Saving and the Real Interest Rate in Developing Countries JONATHAN D. OSTRY AND CARMEN M. REINHART to stimulate saving is unlikely to be success- rates. This feature of credit markets in the \AISING real interest ful in the poorest developing countries, least developed countries may itself make where consumption choices are heavily influ- saving less responsive to interest rates. rates has often been enced by subsistence considerations. Indeed, Another reason that might explain the cited as a way to the evidence suggests that the interest rate failure of existing studies to detect signifi- IN sensitivity of saving to real rates of return cant effects of interest rates on household I increase private saving, rises with a country's income level. Hence, saving in developing countries relates to the and thus provide the resources the same policies undertaken in different fact that—particularly in the poorest coun- countries could produce very different out- tries—subsistence considerations are likely for growth. But this may not be comes, depending on the country's level of to be a significant factor determining con- a viable approach in the development. sumption behavior. Given that, to be able to poorest developing countries, in save, households must first achieve a subsis- Is saving responsive? tence consumption level, the interest rate sen- which most people live at the There is little consensus in the empirical sitivity of private saving will be close to zero subsistence level. literature on the interaction between saving for countries where a large share of the popu- and the real rate of interest in developing lation lives at or near subsistence consump- countries. Some studies have concluded that, tion levels. Indeed, a subsistence model for a large number of developing countries, would predict a nonlinear relationship How does private saving respond to changes there does not appear to be any systematic between saving behavior and the level of in real interest rates in developing countries? relationship between rates of return and con- development, with the most significant The answer will influence judgments about sumption/saving behavior; others have sug- changes occurring when countries move from the effectiveness of a range of policies. For gested that there may be considerable low-income to low-middle-income status, and example, financial liberalizations, which gen- regional variation in this elasticity. relatively minor changes between middle- erate higher real interest rates, will result in One reason may simply be the poor qual- income and high-income countries. Of course, greater savings by households only if the lat- ity of the data in general and, more specifi- the interest rate sensitivity of saving could be ter decide to defer consumption; in other cally, the fact that there is considerable low even in middle-income countries if the words, if the sensitivity of consumption and variation in the economic significance and income distribution were sufficiently skewed saving to higher interest rates is significant. informational content of the data on real so that a large proportion of the population Similarly, when fiscal policy shocks con- rates of return. Lack of sophistication and lived at or near subsistence levels. tribute to movements in domestic interest depth in domestic financial markets or direct A frequently used proxy for the impor- rates, their impact on the external current regulation may result in interest rates that tance of subsistence in household budgets is account will depend on how responsive pri- do not adequately reflect expectations about the budget share going to food. It is indeed vate saving is to changes in real rates of the underlying economic fundamentals. In noteworthy that food consumption accounts return. many low-income developing countries, for a markedly lower share of total expendi- In this article, we present some evidence to there are few banks, and there is little scope ture in high-income than in low-income coun- suggest that raising domestic interest rates for true market determination of interest tries. As shown in Table 1, food consumption Jonathan D. Ostry, Carmen M. Reinhart, a Canadian national, is a Senior Economist in the IMF's Southeast Asia and a US national, is an Economist in the IMF's Western Hemisphere Department. Pacific Department. 16 Finance & Development / December 1995 ©International Monetary Fund. Not for Redistribution income developing countries, and the fact that tries than among the Latin American coun- Table 1 Food as a share of expenditure 1 the share of subsistence in total con- tries in the sample, despite similar income lev- (1990)' sumption—perhaps proxied by the food els. The more equitable income distribution share—declines as income increases. The sec- that characterizes the Asian countries may be Country groupings Percent ond prediction may also be related to subsis- a factor behind those differences. Institutional Low-income 55.6 tence considerations, since incentives to save arrangements (such as pension funds), which Lower-middle-income 32.1 over time should affect only that portion of the play a more prominent role in several Asian Upper-middle-income 30.5 budget left over after subsistence has been countries, may also be conducive to fostering High-income 13.0 achieved, that is, discretionary income. higher saving rates. Source: Judith Jones Putnam and Jane A. Allshouse, Among countries in various income groups, The role of real interest rates in saving Food Consumption, Prices and Expenditures, United the patterns of saving rates that emerge are behavior is more difficult to gauge. One prob- States Department of Agriculture, Statistical Bulletin No. 867. broadly consistent with the predictions of the lem—which is particularly important in 1 Expenditure on food as a percent of total personal subsistence model. As Table 2 shows, private Africa—is that financial markets remain thin expenditure. For details of the countries included in each country grouping, see World Bank, World saving is, on average, considerably lower for and governments often set interest rates at Development Report 1994: Infrastructure for the poorest developing countries, where the nonmarket levels. Nevertheless, there is some Development, Washington, DC, 1994. saving rate is about one half that of the high- evidence that financial saving increased as a 2 Data refer to averages for each country grouping. income group. In fact, such differences also result of the increase in real interest rates appear within regions. World Bank data show associated with liberalization of financial mar- that median gross domestic saving as a per- kets in developing countries, both in Africa accounts for an average of 13 percent of total centage of GDP (1987-91 average) was 5.6 per- and elsewhere. For example, increases in sav- expenditure in high-income countries and for cent for low-income African countries and 19 ing rates have been associated with higher only 8 percent of total consumption in the percent for middle-income African countries. real interest rates in Indonesia and the United States. For middle-income countries, Average gross domestic saving for both Republic of Korea and, more recently, in such as Mexico and Thailand, the share is groups was 7.7 percent of GDP. Argentina, Chile, and Pakistan. There is also often 30-40 percent while, for the poorest Furthermore, the relationship between the some evidence that reform programs in countries, the share of food is over 50 percent; level of income and the saving rate appears to Africa—which caused real interest rates to it is in the 60-70 percent range in some coun- be nonlinear, as the largest increases in saving move from sharply negative to mildly positive tries, such as Sierra Leone and Sudan. The rates occur in the transition from low- to levels—were successful in mobilizing domes- very sharp differences in food expenditure lower-middle-income levels, where the average tic savings. across countries with different per capita personal saving rate rises by 5.5 percentage income levels suggests that subsistence con- points. The average for the upper-middle- Empirical findings siderations may indeed be important in under- income countries is still 2.8 percentage points When households are assumed to maximize standing saving behavior, particularly in above that of the lower-middle-income group, utility, or welfare, subject to a resource con- low-income developing countries. but there appears to be relatively little differ- straint, the interest-rate sensitivity of house- There are, however, additional reasons why ence between the average saving rates in the hold saving depends on how easily saving may be less responsive to changes in high-income and upper-middle-income coun- households can substitute future consumption real interest rates in low-income than in mid- tries in the sample. for current consumption (technically known dle-income countries. Some have argued that It is noteworthy that liquidity constraints as the intertemporal elasticity of substitution low-income countries are characterized by and precautionary motives for saving could (IBS) in consumption). If a given change in pervasive liquidity constraints, which implies produce the opposite pattern in saving rates. real interest rates induces large shifts in con- that changes in consumption will be heavily If poor consumers cannot borrow but face sumption, then the IBS—one of the parame- influenced by changes in current income, an uncertain income stream, the demand ters describing household preferences—will rather than by changes in rates of return. for precautionary saving rises. Hence, the liquidity-con- Table 2 Savings and income straint/precautionary saving Income and personal saving rates Subsistence considerations offer two main hypothesis would predict that it predictions about saving behavior. First, sav- is the poorest consumers, who GNP per adult Personal saving as in 1985 dollars a percentage of GDP ing rates should increase with the level of real have no access to credit mar- Country groupings (1980-87 average) (1985-93 average) income at the initial stages of development, kets, who would save the most.