proportion of younger, less experienced people in total employment will tend to reduce average productivity. According to virtually all research studies there is a significant positive correlation between workers level of education and productivity. For example, the economy of the United States of America has benefited frequently from the immigration of highly skilled labor including scientists, notably between the early 1930s and early 1940s.
Technological progress. Many economists consider technological change as the key factor for increasing productivity. The most important determinant for technical progress is the investment in research and development (R & D), both by government and the private sector. There is a close relationship between the level of GDP per capita and R&D spending. Developing countries spend some 0.5% of GDP on R&D while industrial nations spend about 2.5% of GDP on R & D. 
The fourth classical factor impacting on economic growth is natural resources, such as fertile land, oil and gas, mineral resources. A case in point is the economic development of the oil-rich countries in the Middle-East or of Norway in recent years. On the other hand, there are a number of countries with virtually no natural resources which belong to the richest nations in the world, such as Japan, Switzerland, Hong Kong or Singapore. They have developed by specializing in capital- and/or human skill intensive activities, adopting higher technology, and by closer integration in the international economy via foreign trade. These factors are in the long run more important for sustaining economic growth than natural resources. In a publication on Natural Resource Abundance and Economic Growth, Harvard economist Jeffrey Sachs and Andrew Warner conclude that there is some evidence that countries with abundant natural resources grow less than one would expect. One reason is that there is a tendency in these countries to squander their wealth. To illustrate, years ago Saudi Arabia started to produce irrigated wheat, the production costs of which were three times higher than world market prices at which Saudi Arabia could have purchased this commodity in the international market place. 
For buying machines and means of transportation, for improving education, research and development (R & D) and for exploiting the natural resources available to a country, a nation needs capital. Investments can be financed either from national savings (the difference between gross national disposable income and total private and government consumption) and/or from borrowing abroad. If investment is financed by foreign credits it must be ensured that the returns from the investment are sufficient to repay the credit including interests. Otherwise, the country runs into debts. An attractive alternative to foreign borrowing is foreign direct investment. Foreign direct investment does not create debt, tends to stay in the country in which the investment takes place and transfers innovation and technology into the capital importing country. The preference of equity investment over debt had already been noted by a committee of the League of Nations in 1943 when considering policies for the reconstruction of the post-war economies in Europe. 
Obviously, the amount which a country is able to save for financing investment is of paramount importance for achieving economic growth. Historically, (and with a few exceptions) high rates of national savings tend to correspond with high rates of investment and economic growth. This is documented in many studies. But there is another important reason for achieving a high saving rate. At a time of increased international financial integration and unexpected shifts in international capital movements, high savings, which can largely finance the domestic investment requirements, reduce the vulnerability of a country to external shocks and sudden capital outflows, and help to ensure macroeconomic stability. How much a country is able to save depends on levels of income, population, tax structure, labor force participation, etc. 
Hence, for assessing the growth prospects for Yemen a key figure is the level of national savings in this country. For computing the gross national saving and investment rates statistical data of the Central Statistics Organization was used. In addition, IMF estimates are mentioned which, for some years, differ considerably from the rates calculated on the basis of CSO statistics although the pattern is somewhat similar. Even if lower IMF rates are used for economic analysis it has to be noted that both national saving and investment rates are relatively high in Yemen. The relatively high national saving rates are largely explained by the high remittances of Yemenis working abroad. These high remittances also suggest that savings out of domestic income are probably rather low. Workers remittances have been on a rising trend and were at some 1.2 billion US$ in 1999. They constitute, besides oil, the most important foreign exchange income from abroad and can be considered as the principal source for the financing of domestic investment.
Yet, those high workers remittances from abroad carry a risk: They tend to make Yemen vulnerable to external shocks. At any point in time, depending on the external economic environment but also on the economic and financial conditions prevailing in Yemen, the level of workers remittances may fluctuate more or less strongly with concomitant effects on disposable income, consumption, savings and the current account. 
National savings consist of:
1. private savings (which include personal and business savings) and
2. public savings (which is the difference between government tax revenue and expenditures on goods, services and transfers). For all years between 1995 and 1999 private sector savings were higher than public sector savings. However, private sector savings as a percentage of GDP were on a declining trend, eventually reflecting the need of the people to set aside a larger share of their income for consumption while public sector savings increased, eventually, as a result of the various fiscal measures to balance the budget, in particular the phasing out of most subsidies.

Gross domestic investment consists of fixed capital formation and changes in inventories. The above rates are somewhat higher than the equivalent figures of other low income countries. As was the case for national savings, the bulk of investment was done by the private sector. The counterpart to the national saving/investment balance is the balance on the current account. Except for 1998, Yemen had a surplus of savings over investment which was reflected in a corresponding surplus on the current account.
While saving is of paramount importance to generate capital for investment, so is the use of the available savings for investment to stimulate economic growth. Output growth could be large, small or negative depending on the quality of the investment. For example, if a government invests in a highly subsidized, loss-making public enterprise, the relevant funds might well increase the quantity of investment made but are not likely to contribute to economic growth. In other words, national savings spur economic growth only to the extent that the investments which are financed from those savings are profitable investments. (Continued) 
Whereas both saving and investment in Yemen are at levels comparable with other low income countries (although eventually not sufficient for sustained increase in per capita income due to demographic pressures), the role of the financial system in translating savings into investment is poor. An indication for the low financial depth are the low ratios of M2 (Narrow Money and Quasi Money) to GDP and of domestic credit provided by the banking sector to GDP. For 1999 these ratios were at 31.6% and 22.1% respectively which are considerably lower than the corresponding figures even of most other low income countries. Low financial depth tends to deteriorate the productivity of investment and involves the risk that sub-optimal projects are financed thus constraining economic growth. 
Continued next week
There is a host of reasons which explain the low financial depth in Yemen. Many Yemenis do not use banks for saving and investment purposes. Banks exist only in the major cities and there is a tendency of many Yemenis, particularly in rural areas, to keep savings at home. Furthermore, eventually high real interest rates had a negative effect on investment. However, very important is the fact that banks (which are highly liquid) hesitate to lend money to creditors because of the risk of non-performing loans and the difficulty and time consuming enforcement of loan contracts in default. Information about loans to the private sector are available from the consolidated balance sheet of the commercial banks. Loans to the private sector accounted for only a quarter of banks total assets in 1999. They corresponded to only 4.9% of GDP in 1999. 

This low share takes on an even more critical importance when the distribution of loans across sectors and the duration and type of loans is taken into account. In 1999, almost 42% of loans to the private sector were used for import/export and domestic trade financing, which were largely short term loans and advances. Some 20% of loans went to industry, construction and agriculture, about half of which in the form of short term loans and advances. A mere 12% were medium and long term credits for financing investment projects in industry, construction and agriculture. In addition, only a few larger firms benefit from bank financing while the large number of smaller companies have only limited access to bank credits. In this connection it has to be noted that investments in raw material exploration projects are almost entirely financed through foreign direct investment and not by national savings.
Loans and Advances of Commercial Banks to Private Sector in 1999
(in millions of YR) 
Total:51.816
Short term loans and advances: 33.647
Medium and long term loans: 4.725
Investments (Islamic Banks):13.444
Source: Central Bank of Yemen
The above have important implications for the development prospects of the country in general and for the growth of the small and medium sized industry in particular (including the success of technical assistance projects in the widest sense provided directly or indirectly to this sector of the economy). The availability of credits at competitive terms is one crucial factor for the development of the industry given its low capital basis. To the extent that credits for private investments are only available in a very limited way, the development of the industry will be negatively affected which is confirmed by the modest growth rate of the manufacturing industry during the last years. 
Regarding the structure of deposits the high share of foreign currency deposits in M2 (dollarization ratio) has to be noted. It shows that many Yemeni savers still have little trust in their own currency. 
Saving Deposits (Quasi money) in Yemen in 1999
(in millions of YR)
Total: 160.166
Time deposits: 30.427
Saving deposits: 25.681
Earmarked deposits: 4.185
Foreign currency deposits: 99.873
Source: Central Bank of Yemen
In 1997, real interest rates on YR deposit accounts turned positive for the first time in years, becoming slightly negative in 1998 and turning back to positive in 1999. During the years when real interest rates on YR deposit accounts were positive, they were also higher than real interest rates on foreign currency deposit accounts. In spite of this, many Yemenis saved on foreign currency deposit account, obviously because of the lingering risk of a higher than expected depreciation of the YR vis-a vis the US$ than covered by the interest rate differential between domestic currency and foreign currency deposits. Indeed, this concern of Yemeni savers has been confirmed for 2 years out of 3 years since 1997.
Depreciation of YR vis-à-vis the US$ and Real Interest Rates on YR Deposit Account 
(1) (2) (3)
1995: 50.0% 25.9%
1996: 5.9% 0.0%- 16.42
1997: 0.0% 2.8% 10.68
1998: 5.1% 8.6%- 0.45
1999: 14.6%12.3% 9.67
(1) depreciation based on yearly average exchange rate
(2) depreciation based on end of month (December) exchange rate
(3) real interest rate (nominal interest rate minus inflation) on YR deposit account (12 month) 
Source: Central Bank of Yemen
The dollarization ratio in Yemen has been 29.4 % in 1999 as compared to 22.4 % in 1995. Although it has been increasing over the last 5 years, the pace of dollarization seems to have slowed down in 1999. Dollarization occurs at times of high and volatile inflation and when there is a risk of a depreciation of the currency. Experience shows that success in containing inflation to normal levels is not rapidly rewarded by a full shift from foreign currency into local currency assets.
Dollarization has the positive result that citizens dispose of a reliable store of value and that it may halt the outflow of capital. Also, agents tend to hold deposits in the banking system and financial deepening is fostered. On the other hand, policy makers are faced with the challenge that the foreign currency component of the money supply cannot be directly controlled by the monetary authority which is hindering monetary policy. 
Inflation (%), Exchange Rate (YR/US$) and Interest Rate (%) in Yemen 
Inflation Exchange rate* Interest rate**
1995 62.5 121.0920.00
1996 40.0 128.18 23.58
1997 4.6 129.28 15.28
1998 11.5 135.8811.05
1999 8.0 155.7517.67
* yearly average, free market
** nominal yearly weighted average (benchmark) on YR saving deposits (12 months) 
Source: Central Bank of Yemen , except for inflation (IMF) 
The World Bank and the IMF have stressed i.a. the urgent need for improving financial intermediation. In recent years, Yemen has been successful in improving its macroeconomic policies by containing inflation, reducing the budget deficit and striving to stabilise the exchange rate; but in order to fully reap the fruits of these efforts, it is of basic importance that the banking sector plays its proper role in the matching mechanism between saving and investment and that the judiciary system provides adequate security for banks in the provision of credit to the private sector. By and large, it is less foreign grants but principally private investment – whether domestic or foreign – which is the engine for diversifying exports away from oil and thus helping to stimulate economic growth, reduce unemployment and put development on a broader basis. 
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* Dr. Alexander Bohrisch is currently with GTZ (German Technical Cooperation), Sanaa Office until June 2001. Before, he has been a senior staff member of the United Nations Conference on Trade and Development (UNCTAD), Geneva, Switzerland. The views expressed in this article are those of the author and do not necessarily reflect those of GTZ.

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