Financial sector development - Sida

along with growth. This approach highlights the importance of the quality of investments,
not just the investment rate as such. Some empirical findings suggest that investments in
equipment (machinery) are more important for growth than so called structural investment.
In fact, some low-quality investment might waste resources in the economy and, thereby,
be detrimental to growth in the long run although temporarily boosting the growth rate. The
risk that such investments are undertaken is higher in economies with large distortions in
the working of market forces, e.g. high barriers to market competition or foreign trade, price
distortions, administrative investment regulations or skewed credit schemes. Another line of
research suggests that public investment may be instrumental for growth, although the type
of public investment is of importance (infrastructure investments may be growth promoting,
while investments in state industry are not necessarily so).
The discussion leads to a complex picture of the investment and growth relationship.
Technological change, and not physical capital accumulation per se, seems to be a crucial
ingredient in the growth process. The technological change factor depends to a large
extent on factors such as human capital investments, innovation climate, and
entrepreneurship. The driving forces behind these qualities of economic life are found in
the institutional framework of an economy, i.e. the rules, formal (laws) and informal (norms
and conventions), constraining economic action. A general requirement for economic
activity is clear and stable rules of the game. These include transparent and enforceable
legislation, and limited risks of unpredictable changes in enterprise conditions. Well-defined
and enforceable property rights may reduce the risk of expropriation (either through
nationalisation or heavy taxation), a risk which most likely has a very negative impact on
entrepreneurs' willingness to invest. Another particular growth promoting institution is a
framework for efficient intermediation of financial resources, since a major obstacle to the
entrepreneurs' ability to realize their ideas, is lack of capital.
3.2 Investment and savings
In a closed economy, national savings and domestic investments are equal by definition. In
a fully open economy, i.e. an economy where capital can flow freely, across the borders,
the expected rates of return internationally will determine where people's savings are
placed. In view of the substantial reduction in barriers to capital flows in recent decades, it
can be expected that the correlation between savings and investments within countries has
been reduced. This notion is challenged by empirical findings, and to some extent also
theoretically. The correlation between domestic savings and investments, despite capital
mobility, have been shown to be very strong in a large number of countries (the Feldstein-
Horioka puzzle). The most straight-forward explanation is to claim that capital is not as
mobile as believed for various reasons (political risk, currency premiums, "home-country
bias", etc). Another type of explanation turns on domestic capital immobility: firms' and
households' tendency to finance investments from their own savings.
Indeed, a very large proportion of all investments made, in particular in developing
countries, are self-financed. Firms and households retain a substantial share of their
profits/surpluses and invest them in their own businesses. Self-financing may be beneficial
for the firm or the household: it internalizes information and incentives, which may
substantially reduce a number of transaction costs. The drawback of self-finance is that it
may not provide sufficient resources to fully realize the investment opportunities. There is,
thus, a role for the financial system to reallocate resources from savers to investors.
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