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Interest rates, saving and investment: Evidence from India

PremaChandra Athukorala
a a

Department of Economics and Australia South Asia Research Centre, Research School of Pacific and Asian Studies, Australian National University, Canberra, ACT, 0200, Australia Version of record first published: 26 Nov 2007.

To cite this article: PremaChandra Athukorala (1998): Interest rates, saving and investment: Evidence from India, Oxford Agrarian Studies, 26:2, 153-169 To link to this article: http://dx.doi.org/10.1080/13600819808424151

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Oxford Development Studies, Vol. 26, No. 2, 1998

153

Interest Rates, Saving and Investment: Evidence from India

PREMA-CHANDRA ATHUKORALA Downloaded by [INASP - Pakistan (PERI)] at 00:47 06 October 2012

ABSTRACT The role of interest rates in the process of economic development is examined through an empirical inquiry into the interest rate-saving-investment nexus in the Indian economy during the period 1955-95. The results are generally in support of the financial liberalization school of thought. Higher real interest rates seem to promote both financial and total savings, and stimulate private investment. On the investment side, the combined salutary effect of interest rate increases operating through increased debt intermediation and selffinanced capital accumulation outweighs the direct cost effect on investment. Overall, the study casts doubt on the robustness of results coming from the vast cross-country literature on the subject and calls for systematic time-series analyses covering a variety of country situations to inform the on-going policy debate.

1. Introduction The role of interest rates in the process of economic development has long been at the centre of the debate on economic policy reforms in developing countries. Until the 1970s interest rate policy in these countries was primarily guided by the Keynesian view that interest rates should be kept low in order to promote investment. A shot across the bows of this view came from McKinnon (1973) and Shaw (1973), who forcefully argued that in the context of the typical developing economy, financial repression retards (rather than promotes) growth, by both reducing the volume of investible funds and interfering with the efficient allocation of such funds. Despite counter arguments by economists of Keynesian persuasion and structuralist development economists (Davidson, 1986; Thirlwall, 1976; Taylor, 1983), the McKinnon-Shaw "financial repression paradigm" soon became the new orthodoxy of financial sector reforms in developing countries. In response to this shift in conventional wisdom, many developing countries have experimented with financial liberalization reforms since the late 1970s, mostly as part of IMF-World Bank sponsored liberalization/stabilization programmes. In line with this policy emphasis, a sizeable body of empirical literature has attempted to quantify the impact of interest rates on saving and investment. Given the
P. Athukorala, Department of Economics and Australia South Asia Research Centre, Research School of Pacific and Asian Studies, Australian National University, Canberra ACT 0200, Australia. I have received valuable comments from many individuals, comprising a list that is too long to acknowledge here. However, special thanks go to Max Corden, George Fane, Ross McLeod, Jayant Menon, James Riedel, Kunal Sen, Tony Thirlwall, Pan-Long Tsai and an anonymous referee who provided comments that materially improved this work. Of course, any errors are mine. 1360-0818/98/020153-17 1998 International Development Centre, Oxford

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nature of data availability, many of these studies have been conducted using crosscountry time-series data, focusing largely on the total domestic saving-interest rate nexus.1 The results of these studies are at best ambiguous; while some studies come down against any interest rate effect on savings, others find a positive but rather small interest elasticity (around 0.1) which is "not large enough to warrant much policy significance" (Fry, 1995, p. 42). Overall, at face value, the available evidence seem to suggest that "the financial repression paradigm is ... a kernel of truth and a vast exaggeration" (Dornbusch & Reynoso, 1989, p. 205). However, many of these studies "do not reach econometric standards that would allow the reader to take their results at face value" (Deaton, 1989; Gibson & Tsakalotos, 1994). Quite apart from general methodological flaws relating to model specification and econometric procedure, there are two fundamental limitations that make results from any cross-country study on this subject rather dubious. First, cross-country regression analysis is based on the implicit assumption of "homogeneity" in the observed relationship across countries. This is a very restrictive assumption. It is common knowledge that there are considerable variations among developing countries in relation to various structural features and institutional aspects which have a direct bearing upon the impact of financial factors on the growdi process. Second, given vast differences among countries with respect to the nature and quality of data, cross-country comparison is fraught with danger (Deaton, 1989; Srinivasan, 1994). Not only the statistical procedures for measuring saving and investment, but also the magnitude of errors in data in the implementation of these procedures, vary significantly among countries. These considerations point to the need for undertaking econometric analysis of saving/investment behaviour within individual countries over time in order to build a sound empirical foundation for informing the policy debate. Unfortunately, systematic country studies of this nature are few and far between.2 Interestingly, some of the available country studies have, in fact, produced large and quite significant interest elasticities with respect to saving and investment. At the same time there are significant variations in the magnitude of measured elasticities among countries, suggesting that data should not be pooled without considerable caution. This article seeks to add to the literature by systematically tracing out the interest rate-saving-investment nexus in the Indian economy using data for the period 195595. India seems to be a very appropriate case study of the subject at hand for the following reasons. First, the Indian saving and investment database is considered relatively good by developing country standards, and data are available on a comparable basis for a period of time which is adequate for systematic econometric investigation (Srinivasan, 1994). Second, saving/investment performance is a key emphasis in the policy debate in India following the structural adjustment reforms initiated in 1991 (EPWRF, 1995; Athukorala & Sen, 1995); but, there is no hard empirical evidence to inform this policy debate.3 The empirical analysis of the present paper focuses separately on total savings, private savings and financial savings. An attempt is also made to test explicitly the nexus of financial saving and investment by separate estimation of credit supply and investment functions. The estimation procedure draws upon recent advances in timeseries econometrics, in an attempt to derive robust coefficient estimates while guarding against the possibility of uncovering spurious relations. The paper is structured in the following manner. Section 2 sets out the analytical framework, drawing upon the theoretical debate on the role of interest rate policy in developing countries. The database and the econometric procedure are described in Section 3. Results are

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presented and analysed in Section 4. The final section provides a summary and concluding remarks. 2. Analytical Framework For the purpose of empirical analysis, we formulate behavioural relationships for domestic saving (DS), private investment (PRIV) and bank lending behaviour (BCP). The saving function is estimated separately for total domestic saving (TS)S private saving (PS) and financial saving (FS). Most of the previous studies of saving behaviour in developing countries have focused solely on total saving as the dependent variable. This is unsatisfactory because the positive response of private savings to interest rates stipulated by the financial repressionist theory may be obscured in the typical developing country context where public sector saving is a significant element in total saving. To shed light on this possible aggregation bias, we chose to estimate functions separately for total and private savings. Financial saving is treated separately for two reasons. First, a comparison of results for the interest rate variable in the financial savings and total private savings functions would shed light on possible substitution between financial assets and total assets in response to interest rate changes. Second, the financial saving function, together with the function for bank credit to the private sector, provide a test of the link between deposit interest rates and private investment that operates via credit supply. Previous analyses of the impact of interest rate on investment have paid little attention to the intermediate link between financial saving and bank lending,4 on the implicit assumption that the former is automatically translated into investment. This is an incomplete approach because, as the post-Keynesians remind us, the availability of financial saving does not necessarily imply increased bank lending. If the banks can create credit without having to rely on initial deposits, an increase in financial saving through higher real deposit rates makes no difference to the amount of total credit given to the private sector (Davidson, 1986; Thirwall, 1976). Domestic saving (TS, PS or FS) is specified as a function of real interest rate on bank deposits (RID), expected rate of inflation (PE), income (YR), terms of trade (TOT), the share of agriculture in GDP (AGS), population per bank branch ("bank density", BDN) and real remittance transfers by expatriate Indians (TRN). According to the Keynesian view on saving behaviour, the income and substitution effects of a change in the real interest rate may work in opposite directions, rendering the net effect ambiguous. Thus, the interest rate effect on saving is considered "secondary and relatively unimportant, except where unusually large changes are in question" (Keynes, 1936, p. 94). The financial repression paradigm of McKinnon (1973) and Shaw (1973), however, postulates the impact of a change in real interest rate on saving in the typical developing economy to be positive. The underlying reasoning is the following. In the typical developing economy where portfolio choices are rather limited, the saving process tends to be highly money intensive. Given this peculiarity of saving behaviour, plus the fact that the bulk of saving comes from small savers, the substitutions effect generally tends to be much larger than the income effect of an interest rate change. On these grounds we expect the regression coefficient of RID to be positive. In most of the existing studies, PE is assumed to impact on saving only through its role in the determination of RID. This model formulation assumes inflation neutrality; the absence of money illusion or real balance effect. There are, however, good reasons for doubting the validity of this assumption. Quite apart from its influence on real returns to saving, inflation may influence savings through its impact on real wealth.

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156 P. Athukorala
If consumers attempt to maintain a target rate of consumption to wealth or of liquid assets to income, saving will rise with anticipated inflation. Also, consumer response to unexpected changes in inflation can result in involuntary saving (Deaton, 1977). On the other hand, in an inflationary situation, a switch from financial assets to real assets can results in a decline in savings. For these reasons, we include PE as an additional variable and assume its sign to be either positive or negative. The third variable, YR, is based on the Keynesian absolute income hypothesis. The TOT is included to capture the impact of real income losses or gains brought about by change in the price of foreign goods in terms of domestic goods.5 Conventionally, the sign of its coefficient is assumed to be positive. However, when we assume forward-looking consumption smoothing behaviour on the part of private agents (households) in the face of volatile and unpredictable income, the sign can go either way, depending on whether movements in TOT are perceived to be temporary or permanent (Frankel & Razin, 1992). A terms of trade deterioration that is perceived to be temporary may lead to an increase in absorption (that is, an increase in expenditure measured in terms of domestic goods) as consumers attempt to offset the decrease in purchasing power of domestic goods so as to keep real expenditure constant. In other words, deterioration of the terms of trade induces domestic residents to reduce their savings in order to sustain their real standard of living. By the same reasoning, households increase savings when faced with lower future real income as a result of a long-run terms of trade deterioration. The remaining three variablesTRN, AGS and BDNare chosen in the light of the Indian debate on the determination of domestic savings. Since the mid-1970s, there has been a significant increase in inward remittances by expatriate Indians, mostly the Indian workers who migrated to the Gtf countries in response to the oil boom.6 As it is unrealistic to assume that they are current transfers intended solely for consumption, remittances can be considered a positive influence on domestic savings Qoshi & Little, 1994).7 Quite apart from this general impact, some studies have treated remittances as a special influence on financial savings (RBI, 1982, Appendix VI; EPWRF, 1995). The theory behind this relationship has not been stated explicitly, but the underlying assumption seems to be that, as the bulk of remittances is transferred through banking channels, these tend to raise the money holdings of households. However, as Rakshit forcefully argues, "the fact that [remittances] initially raise money balances is of no importance in explaining why households find it advantageous to hold a large fraction of their savings in the form of currency and bank deposits" (Rakshit, 1983, p. 761). In the debate on the causes of the rapid increase in the saving rate in India in the second half of the 1970s (the high saving phase of the Indian economy), one of the underlying causes considered was the significant decline in the share of agriculture in total GDP, partly as a result of a significant worsening of the internal terms of trade and partly as an outcome of the on-going process of structural transformation in the economy (Rakshit, 1983, p. 76; RBI, 1982, p. 46; Joshi & Little, 1994, p. 297). This view was based on the hypothesis that agricultural households have a greater marginal propensity to consume compared to non-agricultural (mostly urban) households; a hypothesis which has not yet been supported by firm statistical evidence. In fact, the permanent income hypothesis (which postulates a higher marginal propensity to save out of transitory income) would lead one to expect marginal propensity to save to be higher for agricultural households than for non-agricultural households. A notable development in the Indian financial system following the nationalization of commercial banks in 1969 has been the rapid expansion of bank branches in the country. Population per bank branch declined persistently from over 90 000 in the

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157

mid-1950s to around 14 000 in the early 1990s (see Table 2 later). The rapid expansion of bank branches would have contributed to an increase in financial savings in the economy, both by improving the accessibility to banking facilities of the general public and by reducing the cost of banking transactions (through reduced transport cost) (Joshi & Little, 1994). Thus, a negative relationship can be assumed between population per bank branch (bank density) and financial saving. However, whether increased financial intermediation itself significantly raises the overall propensity to save depends also on the degree of substitution between financial saving and other items in the household asset portfolio. Thus, the expected sign of this relationship in private and total saving functions is ambiguous. Common practice in the empirical literature on the determination of savings has been to specify the dependent variable as the ratio of saving to income.8 A major limitation of this approach is that it implicitly imposes the "income homogeneity assumption" (that is, "savings are proportional to income, other things equal") on coefficient estimates. In practice, income and saving may not always move in tandem and hence the arbitrary imposition of income homogeneity assumption may distort coefficient estimates. The procedure followed in this study is therefore to start with an unrestricted equation (which contains the dependent variable in level form and the level of real GDP as an additional explanatory variable) and then to impose and test the coefficient restriction as part of the estimation process. Bank credit to the private sector is specified as a ftinction of FS, BDN and PRIV. The nationalization of banks in India (in 1969) and the subsequent expansion of bank branches were largely motivated by the objectives of promoting financial savings and making bank credit accessible to a wider segment of the economy, particularly those in the rural areas of the country as well as those engaged in small-scale business. We include BDN in the credit supply function on these grounds and expect its sign to be negative. PRIV is included in the light of the Keynesian proposition that, in a fractional reserve banking system, investment (demand for credit) can induce credit supply independently of changes in financial savings. The explanatory variables in the investment function are bank credit to the private sector (BCP), the change in income (A YR), public sector fixed investment (PBIV) with a 1-year lag, implicit real rental cost of capital (RRCC) and real interest rate on bank deposits (RID). BCP constitutes the key link between financial savings and private investment. The inclusion of A YR as an explanatory variable implies an acceleratortype relationship between the level of domestic economic activity and capital formation. Previous studies on the determinants of private investment in developing countries have commonly used real lending rate to capture cost of investment. This practice is susceptible to specification error as the cost of credit is obviously only one element of the investor's profitability calculations. Mindful of this limitation, we use an overall index of RRCC to represent the cost of investment in the investment function. RRCC captures the combined effect of changes in the cost of credit (bank lending rate), net of the expected rate of change of the price of investment goods, the rate of depreciation and the current price of investment good, relative to the price of output (general price level, PG).9 It is constructed as,

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where NIL is the nominal interest rate on bank lending, PK is the price of capital goods proxied by the implicit price deflator of fixed investment (1980= 1.00), PG is the

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general price level, measured by the GDP deflator (1980 = 1.00), PEK is the expected rate of change in price of capital goods proxied by the rate of change in PK with a 1-year lag and DR is the rate of depreciation. RID is included in the investment function to test McKinnon's "complementarity hypotheses" which postulates that higher deposit interest rates promote investment, independently of their impact on investment via greater credit availability (McKinnon, 1973, pp. 60-61). In an economy with a rudimentary capital market, self-financing is a major source of investment funds. Given the fact that investment projects are lumpy, investors must accumulate funds in the form of deposits until the required principal is reached. This process of self-finance within enterprises is impaired by financial repression because low real yield on deposits increases the cost of accumulating the necessary money balances in preparation for making future investments. Thus, the more attractive the return on deposits, the more willing investors are to engage in the accumulation process If this complementarity is at work over and above the cost effect of interest rate changes on investment, then the regression coefficient attached to RID should attain statistical significance with a positive sign. The choice of lagged PBIV is guided by the prevalent view in the Indian economic literature that public investment plays an important complementary role in promoting private investment (Bardhan, 1984, Chapter 4). This complementarity is expected to work on both supply and demand sides. On the supply side, the private sector relies on public investment for most of the infrastructure, because this is either a natural or a legal monopoly of the government. Thus, public investment in infrastructure and private investment should be complementary. On the demand side, in theory, the relationship is ambiguous. If there is some slack in the economy one would expect a change in public investment to push private investment in the same direction. Otherwise, some private investment will probably have to be "crowded out". This ambiguity notwithstanding, given the dominant role played by the government in the provision of infrastructure and in key intermediate and investment goods producing industries, it is generally assumed that "the stimulation effect of public investment on private investment tends to dominate any possible negative effect through competing for investible funds" (Bardhan, 1984, p. 25). Apart from the explanatory variables discussed above, an intercept dummy variables ("liberalization dummy", LBD) is included in all equations, in order to test whether the market-oriented policy reforms initiated in 1991 per se has had a specific influence (over and above their impact operating through the other variables explicitly allowed for in regression specifications) on saving/investment behaviour in the Indian economy. There has been a slowing down of the annual increase in domestic saving/ investment (and therefore a decline in the saving and investment rates) in India in the aftermath of the reforms. Two schools of thoughts have emerged to explain this phenomenon (EPWRF, 1995; Athukorala & Sen, 1995). The "official" view10 takes the position that the decline is simply a reflection of lags involved in the adjustment of the economy to the new policy environment, and the improved incentives for private sector performance should eventually lead to higher saving/investment levels. The critics of reforms, however, interpret the phenomenon as an invariable adverse outcome of the reform process. According to this interpretation the reform process, by encouraging conspicuous consumption among the rich and middle classes, has paved the way for a long-term deterioration in saving/investment performance in the economy.11 For ease of reference, the complete model with the variable definitions is listed in Table 1.

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Interest Rates, Saving and Investment

Table 1. The model
DS',=f(YR RID PETOT TRN AGS BDN LBD) DS,= TS DS FS, BCP, =f(DFS BDN PRIV,, LBD) PRIV,=f(BCP GYR RRCC,, PBIV,-, RID,, LBD) Dependent variables DS domestic saving8 TS total domestic saving3 PS private saving8 FS financial saving11 BCP bank credit to the private sector3 PRIV private fixed investment3

159

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Explanatory variables^ YR ( + ) domestic income (proxied by GDP) 3 RID ( + ) NID - PE, real interest rate on bank deposits NID nominal interest rate on bank deposits PE ( + or ) expected rate of inflation proxied by the actual rate of inflation with a 1 -year lag TOT{+ or - ) = [PX/PM]* 100, terms of trade PX price index of exports (1980 = 1.00) PM price index of imports (1980 = 1.00) AGS ( + or - ) share of agriculture in total GDP TRN ( + ) remittances by Indian expatriates3 BDN ( ) population per bank branch ("bank density") GYR{ + ) growth rate YR3 RRCC ( ) real rental cost of capital NIL nominal interest rate on bank lending PK price of capital goods proxied by the implicit price deflator of fixed investment (1980 = 1.00) PG general price level, measured by the GDP deflator (1980 = 1.00) PEK expected rate of change in price of capital goods proxied by the rate of change in PK with a 1-year lag DR rate of depreciation PBIV ( + or ) public sector fixed investment3 LBD ( + or ) a dummy variable (which takes value one for years 1991-95 and zero for other years) to represent the post-trade liberalization period "Expressed in real terms. The sign expected for the regression coefficient is given in parentheses.

3. Data and Econometric Procedure

The model formulated in the previous section is estimated over the sample period 1955-95 using annual data.12 All variables, except interest rates and inflation (which are measured in proportional form), are measured in natural logarithms. Data sources are listed and methods of data transformation adopted and key limitations of the data are discussed in the Appendix. The data series are summarized in Table 2, in order to aid the interpretation of the results. In line with standard practice in modern time-series econometrics, we begin the estimation process by testing the time-series properties of the data. Two tests for unit roots are used: the augmented Dicky-Fuller (ADF) test and the Kwiatkowiski-PhillipsSchmidt-Shin (KPSS) test. The latter tests the null of a unit root against the alternative of stationarity, while the former tests the null of stationarity against the alternative of a unit root. The choice of the KPSS test to supplement the widely used ADF test is based on evidence that tests designed on the basis of the null that a series is 7(1) have low

ON

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Table 2. Summary data on variables used in econometric analysis

1956-60 Dependent variables 1961-65 1966-70 1971-75 1976-80 1981-85

1986-90

1991-95

1955-95

S
7185 (12.35) 6136 (10.55) 1703 (2.93) 648 (1.11) 5534 (9.52) 58156 0.70 2.88 89.0 135 250 (0.43) 3854 (6.63) 49.4 3.46 9583 (13.23) 7305 (10.09) 2140 (2.96) 1012 (1.40) 6363 (8.79) 72412 -0.36 1.38 81.8 144 146 (0.20) 6070 (8.38) 45.8 4.26 12300 (14.62) 10178 (12.05) 2320 (2.76) 1422 (1.69) 9227 (10.96) 84150 -2.30 -0.90 65.1 145 242 (0.29) 6661 (7.92) 47.1 3.46 17294 (17.11) 14203 (14.05) 4007 (3.96) 2419 (2.39) 10518 (10.40) 101093 -1.08 1.92 37.7 154 206 (0.20) 7342 (7.26) 45.3 4.68 26577 (21.40) 20969 (16.88) 7100 (5.72) 4160 (3.35) 12565 (10.12) 124190 1.46 8.56 23.6 116 29414 (19.40) 23847 (15.73) 10307 (6.80) 5627 (3.71) 14593 (9.63) 151589 -2.76 5.84 16.8 119 2059 (1.36) 14135 (9.32) 37.9 8.94 41275 (20.94) 36668 (18.60) 15111 (7.67) 6899 (3.50) 20890 (10.60) 197086 0.98 8.68 14.1 117 1957 (0.99) 19156 (9.72) 31.9 13.48 58059 (23.01) 54623 (21.65) 25945 (10.28) 8370 (3.32) 33081 (13.11) 252275 0.52 7.12 14.3 109 3313 (1.31) 21903 (8.68) 31.1 10.50 25211 (19.38) 21741 (16.71) 8579 (6.59) 3820 (2.94) 14096 (10.83) 130119 -0.28 3.94 42.8 129.8 1144 (0.88) 11168 (8.58) 41.1 7.12 35

TS PS FS

2 * .

BCP
PRIV Explanatory variables

YR RID RIL
BDN (x 1000)

TOT TRN
PBIV

977
(0.79) 10224 (8.23) 40.0 8.14

AGS
PRCC

"Value series are in crores of Indian rupees at constant (1981) prices (crore = 10 million). Figures in parentheses are percentage of GDP. Annual averages. Source and methods: Data sources and methods of data compilation are explained in the Appendix.
b

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power in rejecting the null. Reversing the null and alternative hypotheses is helpful in overcoming this problem (Kwiatkowiski et al, 1992). According to the test results the key variables of interest do not have the same order of integration; in particular, the three saving series and the interest rate series are stationary.13 The two alternative tests yield remarkably similar results. Thus, nowfashionable econometric procedures that are appropriate for 7(1) variables are not applicable in our case. However, given the presence of non-stationary variables, it is necessary to guard against the possibility of estimating spurious relationships. The time-series econometrician's prescription in this type of situation is to difference the non-stationary variables (to achieve stationarity) and use them in that transformed form together with the other (stationary) variables. This procedure, while statistically acceptable, has the disadvantage of ignoring long-run relations. We therefore opted to use the unrestricted error correction modelling (JJECM) procedure of Hendry, which minimizes the possibility of estimating spurious relations while retaining long-run information (Hendry, 1995). This approach also has the added advantage that it provides for estimating lag effects without arbitrarily constraining the lag structure at the outset. Under the UECM method, the long-run relationship being investigated is embedded within a sufficiently complex dynamic specification, including lagged dependent and independent variables, in order to minimize the possibility of estimating spurious relationships. The estimation procedure starts with an autoregressive distributed lag (ADL) specification of an appropriate lag order:
m m

Y, = a + 2 AiYt- X BiX,-i + p,
1=1
i"=0

(1)

where a is a vector of constants, Yt is an (XI) vector of endogenous variables, X, is a (k X 1) vector of explanatory variables, A and B are (n X ri) and ( X k) matrices of parameters, and xt is a stochastic error term. Equation (1) can be reparameterized in terms of differences and lagged levels so as to separate the short-run and long-run multipliers of the system.
m 1

m i

AY,= a+ X AY,-i+ BAX,-i+C0Yt-m + C1X,-m +lit

1=1 =0

(2)

where

= C,=

V=o '

SB,

and where the long-run multipliers of the system are given by Co lC\. Equation (2) constitutes the "maintained hypothesis" of our specification search. This general model is "tested down" (using ordinary least squares, OLS) by dropping statistically insignificant lag terms and imposing data-acceptable restrictions on the regression parameters. The testing procedure continues until a parsimonious error correction representation is obtained which retains the a priori theoretical model as its long-run solution. To be acceptable, the final equation must satisfy various diagnostic checking procedures. In applying the UECM procedure, we set the initial lag length on all variables in the general ADL equation at two periods. This is the established practice in modelling with annual data. After undertaking a preliminary specification search using OLS, the equation for PRIV (which contains a contemporaneous terms of a jointly determined variable (BCP) among explanatory variables) was estimated using two-stage least squares (2SLS). The remaining equations were estimated using OLS.

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PE and AGS variables in the three saving equations and TOTin the financial saving equation had statistically insignificant coefficients in all experimental runs and were therefore dropped in the final equations. BDN was omitted from the equation for bank credit as it turned out to be highly correlated with DFN. In all cases the specification choice was statistically acceptable in terms of the joint variable deletion tests against the maintained hypothesis. As intercept dummy variable, DIP, was included in the equation for total domestic saving to allow for an "unexplained" dip in the saving rate between 1982 and 1987.14 Likewise, an intercept dummy variable, >58, was added to the equation for bank credit equation to allow for an outline observation for 1958 in the BCP series. In both cases, without these intercept dummies the equation does not pass the tests for normality (JBN) and heteroscedasticity (ARCH). However, the coefficient estimates for the other variables are remarkably resilient to the addition of these variables. Downloaded by [INASP - Pakistan (PERI)] at 00:47 06 October 2012

4. Results
The final parsimonious estimated equations, together with a set of commonly used diagnostic statistics, are reported in Table 3. Long-run elasticities relating to the key explanatory variables computed from the long-run (steady-state) solutions to the estimated equations are given in Table 4. All equations are statistically significant at the 1% level (in terms of the standard F-test) and they perform well by all diagnostic tests. In terms of the Chow test for parameter stability conducted by splitting the total sample period into 1956-79 and 1980-95,15 there is no evidence of parameter instability. On reestimating for the sub-period 1956-90, all equations pass the Chow test of out-of-sample forecasting ability (Chow's prediction failure test) for the post-reform period (1991-95). Apart from these tests, a residual correlogram of up to 6 years was estimated for each equation, with no evidence of significant serial correlation. The equations also comfortably passed the CUSUM test on the recursive residuals and the CUSUMSQ test. To comment first on the three saving functions,16 the long-run income homogeneity assumption (unit coefficient restriction on the real income variable) is statistically acceptable in all three equations. Thus, other things remaining equal, a 1% change in real GDP is associated with a similar change in savings, resulting in a constant ratio of each component of saving to GDP in the long run. The results for the RID variable suggest that saving behaviour in India depends significantly on the real rate of return on bank deposits. A 1% increase in RID is associated with a 1.50% increase in real financial saving, 1.72% increase in real total private saving and 1.1% point increase in total private saving. Considering the fact that during the study period financial savings on average accounted for over 45% of total private savings (Table 2), there is no evidence of substitution of other assets for financial assets in response to changes in the real deposit rate. Overall, the Indian experience provides ample support for the McKinnon-Shaw proposition that, in an economy where the saving behaviour is highly intensive in financial assets, high real interest rates promote both financial and total saving in the economy. The interest elasticity of total private saving (1.71) is greater in magnitude compared to that of total domestic saving (1.11) and the difference is statistically significant at the 1% level. These results support our postulate that use of total saving (which include public sector saving) as the measure of saving performance, as has been done in most of previous studies on this subject, is likely to infuse a downward bias into estimates of interest elasticity of saving. Among the remaining variables, BDN stands out as a highly significant variable in explaining both total and financial savings. Thus, there is strong support for the view

Interest Rates, Saving and Investment

Table 3. Determinants of saving and investment in India: regression results
1. Total domestic saving (TS) ATS,= - 1.04+1.31AGDP1 + 0.69ARID, + 0.lOATRN, + 0.77RID,-,-OAOBDN,-1-0.23BDN,-1 (2.13)** (3.28)*** (2.33) (2.56)*** (2.02)** (1.56)* (4.06)*** 0.12TOT,-,- 0.69(7-5- GDP),-,(1.10) (4.14)*** 0.12D/P (2.91)***

163

i?2 = 0.65 F(9,28) = 5.70 S=0.07 L / H - F ( l , 2 9 ) = 0.07 L M l - F ( l , 2 7 ) = 0.93 LM2-F(2,26) = 1.00 RESET- F(l,27) = 0.32 JBN-f(2) = 0.83 ARCm - F(l,27) = 0.27 ARCH2 - F(2,26) = 1.16 CHOW- F(9,20) = 1.33 PRF- F(5,23) = 0.83 2. Total private saving (PS)

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ADS,= - l.62+l.29AGDP, + 0.90ARIDt + 0.l3ATRN,+ (2.57)*** (3.33)*** (2.49)*** (2.62)*** 0.227OT,-,- 0.62(DS- GDP),-,(1.62)* (3.78)*** 0.10DLB (1.87)**

1.07RIDt-,-0.20BDN,-, (2.20)** (3.58)***

^ = 0.57 F(8,29) = 4.69 SE= 0.08 LIH- F(l,28) = 1.80 LAfl(l)-F(l,28) = 0.03 LM2 -F(2,27) = 0.07 RESET-F(l,28) = 0.20 JBN- *2(2) = 0.85 /AC/1 - F(l,28) = 0.03 ARCH2 - F(2,27) = 0.06 CHOW- F(7,24) = 2.09 PRF - F(5,26) = 1.42 3. Financial saving (FS) JKS, = - 0.95 + 1.20iGDP, + 1.31/D,- 0A9BDN,-, - 0.87(F5- GDP),-, + 0.15F5,-2 + 0.26DL (3.96)*** (1.34)* (2.18)** (5.16)*** (5.59)*** (1.47)* (2.55)*** i?2 = 0.55 F(6,28) = 6.64 S=0.16 UH- F(l,32) = 0.62 LMl -F(l,32) = 0.02 LA2-F(2,31) = 0.27 RESET-F(.l,?>2) = 4.81 JBN~x2(2) = 0.13 0.35 ^i?CH2-F(2,31) = 1.23 CHOW- F(14,20) = 0.73 PRF-F(5,29) = 1.63 4. Bank credit to the private sector (BCJ?) ABCR, = - 2.77 + 0.37AFS, + 0A7FS,-1 + 0.59PRIV,-, + 0.84BCR,-1 - 0.46DLB- 2.11D58 (2.04)** (2.06)** (3.40)*** (2.32)*** (7.75)*** (2.51)*** (8.36)*** R2 = 0.84 F(6,33) = 30.47 SE = 0.22 M l - F ( l , 3 2 ) = 2.05 LA2-F(2,31) = 1.23 RESET-F(.\,32) = 1.29 JBN-y?(2) = 0.03 y4i?CHl-F(l,32) = 0.03 ^i?CH2-F(2,31) = 0.53 CHOW-F(5,30) = 1.79 FiF-F(5,30) = 1.24 5. Private investment JPR/F, = 0.73 + 0.07BCP, + 0.81A2YR, + 0.89AYR,-t + 0.16PBIV,-2 (1.58)* (2.15)** (2.38)** (1.56)* (2.22)** - 0A5RRCC-1 + 0.56RID,-1 - 0.28PRIV,- + 0.23APRIV,-2 + 0.10DLB (1.37)* (3.03)*** (3.35)*** (1.95)** (1.74)** /?2 = 0.62 F(9,29) = 5.30 5B=0.06 SPEC-^(3) = 3.35 LM1(1)-Z 2 (1) = 1.24 LM2-x 2 (2) = 1.52 RESET- / ( I ) = 0.76 JBN - z 2 (2) = 1.05 A R C m ( l ) - F ( l , 2 8 ) = 0.42 A RCH2 - F(2,27) = 0.75 CHOH7- F(14,21) = 1.43 PF-F(5,25) = 1.32 Notes: t-ratios of regression coefficients are given in parentheses. Approximate critical values for the f-ratios are as follows: 10%= 1.30 (*), 5%= 1.69 (**) and 1% = 2.42 (***). Test statistics: LIH = F-test for the long-run income homogeneity restriction; SPEC = Sargan's test for the correct specification of instruments; LM = Lagrange multiplier test of residual serial correlation; RESET = Ramsey test for functional form mis-specification; JBN = Jarque-Bera test for the normality of residuals; ARCH= Engle's autoregressive conditional heteroscedasticity test; CHOW= Chow test for parameter stability conducted by splitting the sample period into 1956-79 and 1980-95; PRF= Chow's test for prediction failure (the out-of-sample forecasting ability) conducted to test the ability of the equation reestimated for the pre-reform period (1956-90) to forecast the dependent variable for the post-reform years (1991-95).

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Table 4. Estimates of long-run elasticities

Explanatory variable RID 1. Total domestic saving (TS) 2. Total private saving (PS) 3. Financial saving (FS) 4. Bank credit to the private sector (BCP) 5. Private investment (PRIV) 1.11 (1.81)** 1.71 (1.92)** 1.50 (2.02)** 1.94 (2.17)** GDP 1.00 (4.14)*** 1.00 (3.78)*** 1.00 (5.58)*** BDN -0.33 (9.58)*** -0.32 (7.15)*** -0.56 (12.11)*** TOT 0.17 (1.01) 0.35 (1.46)* FS BCP PRIV PBIV RRCC

0.56 (3.71)***

0.23 (2.32)**

0.69 (2.61)***

0.55 (2.59)***

-1.55 (1.32)*

Note: f-ratios of regression coefficients are given in parentheses. Approximate critical values for the f-ratios are as follows: 10%= 1.30 (*), 5%= 1.68 (**) and 1% = 2.42 (***). Not applicable. Source: Computed from the long-run (steady-state) solutions to the estimated models reported in Table 3.

Interest Rates, Saving and Investment

165

that the expansion of banking facilities since the 1970s seems to have contributed significantly to improvement in saving propensity in the economy. There is no evidence to suggest that the expansion of bank branches generated greater financial savings in the form of bank deposits at the expense of the accumulation of other assets. The coefficient of TO 7* is positive and statistically significant in both total and private saving functions, suggesting that real income gains (losses) associated with terms of trade improvements lead to higher (lower) saving. Thus, Indian households seem to consider terms of trade movements as temporary shocks. Remittances (TRN) seem to impact on year-to-year fluctuations in total and private saving, but do not seem to yield a statistically significant long-run impact. As noted, AGS failed to attain statistical significance in all saving functions. Thus, there is no empirical support for the view that the decline in the share of agriculture in domestic production (and the accompanied increased urbanization of the economy) has contributed to the growth in domestic saving. Among the developing countries of similar income status, India has shown a remarkably high propensity to save, particularly since the early 1970s (Joshi & Little, 1994). Our results clearly point to the progressively important role financial intermediation has played in the continued buoyancy in domestic saving. Throughout the period under study up to 1991, the nominal interest rate was an administered price, changed at infrequent intervals. However, there were no persistent adverse movements in real deposit rates; macroeconomic policy had an anti-inflationary stance, and high inflation and sharply negative real deposit rates were not allowed to persist for long. At the same time, the spread of banking facilities played a useful supplementary role in increasing financial (and hence total) saving. The equation for bank credit to the private sector suggests that a 1% increase in financial saving is translated into a 0.56% increase in bank credit to the private sector. PRIV is also highly significant, suggesting that investment demand is a significant determinant of bank lending. In the investment function, the coefficient of the real bank credit variable (BCP) is significant and suggests that a 1% point change in the volume of real bank credit is reflected in a 0.23% change in the level of real private investment. This result, taken together with the estimates of interest elasticity of financial saving (1.5) and elasticity of bank credit with respect to financial saving (0.56), suggest that a 1% increase in real deposit rate brings about a 0.20% increase in private investment through the supply of real bank credit. There is some statistical evidence (significant at the 10% level) of a negative effect of the bank lending rate (as part of total cost of investment) on the level of investment; a 1% increase in the former results in a 1.50% decline in the latter. At the same time, there is strong statistical support for McKinnon's complementarity hypothesis that high real deposit rates promote private sector capital formation by facilitating the accumulation of finance necessary to make the investment. After allowing for other influences, a 1% increase in the real deposit rate is associated with over 2% increase in private investment.17 Overall, the cumulative net impact of the real deposit rate on investment operating through financial intermediation and through the direct complementarity effect outweighs the cost effects of interest rate changes on investment. There is also evidence of a significant positive effect of lagged government investment on private investment. This result supports the view that in the Indian economy public investment plays an important complementary role in promoting private investment. The standard accelerator mechanism also appears important in explaining private investment. Finally, the results for the LBD do not lend support to the pessimistic view that the market-oriented policies initiated in 1991 have had an adverse

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166 P. Athukorala
effect on saving/investment performance in the Indian economy. On the contrary, the coefficient of LBD is statistically significant with the positive sign in private saving, financial saving and private investment functions. This result suggests that, once allowance is made for the other influences, liberalization has in fact enhanced saving/ investment performance in the economy. In the bank credit equation the coefficient of LBD is negative and statistically significant. This result seems to reflect stringent restrictions on bank lending as part of the stabilization policy in the aftermath of the reforms.

5. Conclusion
Downloaded by [INASP - Pakistan (PERI)] at 00:47 06 October 2012 In this paper, we have examined the interest rate-saving-investment interrelations in the Indian economy using annual data for the period 1955-95. The results are generally in support of the propositions of the McKinnon-Shaw financial repression paradigm. In the Indian context higher real interest rates seem to promote both financial and total saving. There is no evidence of a significant asset substitution effect resulting from changes in interest rate as postulated by the neo-structuralist development economists. In line with Shaw's debt-intermediation view, financial saving in turn promotes investment through the provision of bank lending to the private sector. There is also strong statistical support for McKinnon's complementarity hypothesis that higher deposit rates promote investment through facilitating self-financed capital accumulation. The higher level of real interest rates does seem to have a negative impact on the level of investment, but the cumulative net effect of interest rates on investment is unambiguously positive. It is of course not possible to generalize from a single country case. However, our results do cast doubt on the robustness of results coming from the vast cross-country literature on this subject. Thus, further systematic empirical investigations covering a variety of individual country situations are needed before valid generalizations on the policy relevance of the financial repression paradigm can be made.

Notes
1. For recent surveys of this literature, see Fry (1995), Gibson & Tsakalotos (1994) and Deaton (1989). 2. The available country studies include, Athukorala & Jayasuriya (1994), Onis & Riedel (1993), Collins (1994), Warman & Thirlwall (1994) and de Melo & Tybout (1986). 3. The most recent Indian studies in this subject area are Krishnamurty et al. (1987), Ketkar & Ketkar (1992) and Laumas (1990). These are both dated and partial in subject coverage. Krishnamurty et al. (1987) examine the determinants of the saving rate using data from 1954/55 to 1981/82. Lauma's (1990) test of McKinnon's complementarity hypothesis relates to the period 1954/55-1974/75. Ketkar & Ketkar (1992) examine the impact of bank branch expansion on financial saving, private investment and GDP growth covering the period 1952/53-1984/85. 4. One notable exception to this general practice is the study by Warman & Thirlwall (1994), who explicitly test the link between financial saving and investment through the estimation of a bivariate credit supply function. 5. In theory, terms of trade changes are already a part of real GDP. However, in practice the price deflators used in national accounting generally allow only for changes in the general level of prices and fail to capture price structural effects on the level and growth of real income such as those due to changes in the terms of trade. Thus, changes in TOT can be expected to have an additional effect on that of changes in GDP on savings (Ady, 1976, p. 110).

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6. According to balance of payments records, private transfers (which predominantly consist of remittances) increased from 0.2% of GDP in the early 1970s to 1.5% of GDP in the early 1990s (Table 2). 7. In this connection, it is important to note that, according to the method of estimation of household saving in India, the contribution of migrant transfers (or any other form of income transfers from the rest of the world such as interest and dividend transfers) is captured in reported saving estimates (Little & Joshi, 1994). 8. This specification is usually adopted purely for practical reasons: to conserve degrees of freedom, to minimize the problem of collinearity among the explanatory variables and to circumvent the problem of lack of appropriate price deflators. 9. I am grateful to George Fane for help in developing this measure of RRCC. On the theory behind this measure, see Jorgenson (1967). 10. This view has been expressed in annual issues of The Economic Survey, Ministry of Finance, Delhi. 11. For details on this debate see Athukorala & Sen (1995). 12. All data series are on the basis of the Indian fiscal year, 1 April in the previous year to 31 March of the given (stated) year. 13. The test results are available on request from the author. 14. In these 6 years the rate of growth of domestic savings lagged behind that of GDP, resulting in a decline in the saving rate below the historical trend. The underlying causes of this dip in saving rate are still debated. See Roy & Sen (1991) and the work cited therein. 15. This time division is chosen to reflect the gradual pro-market shift in India's economic policy from about the early 1980s. We also conducted the Chow test for parameter stability by equal splitting of the data to yield the same test results. 16. Note that the estimated financial saving function (Table 3) has relatively low overall explanatory power (in terms of lower R2 and higher SE) compared to the total and private saving functions. Perhaps this somewhat surprising result has something to do with the method adopted by the Central Statistical Organisation (CSO) in compiling the financial saving series. The CSO estimates show only the net increase in financial assets (assetsliabilities). Given the rapid growth of borrowing by the household sector from banks and other institutional sources since the early 1970s and the resulting additions to its financial liabilities, it is likely that this series does not fully reflect the rate of growth of financial saving in the economy (RBI, 1982, p. 35). 17. Contrary to what one would have anticipated a priori, the intercorrelation between RID and RRCC does not seem to have disturbed the robustness of this result. In the formulation adopted, the partial correlation coefficient of RID (0.49) is larger in magnitude than simple correlation between RID and RRCC (0.32).

References
Ady, P. (1976) Growth models for developing countries, in: A. Cairncross & M. Puri (Eds) Employment, Income Distribution and Development Strategy: Problems of the Developing Countries (London, Macmillan), pp. 106-119. Athukorala, P. & Jayasuriya, S. (1994) Macroeconomic Policies, Crises, and Growth in Sri Lanka, 1969-90 (Washington, DC, World Bank). Athukorala, P. & Sen K. (1995) Economic reforms and the rate of saving in India: some observations, Economic and Political Weekly, 30, pp. 2184-2190. Bardhan, P. (1994) The Political Economy of Development in India (Oxford, Basil Blackwell). Collins, S.M. (1994) Saving, investment and external balance in South Korea, in: S. Haggard, R.N. Cooper, S.M. Collins, C. Kim & S. Ro (Eds) Macroeconomic Policies and Adjustment in Korea, 1970-1990 (Cambridge, MA, MIT Press). Davidson, P. (1986) Finance, funding, saving, and investment, Journal of Post-Keynesian Economics, 9, pp. 101-110. de Melo, J. & Tybout J. (1986) The effect of financial liberalisation on savings and investment in Uruguay, Economic Development and Cultural Change, 34, pp. 561-587. Deaton, A. (1977) Involuntary saving through unanticipated inflation, American Economic Review, 67, pp. 899-910. Deaton, A. (1989) Saving in developing countries: theory and review, Proceedings of the World Bank Annual Conference on Development Economics, 1989 (Washington, DC, World Bank), pp. 61-108.

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Dombusch, R. & Reynoso, A. (1989) Financial factors in economic development, American Economic Review Papers and Proceedings, May, pp. 204-209. EPWRF (Economic and Political Weekly Research Foundation) (1995) Economic reforms and rate of saving, Economic and Political Weekly, 30, pp. 1021-1041. Frankel, J.A. & Razin A. (1992) Fiscal Policies and the World Economy, 2nd edn (Cambridge, MA, MIT Press). Fry, M. (1995) Financial development in Asia: some analytical issues, Asian-Pacific Economic Literature, 9, pp. 40-57. Gibson, H.D. & Tsakalotos, E. (1994) The scope and limits of financial liberalisation in developing countries: a critical survey, Journal of Development Studies, 30, pp. 578-628. Hendry, D.F. (1995) Dynamic Econometrics (Oxford, Oxford University Press). Jorgenson, D.W. (1967) The theory of investment behavior, in: R. Ferber (Ed.) Determinants of Investment Behavior, Universities-National Bureau Conference Series No. 18 (New York, Columbia University Press), pp. 129-155. Joshi, V.H. & Little, I.M.D. (1994) India: Macroeconomics and Political Economy, 1964-1991 (Washington, DC, World Bank). Ketkar, K.W. & Ketkar, S.L. (1992) Banking nationalisation, financial savings, and economic development: a case study of India, Journal of Developing Areas, 27, pp. 69-84. Keynes, J.M. (1936) The General Theory of Employment, Interest and Money (New York, Harcourt Brace). Krishnamurty, K., Krishnaswamy, K.S. & Sharma, P.D. (1987) Determinants of saving rates in India, Journal of Quantitative Economics, 3, pp. 335-357, Kwiatkowiski, D., Phillips, P.C.B., Schmidt, P. & Shin, Y. (1992) Testing the null hypothesis of stationarity against the alternative of a unit root: how sure are we that economic time series have a unit root?, Journal of Econometrics, 54, pp. 159-179. Laumas, P.S. (1990) Monetization, financial liberalization, and economic development, Economic Development and Cultural Change, 38, pp. 377-390. McKinnon, R.I. (1973) Money and Capital in Economic Development (Washington, DC, Brooking Institute). Onis, Z. & Riedel, J. (1993) Economic Crises and Long-term Growth in Turkey (Washington, DC, World Bank). Rakshit, M. (1983) On assessment and interpretation of saving-investment estimates in India, Economic and Political Weekly, Annual Number, pp. 753-776. Roy, T. & Sen K. (1991) Changes in saving rate and its implications for growth, Economic and Political Weekly, 20, pp. 1055-1058. RBI (Reserve Bank of India) (1982) Capital Formation and saving in India: 1950-51 to 1979-80, Report of the Working Group on Saving, (Delhi, RBI). Shaw, E. (1973) Financial Deepening in Economic Development (Oxford, Oxford University Press). Srinivasan, T.N. (1994) Data base for development analysis: an overview, Journal of Development Economics, 44, pp. 3-27. Taylor, L. (1983) Structuralist Macroeconomics: Applicable Models for the Third World (New York, Basic Books). Thirlwall, A.P. (1976) Financing Economic Development (London, Macmillan). Warman, F. & Thirlwall, A.P. (1994) Interest rates, saving, investment and growth in Mexico 1960-90: tests of the financial liberalisation hypothesis, Journal of Development Studies, 30, pp.629-649.

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Appendix
The data series used in this study were obtained directly or compiled from following publications: CSO, National Accounts Statistics, Delhi (various issues); Government of Indian (1995), Economic Survey 1994-95, Delhi: Ministry of Finance; and Reserve Bank of Indian, Monthly Bulletin and Report on Currency and Banking, Delhi (various issues). In the selection and transformation of most of the data series, we have simply followed established practice in this field of research. However, the choice of data series on private and financial savings, price deflators and interest rates, and the measurement of expected inflation need some explanation. CSO data permit disaggregation of private savings into corporate savings and household savings. However, the line of demarcation between households and firms in these estimates is

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rather arbitrary. The "household sector", as denned by the CSO, is highly heterogeneous and is virtually synonymous with the non-corporate sector of the economy. Apart from the "household proper", it includes partnerships and unincorporated businesses, and there is evidence that the relative importance of the latter two has increased over time (RBI, 1982). Thus, the available household saving series is not a good measure of household saving behaviour as suggested by theory. Moreover, as "household saving" is measured by deducting government saving and corporate saving from total gross domestic savings, measurement errors in the latter variables are invariably absorbed into the former (Srinivasan, 1994). For these reasons, we do not treat household saving as a separate category in this study. The deposit and lending rates used are the 1-year deposit rate (minimum) and the 1-year lending rate of the State Bank of India. Ideally, the lending and deposit rate series should have been constructed as weighted averages of rates relating to deposits/loans of different term structures using relative shares of respective deposits/loans. Unfortunately, information on the maturity structure of deposits is not readily available. There is, however, evidence that, as most of the key series move in tandem, the choice of a particular series over the preferred weighted average does not make significant difference in empirical analysis (Laumas, 1990). The data series on saving (TS, PS, FS) and remittances (TKN) were deflated by the GDP deflator (1981 = 1.00). The series on bank credit (BCF) and private and public fixed investment (PRIVand PBIV) were deflated by the implicit deflator for fixed capital formation (1981 = 100). Following the majority of studies in this subject area, the expected rate of inflation is proxied by the rate of inflation (measured using the GDP delator) with a 1-year lag. Likewise, the expected rate of change in capital goods price is measured as the rate of change of capital goods price (measured by the implicit deflator for gross domestic fixed capital formation) with a 1-year lag. The static inflationary expectations hypothesis that undergirds this variable choice is considered appropriate for a low-inflation country like India, especially when working with annual data. For useful discussions on the nature and limitations of Indian data on saving and investment, see RBI (1982), Rakshit (1983) and Srinivasan (1994). It is generally believed that, on the whole, these data have a much firmer foundation (both in terms of coverage and intertemporal consistency) than those for any other country at the same stage of development.