The following study on the international relation of investment,
savings and economic growth is based on a paper produced by the author
for Antai College of Economics and Management, Jiao Tong University
Shanghai. It originally appeared on the blog China in the International Financial
Crisis.
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Introduction
This is the first of two papers devoted to the evidence on the
relation between investment, savings and growth with particular regard
to present economic issues facing China in relation to the international
financial crisis. The two papers, although interrelated, are produced
separately for the following reasons.
The first paper is an historical and comparative examination of the
factual relation between investment rates and economic growth rates. The
economic evidence it produces is clear. A very high rate of investment
is required for rapid economic growth of the 8% a year level China
requires. It is a high level of investment, not a high level of
consumption, which is indispensable for rapid economic growth rates –
there are no examples of countries with low rates of investment and very
high economic growth. Those who argue that China, to maintain its level
of economic growth, must increase its consumption level and reduce its
rate of investment must produce evidence to justify that claim – and
will be unable to do so.
However, from an underlying strategic economic issue such as the
above, it is not possible in a one to one mechanical way to derive
immediate policy conclusions – something the present author is acutely
aware of from both theoretical considerations and practical experience.
In order to judge a specific immediate policy it is necessary to have
not only an overall framework but also detailed knowledge of concrete
economic circumstances. The issues dealt with here affect economic
strategy and other concrete factors must be taken into account in
framing short term economic policy responses.
Investment and savings
In relation to the international financial crisis significant
discussion has taken place regarding the US and China’s savings rate.
However, from the point of view of China’s economic growth rate, the
issue with the most direct effect is China’s rate of investment. The
savings’ rate’s effect on growth is indirect.
This distinction may be easily illustrated by noting that while
savings are necessarily required to finance investment it is both
theoretically and practically possible, for example, for a country to
have a high savings rate but to have relatively low or moderate
investment and economic growth rates – Saudi Arabia and Libya are
examples. In such cases a high savings rate is not used to maintain a
high rate of domestic investment, with an associated high rate of
economic growth, but instead foreign assets or exchange reserves are
accumulated.
It is therefore investment which directly affects the rate of
national economic growth. For that reason, regarding the potential for
strategic economic growth, analysis should commence with the investment
rate.
Confusion of domestic demand and
domestic consumption
This strategic issue relates to a further, more immediate, economic
question. In sections of the media stimulation of ‘domestic demand’ is
sometimes treated as though it were the same issue as the stimulation of
‘domestic consumption’. This is self-evidently theoretically false.
Domestic demand consists of two components, investment and consumption.
Stimulation of domestic investment is just as much stimulation of
domestic demand as is stimulation of domestic consumption.
The consequences of different allocations of GDP resources to
investment and consumption are, however, extremely different from the
point of view of China’s economic growth. As will be seen in detail
below a very high level of fixed investment in GDP is a precondition for
a high economic growth rate in any country - including China. Lowering
the proportion of China’s investment in GDP, that is raising the
proportion of consumption in GDP, will lead to a much slower rate of
growth of China’s GDP. From this more immediate angle also the first key
macro-economic issue that should be examined is the investment rate.
This paper, therefore, examines the relation of the rate of
investment and the rate of economic growth both from a fundamental
historical perspective and from the point of view of the recent
international experience of high growth rate economies.
The tendency of the proportion of
the economy devoted to fixed investment to rise
Considering first the investment rate from a long term historical
perspective, one of the most factually well established historical
trends of economics is that the proportion of the economy devoted to
fixed investment historically rises with time - and that this rise is
correlated with increasingly rapid rates of economic growth.
This process can be clearly measured over a three hundred year
period, and can also be seen to operate dramatically in the period since
World War II. All major economies that have grown rapidly have a high
level of fixed investment. There are no examples of major economies
which have grown rapidly with a low rate of investment.
These facts have evident conclusions for the discussion of the model
of economic growth and for China’s investment level.
After considering this from the point of view of a long timescale,
setting out the factual data, it will be examined from the point of view
of the experience of high growth economies since World War II.
The historical trend of the
proportion of investment in GDP
Figure 1 shows the percentage of fixed investment (gross fixed
capital formation) in GDP for a series of major countries over the
longest periods of time for which data is available. [1]
Figure 1
The
pattern is evidently clear and striking. By far the strongest trend is
for the proportion of GDP devoted to fixed investment (gross domestic
fixed capital formation) to rise with time. This in turn, as will be
shown, is associated with progressively rising rates of economic growth.
The historical correlation of increasing proportions of GDP devoted
to investment with rising rates of GDP growth
Considering this historical trend in more detail, and analysing
countries in the chronological order in which a new peak in the
proportion of GDP devoted to gross fixed domestic capital formation
appeared, the following is the historical pattern.
- Commencing with the period immediately antedating the industrial
revolution, the proportion of GDP devoted to fixed investment in England
and Wales, at the end of the 17th century, was 5-7 per cent. [2] This
rose slightly, although current estimates are that it did not rise
greatly, during the 19th century - peaking at over ten percent of UK GDP
prior to World War I.
This level of investment was sufficient to launch the first
industrialisation of any country but at a rate of growth which, while
unprecedented at the time, was extremely slow by contemporary
international standards - about two per cent a year.
- Turning to the latter part of the 19th century, the proportion of
US GDP devoted to fixed investment had risen to considerably exceed that
for the UK – reaching a level of 18-20 per cent of GDP by the last
decades of the century.
A sharp fall in the proportion of the US economy devoted to fixed
investment commenced in the late 19th century, and was particularly
pronounced during the period between World War I and World War II –
being associated with the great depression of the inter-war period.
After World War II the US resumed its pattern of 18-20 per cent of GDP
being devoted to gross fixed capital formation. This generated an
average growth rate of 3.5 per cent a year. With such a growth rate an
economy doubles in size every 20 years and quadruples in size every 40
years. It was on the basis of this historical level of investment, and
growth rate, that the US overtook Britain to become the world’s greatest
economic power.
- In the period following World War II Germany achieved a level of
fixed investment exceeding 25 per cent of GDP – peaking at 26.6 per cent
in 1964. This period 1951-64 was that of the post-war German ‘economic
miracle’ with average growth of 6.8 per cent a year - with such a growth
rate an economy doubles in size every 11 years and quadruples in 22
years.
- Starting at the beginning of the 1960s Japan achieved a level of
gross domestic fixed capital formation of more than 30 per cent of GDP.
This reached a peak in the early 1970s, at 35 per cent of GDP, before
later sharply falling. During the period of a high and rising rate of
investment in GDP the average annual rate of growth of the Japanese
economy was 8.6 per cent.
- From the 1970s onwards, South Korea similarly achieved a level of
fixed investment of 30 per cent of GDP. During the 1980s this rose above
35 per cent of GDP. The other East Asian ‘Tiger’ economies – Singapore,
Hong Kong and Taiwan – showed a similar pattern. South Korea’s economy
confirmed the relation between fixed investment and economic growth
illustrated by Japan by growing in this period by an average 8.3 per
cent a year.
Such growth rates in Asia showed that something unprecedented in
human history was now possible – that it was possible to industrialise
an economy, and achieve a ‘first world’ level of development, in a
single generation.
- From the early 1990s onwards China achieved sustained rates of
fixed investment of 35 per cent of GDP with, from the beginning of the
21st century, this rising to more than 40 per cent of GDP – a level
never before witnessed in human history. The result was average 9.8 per
cent a year economic growth over a sustained period – also the most
rapid sustained economic growth ever seen in human history.
- To complete the chronological picture, the proportion of GDP
devoted to fixed investment for two countries recently undergoing rapid
economic growth, India and Vietnam, is shown. The proportion of Indian
GDP devoted to fixed investment has not reached the Chinese level but
has become high – reaching 33.7% of GDP in 2007 and 37.6% of GDP by the
second quarter of 2008. On this basis, in the last five years, India has
achieved an average growth rate of 8.8 per cent a year.
In Vietnam the proportion of GDP devoted to fixed investment rose
from 13 per cent in 1990 to 25 per cent in 1995 and then to 37 per cent
in 2007. Economic growth has accelerated rapidly, rising to an average
of 7.9 per cent a year in the five years up to 2007.
Considering these trends, such a high level of investment is a
necessary condition for rapid economic growth. No substantial country
without comparable high levels of fixed investment has achieved such
rapid rates of growth on a sustained basis. But while such a high level
of investment is a necessary condition for rapid economic growth it is
not a sufficient condition. Other elements which must accompany a very
high rate of investment in GDP to produce rapid economic growth are
considered below.
Recent experience of countries with
high rates of economic growth
Turning to analysing post-World War II examples of sustained high
economic growth, only 21 countries have achieved 8% growth a year
sustained over a 20 year period since World War II. Leaving aside two
extremely small states, Botswana (population 1.6 million) and Swaziland
(population 1.1 million), which have economies dominated by individual
projects, these countries that have undergone at least an 8% growth rate
over a twenty year period fall into only two categories.
The first are eight Asian economies which have experienced prolonged
periods of rapid growth - China, Japan, Singapore, South Korea, North
Korea, Taiwan, Thailand, and Hong Kong. These form the primary focus of
this study as their economies are not dominated by direct and indirect
effects of the single commodity oil.
The second group are oil producers, or states adjacent to oil
producers, in which rapid economic growth has been due to the direct and
indirect effects of producing this commodity.[3] Growth rates based on
oil are evidently not available to countries that do not have oil
reserves and therefore do not form a generalisable model of development
or are not immediately adjacent to countries which are large oil
producers – for this reason the growth pattern of economies dominated by
oil production are not considered in detail here.
Investment levels in the high growth
Asian economies
To illustrate the decisive role played by high investment rates in
sustaining high growth rates the percentage of Gross Fixed Capital
Formation (fixed investment) in GDP for six of the eight high growth
Asian economies is shown in Figure 2 - comparable IMF data for North
Korea and Taiwan is not available. India has been added to this
comparison due to the size of its economy and its recent rapid growth.
The evident feature of these economies countries is that all have
had, during their periods of rapid growth, very high percentages of
Gross Domestic Fixed Capital Formation in GDP. Taking the peak years for
each country, Gross Domestic Fixed Capital Formation reached 35.6% of
GDP in Hong Kong, 36.4% of GDP in Japan, 39.1% of GDP in South Korea,
41.6% of GDP in Thailand, 42.7% of GDP in China and 47.4% of GDP in
Singapore.
Figure 2
It may be seen that no cases at all of rapid
sustained economic growth without such a high rate of investment are to
be found in such high growth economies. It is therefore evident that the
economic evidence demonstrates that a high percentage of gross domestic
fixed capital formation is a precondition for rapid economic growth. It
is a high proportion of investment in GDP, not a high proportion of
consumption, that forms the precondition for rapid economic growth.
Furthermore detailed examination makes clear that in those countries
in which investment declined as a proportion of GDP – Japan, Hong Kong,
South Korea and Singapore – this led to a marked decline in economic
growth. On the contrary in those economies in which investment rose as a
percentage of GDP, China and India, economic growth accelerated. The
correlation between a high rate of growth and a high rate of investment
is therefore evident.
In the data below the annual rate of growth is stated as the average
over a five year period - in order to smooth out purely short term
fluctuations in business cycles.
Japan
Measured in PPP terms Japan is Asia’s second largest economy. Japan’s
rate of Gross Domestic Fixed Capital Formation peaked at 36.4% of GDP
in 1973 but then fell to 23.3% of GDP by 2007.
Over the same period of time Japan’s annual rate of GDP declined from
the 8.4% per cent rate in 1973 to only 2.1% (see Figures 3 and 4).
Figure 3
Figure 4
South Korea
South Korea is the Asia’s 4th largest economy - after China, Japan
and India. South Korea’s level of Gross Domestic Fixed Capital Formation
in GDP peaked at 39.1% in 1991, although the 1996 level of 37.5% was
only marginally lower.
Thereafter South Korea’s level of Gross Fixed Capital Formation
declined sharply to 28.8% of GDP in 2007. South Korea’s annual rate of
GDP growth fell in parallel from 9.4% in 1991, and 7.3% in 1996, to 4.4%
in 2007 (see Figures 5 and 6).
Figure
5
Figure 6
Thailand
Thailand’s percentage of Gross Domestic Fixed Capital Formation
peaked at 41.6% of GDP in 1990 and 41.1% of GDP in 1995. It then fell to
26.8% of GDP in 2007.
Thailand’s annual rate of GDP growth over the same period fell from
10.9% in 1991, and 8.6% in 1995, to 5.6% in 2007 (see Figures 7 and 8).
Figure 7
Figure 8
Singapore
Singapore saw one of the most sustained high levels of investment in
GDP in any country in world history with more than 30% of GDP devoted to
fixed investment for 30 years from 1970-2000. Singapore’s Gross
Domestic Fixed Capital Formation peaked at 47.4% of GDP in 1984,
remained at 38.7% of GDP in 1997 and fell to 24.9% of GDP in 2007.
Singapore’s annual rate of GDP growth over the same period fell from
8.5% a year in 1984, and 9.7% a year in 1997, to 7.1% a year in 2007
(see Figures 9 and 10).
Figure 9
Figure 10
Hong Kong
The percentage of Hong Kong’s GDP devoted to Gross Domestic Fixed
Capital Formation, amid significant fluctuations, fell from 35.6% in
1964 to 35.6% and to 20.3% in 2007.
Hong Kong’s annual average growth rate fell from 10.5% in 1964 to
6.4% in 2007 (see Figures 11 and 12).
Figure
11
Figure 12
China and India
India and China show a clear contrast to Japan, South Korea,
Singapore and Hong Kong.
Whereas in Japan, South Korea, Singapore and Hong Kong there was a
decline in the proportion of the economy devoted to investment and a
decline in the rate of economic growth, both India and China India have
systematically increased the share of investment in their GDP and have
seen an acceleration of their growth rates. Because this pattern in
India and China is so strikingly different to Japan, South Korea,
Singapore and Hong Kong it is worth looking at in some detail.
India’s Gross Domestic fixed Capital Formation increased from 17.9%
of GDP in 1977 to 22.7% of GDP in 2000 and to 33.9% of GDP in 2007. By
the third quarter of 2008, before the onset of the international
financial crisis, India’s Gross Domestic Capital Formation reached 37.6%
of GDP. Over the same period India’s annual GDP growth rate accelerated
from 4.5% in 1977 to 6.0% in 2000 and to 8.8% in 2007.
Unlike those who advocate a reduction in investment and savings
rates, Manmohan Singh, who is not only India Prime Minister but an
excellently trained economist, has constantly stressed the need to raise
India’s savings and investment rates and has made this a foundation of
his economic policy – with considerable success, as has been seen, in
terms of sustaining high growth rates.
Manmohan Singh considered China’s high savings and investment rates
as the foundation of superior economic performance. For example in 2003 when asked, ‘is it legitimate to compare India and
Chinese economies?,’ he replied: ‘There is nothing wrong in the
comparison. It is good to try and achieve the growth rate of China. But
we must remember that the Chinese savings rate is 42 per cent of the
Gross Domestic Product, whereas savings in India is hovering at 24 per
cent.’
Before he became Prime Minister in May 2004 Singh set out clearly the investment rate without which
India’s target growth rate could not be achieved: ‘at a Delhi seminar,
Dr Manmohan Singh spoke out regarding the targeted eight per cent growth
rate in the Tenth Plan... he opined that an eight per cent growth rate
would require a 30 per cent ratio of savings to income and a substantial
rise in the tax-GDP ratio.’
Therefore in 2006, after assuming office, Prime Minister Singh noted with satisfaction the increase in India’s
savings rate and set the goal of increasing it further together with a
concomitant rise in the the investment rate: ‘Our statisticians now tell
me that our savings rate has shot up in the last couple of years to
about 27 to 28 percent of our GDP… we are a country where the proportion
of young people to total population is increasing. All demographers
tell me that if we can find productive jobs for this young labour force,
that itself should bring about a significant increase in India's
savings rate in the next five to ten years. If our savings rate goes up,
let us say, in the next ten years, by 5 percent of GDP, we would have
generated the resources for investment in the management of this new
urban infrastructure that we need in order to make a success of our
attempt at modernization and growth.’
By 2007 Prime Minister Singh therefore welcomed the further increase in India’s savings and
investment rates. According to India’s premier financial paper, the
Economic Times: ‘The investment and saving rate is as high as 35 percent
of national economic output, Singh said at a meeting of his Congress
party in this southern Indian city, the hub of a 50-billion-dollar IT
industry at the vanguard of the country's economic resurgence.’
Similarly, India’s finance minister, P Chidambaram , called in
February 2007 for a further increase in India’s savings and investment
rates: ‘India’s savings and investment rate as percentage of GDP have
gone up by 2 per cent each. But to sustain the revised growth rate of 9
per cent in the 11th Plan, he [ P Chidambaram] said: “Both savings and
investment as proportion of GDP must be raised further.”
By February 2008 Prime Minister Singh noted the continued advance of the savings rate and
the new high reached in India’s investment rate: ‘Highlighting the
strong fundamentals of the economy, Dr. Singh said that the savings rate
in the country has touched almost 35 per cent of Gross Domestic Product
(GDP) and the investment rate is at an all time peak of over 36 per
cent of the GDP.’
The orientation of India to very high savings and investment rates,
and the relation of this to rapid economic growth, is therefore clear
(see Figures 13 and 14)
Considering China its fixed investment increased from 27.8% of GDP in
1978 to 34.3% of GDP in 2000 and to 42.7 % of GDP in 2007 42.7%. In the
same period China’s rate of GDP growth accelerated from 4.9% in 1978 to
8.6% in 2000 and to 10.8% in 2007.
Figure 13
Figure 14
Conclusion
The conclusion from economic evidence is therefore clear.
A high percentage of fixed investment in GDP is an indispensible
precondition for a rapid rate of growth – there are no examples of
countries with rapid rates of GDP growth and low proportions of the GDP
devoted to fixed investment. It is a high level of investment in GDP,
not a high rate of consumption, that is necessary for rapid GDP growth.
In those countries in which the rate of investment in GDP fell –
Japan, South Korea, Singpore and Hong Kong – the rate of economic growth
also fell substantially. In those countries – India and China – in
which the percentage of GDP devoted to investment rose the rate of
economic growth also increased.
In short all evidence establishes clearly that it is the high rate of
investment which is decisive for rapid GDP growth.
This overwhelming factual evidence, of course, supports what is
evident from a theoretical point of view. Consumption, by definition,
does not add to productivity potential or production capacity and
therefore increasing the rate of consumption does not raise GDP growth.
If China lowers its proportion of the economy devoted to investment its
economic growth rate will also fall - as is confirmed by the
international experience noted above.
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The paper draws on earlier
material which appeared in 'Why Asia will continue to grow more rapidly than the US
and Europe - a historical perspective' on the blog Key Trends in Globalisation.
References
[1] The figure for England for 1688 is that in Angus Maddison, The
World Economy, OECD Paris 2006 p395. UK figures after 1688 and up
to 1947 are calculated from One Hundred Years of Economic Statistics,
The Economist, London 1989 p74. Figures from 1948 are calculated from International
Monetary Fund, International Financial Statistics (August 2008)
Minor adjustments have been made to chain the earlier statistics to be
consistent with the IMF data – in no case does this make any significant
difference to the pattern shown. The data for fixed investment for the
earlier period used by The Economist One Hundred Years of Economic
Statistics are based on calculations in C H Feinstein and Pollard Studies
in Capital Formation in the United Kingdon 1750-1820, Oxford
University Press, Oxford 1988. Other commentators have suggested that
Feinstein and Pollard's figures are somewhat too high - see for example.
N F R Crafts British Economic Growth during the Industrial
Revolution, Clarendon, Oxford 1986 p73. None of these revisions and
differences however is of sufficient magnitude to alter the fundamental
pattern shown here.
US figures prior to 1948 are calculated from One Hundred Years of
Economic Statistics, The Economist, London 1989 p74. Figures from
1948 are calculated from International Monetary Fund, International
Financial Statistics (August 2008) Data for the earlier period give
only private fixed capital formation whereas that after 1948 is for
total fixed capital formation – i.e. including government fixed capital
formation. There are no reliable estimates of government fixed capital
formation in the earlier period and therefore data for the earlier
period have been adjusted upward by the difference between the two in
1948 – which is slightly over two per cent of GDP. This has the effect
of revising upwards slightly the percentage of GDP allocated to fixed
investment in the earlier period but the difference is too small to
affect the overall pattern.
Figures for Germany prior to 1960 are calculated from One Hundred
Years of Economic Statistics, The Economist, London 1989 p202.
Figures from 1960 are calculated from International Monetary Fund,
International Financial Statistics(August 2008). There is however no
significant statistical difference between the two.
Figures for Japan, South Korea, China, India and Vietnam calculated from
International Monetary Fund, International Financial Statistics.
[2] Phyllis Deane and W A Cole in British Economic Growth 1688-1959,
Cambridge University Press, Cambridge 1980 p2 being closer to the lower
figure while further studies have tended to revise the figure upwards
slightly. The higher estimates for the earlier period have been taken
here so as to avoid any suggestion of exaggerating the degree to which
the proportion of GDP devoted to Gross Domestic Fixed Capital Formation
has risen. The precise figure used here is that calculated by Maddison
in Angus Maddison, The World Economy, OECD Paris 2006 p395. The
higher figure, as can be seen, makes no difference to the overall trend.
[3] These countries are Iran, Iraq, Equatorial Guinea, Kuwait,
Israel, Jordan, Oman, Qatar, Saudi Arabia, Libya, Gabon, Equatorial
Guinea, and the United Arab Emirates.
