UNIVERSITY OF SAINT LOUIS
Tuguegarao City
SCHOOL OF ACCOUNTANCY, BUSINESS and HOSPITALITY
Short Term
A.Y. 2024-2025
COURSE LEARNING MODULE
ECON 1023 – Economic Development
Prepared by:
GLADYS T. TUMBALI, DBM
ECON 1023-Economic Development | 1
COURSE LEARNING MODULE
ECON 1023 (Economic Development)
AY 2024-2025
Lesson 13: Savings and the Financial System
Topic: Determinants of Saving
Banking and the Financial system
Learning Outcomes: At the end of this module, you are expected to:
- Identify the different the determinants of savings.
- Understand the banking and the financial system.
Introduction:
Saving plays a key role in determining growth, as previously presented in the Prelim modules. It is also
important to know how saving behaviour is conditioned in order to explore the implications for macroeconomic
policy and the impact of changing government policies. Much of the literature on the developing countries
deals with how these models can be used and tested.
This chapter aims to summarize the impact of different variables on saving behaviour for the developing
countries, instead of looking deeply into alternative tests for these models. Following a review of saving
behaviour, the chapter continues with a discussion of banking and credit markets in the developing countries
with particular reference to the economies in Asia.
Lesson Proper:
Determinants of Savings
REAL INTEREST RATES Higher real interest rates stimulate saving by offering higher financial returns
for abstaining from consumption through the substitution effect. On the other hand, higher interest rates result
in more income for creditors and this stimulates consumption through the income effect. Furthermore, a
negative income effect could manifest as a decline in pension contributions when interest rates rise. Most of
the empirical evidence shows a limited interest rate effect. What may be more relevant is the stability and
reliability of an interest rate regime. This would be the case if inflation is low and there are no unanticipated
increases in prices which could push interest rates down sharply. Such a reliable interest rate environment
would provide a positive inducement to savers. Given that financial liberalization may have changed interest
rate effects, the lack of an interest rate is not surprising. Financial liberalization can boost saving by providing
more institutional opportunities for saving at lower costs. McKinnon (1973) argues this point strongly. Financial
liberalization may also remove constraints to saving by allowing for more borrowing opportunities. This would
tend to depress saving rates. In cases where financial liberalization has been undertaken, both of these effects
have been observed, although the liberalization effects on raising saving is weaker than the evidence that
access to credit depresses saving and increases consumption.
ROLE OF THE GOVERNMENT If the government raises taxes (increases government saving),
incomes will decline and private saving can also be expected to diminish, other things being equal. Will the
offset be complete? The evidence seems to suggest that it is not (Ricardian equivalence is rejected). Most
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research on the developing countries (Masson et al., 1995, 1998; and Westcott, 1995), suggests that about
half of the change is reflected in a decrease in private saving. The effects on saving will depend upon whether
the change in the fiscal deficit occurs through a change in the tax rate or in the rate of government spending.
Increased government spending may lower the resources available to the private sector and hence, have a
negative effect on private saving independent of its impact on the deficit There is some evidence that
governments in large developing countries, as proxied by the share of government expenditures in gross
national product (GNP), may have a negative effect on private saving ( Masson et al., 1995; and Harrigan,
1998). This could result from the crowding out of private investment (and saving) by the public sector.
Government policies toward saving can also have an impact on the private saving rate. Public pensions can
lower private saving because they may substitute for private pensions. Feldstein (1995) has argued that a
public system based on pay-as-you-go instead of on actuarial principles would lower national saving because
pensions would be paid for by the still unborn children who could not adjust their saving behaviour. There
would also not be a full offset from the working population because Ricardian equivalence would not hold (
Harrigan, 1998).
GROWTH IN INCOME If workers believe that a change in income is permanent, in a LCH/PIH world,
consumption would be adjusted upward accordingly and the current saving rate could fall. On the other hand,
those who do not earn from current income but from accumulated assets, such as those who are retired, might
dissave at a lower rate as a result of the wealth effect of more rapid income growth. The increase in income
could also have an impact on the rate of return on capital and hence the real interest rate. Whatever the
theoretical significance of growth in income, empirical tests by a number of researchers have found that there
is a strong relationship between income growth and saving. This evidence for developing countries is strongly
affected by the results for those Asian countries that have had high-income growth and high saving rates. This
has important implications for countries like Japan, where the growth rate has fallen significantly. However,
saving rates in Japan have not fallen as expected.
POPULATION AGE STRUCTURE LCH implies that the age structure plays an important role in saving
behaviour. The saving rate is expected to decline as the population ages. A country with a very low
dependency rate (large working population as a ratio of total population) can be expected to have a higher
saving rate in an LCH model. The young and the retired are usually dissavers. Several cross section studies
have confirmed this result (Masson et al.1995). However, these macroeconomic results across countries are in
conflict with some microeconomic studies which show that age-consumption profiles do not differ enough to
explain why aggregate consumption should be affected by demographic factors. The LCH assumption that
lifetime income is all “used up” at the moment of death, may also be erroneous. Since the time of death is
uncertain, bequests may not be planned. Alternatively, bequests may be part of a bargain with children in
exchange for taking care of their parents. An alternate model, called the dynasty model, postulates that
individuals build fortunes and save in order to make bequests to family members. There is the, perhaps
apocryphal, story that Henry Ford maintained an MPC of 0.5 throughout his lifetime. In a household where
there are several generations living together, there is no individual saving structure since assets are held in
common. In this setting, the age structure of the population should not have any effect on saving.
LEVEL OF INCOME If LCH and PIH are correct, then saving should not be related to current income.
However, several researchers such that of Hall (1978) have found that current income is an important
explanatory variable. These results lend partial support to the idea that there are liquidity constraints and/or
that income smoothing may be in response to short-run income fluctuations.
It also suggests that precautionary saving motives are stronger than life-cycle effects in the developing
countries.
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TERMS OF TRADE The terms of trade effect works through an unanticipated and transitory increase in
income by an improved trade balance. Since changes in the terms of trade are usually viewed as temporary,
they would be incorporated into the LCH/PIH framework as transitory, with a strong positive effect on saving.
The empirical literature finds this to be generally supported (Masson et al., 1995; and Ostry and Reinhart,
1992).
An unexpected improvement in the terms of trade can have a positive effect on the saving rate because it
represents a windfall gain in income and, according to the life cycle and permanent income models, would be
saved (Obstfeld, 1982). The terms of trade effect can be substantial if the shift is large. For example, the oil
shocks of the 1970s represented a sharp shift in the terms of trade in favour of oil exporters and a similar
increase in the rate of world saving as these funds could not be spent as fast as they accumulated.
DEGREE OF FINANCIAL LIBERALIZATION AND STABILITY A general rule of thumb regarding saving
would be that financial stability and liberalization are positively related to the rate of private saving, other things
being equal. A predictable and stable financial environment that offers a range of financial instruments can be
expected to call forth a higher level of saving from the private sector than a volatile and capricious financial and
economic environment. However, an alternative view would be that increased volatility could lead to a greater
precautionary motive for saving. Theory gives no guidance apart from the recognition that a more liberal
environment should lead to higher saving rates.
BANKING AND THE FINANCIAL SYSTEM
The banking and financial systems in the developing economies in Asia evolved from systems that
were in place during the colonial period. In South Asia, Taiwan, Malaysia, Hong Kong, and Singapore the
British system was adopted, while in East Asia, the Japanese model was adopted in Korea. In cases such as
Thailand and China, which were not colonized to any significant extent (some coastal cities, Such as Hong
Kong, did have significant colonial influence), the financial systems were borrowed from the industrial
countries.
In most cases, these financial systems were dominated by the banking system and commercial banks. The
government in turn controlled the banking systems. By and large, commercial banks were either owned or
controlled by the central bank. In South Asia, this was a persistent pattern of ownership and control that has
changed only slowly in the past decade or so. In East and Southeast Asia with the exception of Hong Kong,
which has been dominated by private commercial banks from its inception as a trading center by the British in
the nineteenth century, there has been a slow devolution of control and ownership by the government.
Nevertheless, by the early 1970s, the region as a whole could be characterized by the widespread presence of
financial repression. Financial repression is a situation, first described fully by Shaw (1973) and McKinnon
(1973) in the early 1970s, where government taxes and subsidies distort the domestic capital market
(compared with a free and competitive system where private banks are supervised by a central bank) by
imposing interest rate restrictions and high reserve requirements. At the same time, there are compulsory
credit allocations to some sectors and the lack of credit to others. As a result, loans extended by banks were
not thoroughly analyzed in terms of risk or project viability. Competition among banks was also limited,
particularly as foreign banks were not allowed to enter the market or where their presence was highly
regulated. In these cases, there were few incentives for improving bank efficiency. In a study of the
Organization for Economic Cooperation and Development (OECD) countries, for example, Terrell (1986)
concludes that the exclusion of foreign banks reduces competition, making domestic banks more profitable but
less efficient. Since requirements were high already, excess funds were often parked in government securities
rather than used to seek out high-yielding, 10w-risk investments in the private sector. Furthermore, in countries
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where foreign banks were allowed to compete vigorously, such as Singapore and Hong Kong, there was much
greater efficiency and lower profit margins.
This kind of banking system evolved during a time when development thinking believed that the government
had to play a strong role in mobilizing and allocating credit to facilitate investment and promote economic
development. There was a widespread belief that the private sector was too weak to mobilize sufficient
resources and that the banking system was to be used as an instrument by the government to step in. Interest
rates had to be controlled and some sectors subsidized further to keep the costs of investments low. Since the
private sector’s role in saving and investments were minimized, the impact of low (and sometimes negative
real) interest rates on savings of the private sector was not systematically considered.
A. Financial Repression
These various controls and schedules interacted, resulting in a financial system that did not allocate
credit to the public in an efficient manner, and the banking sector played a smaller role than it could have in a
more competitive and free environment. Such “repressed” financial systems were characterized by low or
negative real interest rates and a low and sometimes falling ratio of monetary assets to GDP/GNP. In a
repressed system, the government usually plays a dominant role in controlling the banking system by imposing
these kinds of controls, using banks to serve as the instruments for allocating credit to key selected sectors.
Often, specialized banks were created to address the needs of particular sectors. Rural banks were often
created for this purpose in the early stages of development and were complemented by banks focusing on key
industries later in the development process.
At the same time, credit to other potential borrowers was lacking. As a result, informal or “kerb” markets
developed outside the formal financial system to mobilize and direct credit to those sectors not effectively
serviced by the formal financial and banking system. The overall impact of these developments was a
fragmented banking system where the organized banking system serviced only a small Part of the total capital
market while informal finance emerged to serve the needs of other borrowers. Capital was allocated
inefficiently within the banking system since potential borrowers were not properly screened, competition within
the banking system was limited, and loans were extended based on preferential credit allocations and not on
economic feasibility studies or project evaluation. Interest rates did not reflect the interaction of the supply of
and demand for funds. Neither did they reflect the riskiness of projects. Instead, interest rates were determined
by flat based on the perceived importance of the sector to which the funds were being allocated-the more
important and critical the sector, the lower the rate of interest. Self-finance within enterprises was also impaired
when real interest rates were low or negative as it became difficult to save for needed projects. Finally,
financial deepening outside the banking system was difficult in the face of financial repression. This was true
not only because it was discouraged by the government and the central bank, but also because of the lack of
liquidity and the arbitrariness of government policy, and the potential or actual lack of financial stability.
B. Financial Liberalization
How then were the “miracle” economies of East and Southeast Asia able to develop such dynamic
economies? In parts of East Asia, particularly in Hong Kong and to a lesser extent in Singapore, the banking
system was not encumbered by too many regulations and restrictions. In. Korea and Taiwan, there was clear
evidence of financial repression, but the policies of the government did supply cheap finance to support key
sectors in the industrialization effort. Thus, in some sense, financial repression was not as great a handicap in
East Asia as it was in South Asia, where the other policies of openness, competitiveness in exports, and more
liberal industrial policies were not followed. In China, after opening to the rest of the world in the 1980s,
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financial incentives were used to develop the town and village enterprises as foreign investment from Taiwan
and Hong Kong was allowed to enter. However, the continued support of inefficient state-owned enterprises
(SOEs) drained resources for many years. Even now, the budget support for these enterprises continues to be
a challenge. In Southeast Asia, financial repression was not as extensive as in South Asia, and more private-
sector involvement was permitted. As industrialization proceeded, financial liberalization continued and
strengthened, although elements of the old system remained, as we shall see when we look into the financial
crisis of 1997.
Very simply, financial liberalization is designed to remove all the restrictions that characterize financial
repression. These include the lowering of reserve requirements, freeing up interest rates, and allowing them to
respond to market forces. Managed credit allocations to key sectors should be reduced or eliminated, and loan
officers should be required to evaluate potential borrowers on the merits of the project and not to give loans
indiscriminately based on other noneconomic criteria. Competitive forces should be allowed to operate in the
banking system to improve economic efficiency through the relaxation of entry requirements, both domestically
and for international banks. Together with these measures, price levels should be effectively controlled to keep
inflation to a minimum. In this way, positive real interest rates can be easily maintained. Given the strong
theoretical backing of Shaw (1973) and McKinnon (1973), many countries undertook financial liberalization.
C. Asian Experience of Financial Liberalization
In the 1960s and 1970s, the commercial banking system was tightly controlled by the government in
almost all the Asian countries. Banks were owned and operated by the government and it was believed that
one purpose of the banking system was to help further the government’s objectives of making loans to
subsidized sectors through a process of direct credits. It was believed that private banks would not make such
loans. Furthermore, interest rates were controlled and credit allocation schemes were used' Banks were
required to hold government debt that cut the cost of borrowing by the government. Prudential regulations were
largely neglected since the government controlled the banking system. Bank and development finance
institutions (DFIs) were the main financial intermediaries. DFIs were introduced to further allocate credit to
particular sectors, and they were given appropriate names such as Agriculture Development Bank or Industrial
Development Bank. Organized markets for private equities and bonds were either non-existent or very thin,
and few licenses were granted for other non-financial intermediaries such as insurance companies or pension
funds. The quality of loan portfolios was not an important consideration, being outweighed by the need to direct
credit to different sectors at subsidized rates. The only exceptions to these generalizations about banking
during this period were Hong Kong and (later) Singapore. . .
In the 1980s and early 1990s, financial liberalization began in the NIEs and in Southeast Asia. More
competition was permitted as regulations on private and foreign banking were relaxed. Interest rates were
deregulated to a large extent while directed credit and requirements to hold large amounts of government
securities were reduced. A modicum of independence was also evident as they became more autonomous and
escaped the grip of the Treasury. Some prudential regulations were introduced, including auditing and
oversight functions.
D. Measures of Financial Repression
Nevertheless, substantial evidence of financial repression remained in several countries. This is shown
by some aggregate measures of financial deepening. One such widely used measure of financial repression
and financial liberalization is the ratio of money plus quasi money (M2) to GDP/GNP. The ratio rises with
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liberalization and falls with financial repression. A comparison of these ratios for Asia in the last thirty years
shows that this ratio has been increasing rapidly in East and Southeast Asia.
In the Philippines, banks were also liberalized in the 1980s. As a result, the banking system is basically in the
hands of the private sector. There are only two development banks channelling funds to needy enterprises in
the rural areas and to some urban industries. Foreign ownership is allowed up to 40 percent, and no branches
are allowed to be set up by foreign banks outside of Manila. Interest rates are not regulated and reserve
requirements are low. There are some directed credit allocations but they apply mainly to rural banks. As a
result of these reforms and the difficulties experienced in the 1970s, the financial sector in the Philippines was
not highly leveraged in the early and mid-1990s and was therefore able to withstand the financial crisis without
having to introduce an asset management company to deal with bank loans. Nevertheless, the financial
system-has been weakened by the lack of a good prudential and regulatory system and the continued
presence of corruption and crony Capitalism.
In the case of China, where we have data only from 1979, the ratio has fallen slightly over twenty Years. There
are several factors working here. First, financial repression still exists as state banks dominate and funds are
channelled from the banking system to state-owned enterprises. Interest rates remain controlled and there is a
lack of competition. Secondly, much of the finance for the vibrant private sector in the southern coastal region
has come from foreign sources. Thirdly, the growth of the local stock market, also financed in part by foreign
funds inflow, has been responsible for some growth in total liquidity of the financial system.
*** END of LESSON ***
REFERENCES
Dowling, [Link], Valenzuela, Ma.R.,Brux, J. (2019) Economic Development Philippine Edition. Cengage
learning Asia Pte Ltd.
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permission from the University. Unauthorized use of the materials, other than personal learning use, will be penalized.
Please be guided accordingly.
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