The positive correlation between national savings and investment appears to have persisted despite increasingly globalise financial markets where emerging countries have access to foreign savings. The latter should apparently allow for both variables to move independently and indeed for the emerging markets to attract increasing amounts of foreign savings given the presumption of higher returns.
Lower national savings and thus higher external current account deficits could then reflect consumption smoothening during the economic take-off. Foreign savings would be a "cheaper" substitute to domestic savings. Feldstein and Horioka were the first to note the high correlation between national savings and investment, and to interpret it as an indicator that international capital might not be as mobile as thought. This interpretation of their "puzzle" has been much debated.
More recently, Rajan and others at the IMF have suggested that the contrary evidence might be the consequence of underdeveloped financial sectors in the emerging markets, which would limit their ability to absorb foreign savings. When investment opportunities arise, the response might be an increase in domestic savings in emerging markets with underdeveloped financial sectors, but an increase in external borrowing in more advanced economies with developed financial systems. Hence the paradox of poor countries financing the rich countries.
SAVINGS AND GROWTH:
One could interpret the insights from the analysis so far as follows: Investment and the productivity gains associated with its embodied technological progress, cause GDP growth. National savings cause investment because they are critical to finance investment under constrained access to international capital markets. And this is why growth would be correlated with national savings. The positive correlation between national savings and growth is illustrated in Chart 3.
Does it follow from the above interpretation of results that improved access to foreign savings would reduce the importance of mobilising national savings? I' ll argue that this conclusion might be incorrect. Indeed, such "complacency" as regards the role of national savings might result in the higher investment not taking place, even if access to international capital markets is not constrained. This is because national savings and foreign savings generally tend to be complementary rather than substitute.
Specifically, private savings and inward FDI appear to have been positively correlated in Asia, as suggested by Chart 4. High national savings as a positive sign for sustained high growth.
High national savings as much as FDI itself might well be a positive sign in emerging markets that prospects for sustained high growth are excellent. Why would this be the case? Imagine a country implementing market-oriented economic reforms (macroeconomic stabilisation, trade liberalisation, improvement in private sector business environment and investment climate). This should increase both the current state of productivity, and the scope for further productivity improvement through new investment. This latter productivity improvement would be "enhanced" if involving foreign direct investment from countries on the technological "frontier".
But, generally, foreign investors could only be expected to come in if there is some form of domestic contribution to the venture, in the form of commitment and ability of the local management to integrate and implement the new technology in the local context, as well as a financial contribution in the form of co-financing (My argument here follows Aghion, Howitt, and others). Co-financing would serve as collateral and seem especially important when there are perceived asymmetric information, and asymmetric risks, for instance as far as the applicability of the rule of law is concerned. Intertemporal consumption/ investment optimisation by the domestic residents should under those circumstances result in both higher domestic savings and FDI.
It is in this sense that domestic and foreign savings would be complementary rather than substitute, at least in emerging markets. As far as the domestic corporate sector is concerned, higher retained earnings, or lower dividend pay-out ratios, would be the immediate source of additional domestic savings and evidence of enhanced growth prospects. But buoyant investment opportunities should also bring about financial deepening in the form of mobilisation of savings in the banking system to fund higher long-term investment loans.
WHERE DOES PAKISTAN STAND? Recently, Pakistan has witnessed a surge in FDI which appears to have supported the observed rise in overall investment. At the same time, the national savings rate has remained low, on account of both public and private savings. Hence, the widening of the external current account deficit.
HOW TO INTERPRET THESE PRIVATE SAVINGS DEVELOPMENTS IN THE BROADER CONTEXT OF THE PRESENT ANALYSIS?
-- Savings rates may of course differ systematically across countries for reasons not directly related to the themes discussed here, eg different demographics, and degrees of time preference. Pakistan is now only beginning to benefit from the "demographic dividend" associated with declining birth and mortality rates, and which many economies of Asia have experienced earlier. Such development could support an increase in savings rates going forward.
-- The recent rapid development of the financial sector, seemingly well ahead of the other sectors of the economy, and the accommodative monetary and fiscal policies may also have led to unintended distortions. The explosion in consumer finance, in particular, has allowed the households to mortgage their future incomes more than ever before, which may have contributed to a continued low savings rate. A key question would be whether these income expectations are intertemporally consistent.
-- The possibility that the foreign investors' confidence in Pakistan is so high that joint ventures can proceed without significant domestic contribution nor the collateral associated with the co-financing does not seem plausible. Especially in view of (albeit improved) international rankings of Pakistan in the area of ease of doing business, investment climate, and transparency. Most countries of Eastern Europe which have joined or are about to join the EU may offer a contrasting case study in this regard. There, high foreign inflows do not appear to have been accompanied by enhanced domestic savings, with large external current account deficits resulting. But in the case of Eastern Europe, a more convincing argument can be made that the actual or prospective integration within the EU, and its strong regulatory framework, reduces many of the reasons for the need of co-financing, allowing financial integration to proceed very rapidly.
-- Besides the expansionary macroeconomic policies, a likely explanation for the developments in private savings is that the conditions which would yield high national savings, high investment, and high growth in a sustainable way are not yet fully in place. With a few exceptions, large scale new investments in the manufacturing and even trade sectors potentially involving significant joint ventures with foreign companies have been scant so far, suggesting perceived (still) limited investment opportunities. And FDI has so far mostly been in the oil and gas, telecom, and banking sectors. It is no coincidence that the latter two sectors are infrastructural in nature, amounting to a more general "bet" on favourable macroeconomic developments in Pakistan. These are also sectors where the government and its regulatory framework has been able to implicitly provide the necessary collateral. The fact that they are in domestic services rather than traded goods has of course compounded the problems for the external current account balance.
-- Further evidence of the problem can be found in the especially high dividend yield and pay-out ratio in the non-financial corporate sector in Pakistan, in comparison with other Asian countries. These payout ratios have been especially high in the case of business group firms in comparison with non-business group firms.
BOX III DIVIDEND PAY-OUT RATIOS:

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      Averages, in percent
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Emergind Asia 1/ (2003-2004)        24.6
Pakistan (2004-2005, KSE)           57.7
Business groups (2001-2002)         45.8
Non-Business groups (2001-2002)     21.9
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SOURCES: KSE, Ghani amd Ahsraf, and IMF.
1/ China, India, and ASEAN.
High dividend yields and pay-out ratios are generally a signal that growth is not a priority, which could reflect a lack of identifiable investment opportunities, or also an inward looking corporate strategy. As regards state-owned enterprises, dividends distributed to the government have, evidently, not been saved by it either.
POLICY IMPLICATIONS: What are the policy implications of the above analysis for Pakistan? They are of two types:
-- First, monetary and fiscal policy have to be appropriately counter-cyclical through supporting national savings.
-- Attractive positive real interest rates, in particular, should help reduce domestic consumption and restore household savings, thereby reducing the pressures on inflation and the external current account deficit. The combination of increased access to consumer finance (thanks to the reformed banking system) and lax monetary policy in 2003-2004 might have contributed excessively to the households' mortgaging their future income stream.
-- The public sector needs to increase its savings in order to finance higher productive investment outlays within a growth-supportive low fiscal deficit. The necessary adjustment in government savings would be in the order of 4 percentage points of GDP, according to the standards set by the emerging economies of Asia. This points, again, to the critical need for better tax revenue mobilisation, as well as higher public sector efficiency.
Second, structural reforms must support private domestic as well as foreign investment and savings and address Pakistan' s structural savings deficiency.
-- Financial deepening needs to be further encouraged. Following a significant jump from less than 35 percent on 2000-01 to 40 percent in 2003-04, the broad money/ GDP ratio (an important indicator of financial deepening) has mostly stagnated since then.
The factors underlying this development, including possible distortions within and outside the banking system (eg a tax system favouring real estate) should be analysed and addressed on a market basis.
-- Since the analysis suggests that national savings, domestic investment, and FDI are positively correlated, further improving the overall business environment and investment climate should encourage both investment and national savings.
Reduction in the time and cost of securing plant sites, investment approval, licensing, and registration have been mentioned as priorities. As well as strengthening the enforcement of the laws relating to contracts and property rights, improving land title documentation and related procedures to create collateral, and reducing regulatory bottlenecks including the number of government agencies involved with the supervision of businesses.
-- Changes in the corporate sector seem required as well. The family-controlled corporate structures and behaviours in Pakistan have been biased against outsiders (foreign as well as domestic). Therefore, the enhancing of domestic savings for the purpose of co-financing promising joint ventures is likely to have been inhibited.
The concentration of family control over companies in Pakistan, and the high thresholds to initiate corporate actions have limited the role of external investors, undermining corporate efficiency and thus investment opportunities and their financing.
-- Full enforcement of the Code of Good Corporate Governance by the SECP, the Courts, and the stock exchanges, in particular the provisions facilitating the exercise of ownership and independent judgement by all shareholders (including institutional and minority) should help promote the greater corporate dynamism necessary for a virtuous savings- investment cycle to take place.
Undoubtedly, the challenge of increasing corporate dynamism in Pakistan appears huge, especially since the corporate governance standards seem to be especially weak in some very critical sectors of the economy, including export oriented ones, namely agriculture and textiles.
Mergers, acquisitions, and FDI will follow greater corporate dynamism. Other government policies can help as well, especially not systematically providing hand-outs to enterprises under duress.
-- Finally, and critically as well, further steps need to be taken to fill the human capital gap, which has also contributed to low productivity measured as output per worker. The challenge is big: the average number of years of schooling per adult in Pakistan is only 3.9; in East Asia, it is 7; and India, it is 5.1.
Thus, except in some large scale companies, output per worker in sewing is half that in India (and less than half that in China). But in this sector, wages in India are similar to those in Pakistan, while in China they are only 50 percent higher.
(The author is Senior Resident Representative of the IMF in Pakistan. The views expressed are entirely those of the author and do not necessarily reflect the views of the IMF.)
(Concluded)