156 BULLETIN

REPLY

By KEITH GRIFFIN

There are a great many people who in principle would favour a redistributionof income from rich to poor nations. I count myself among them. At this levelof generality my critics and I are all on the side of the angels. In practice, how-

FOREIGN CAPITAL, DOMESTiC SAVINGS AND ECONOMIC DEVELOPMENT 157

ever, we differ and I have come to the reluctant conclusion that 'capital imports,rather than accelerating development, have in some cases retarded it' 1 FrancesStewart, Charles Kennedy and A. P. Thiriwall in their Comments contest thisstatement but provide no empirical evidence. What, then, are the facts?

M. Kellman, in the course of criticizing another of my articles, has suppliedrecent evidence that foreign capital does not seem to have promoted growth.2He measures aid dependence by the ratio of bilateral plus multilateral aid (A) tototal imports (M), and finds that the rate of growth of income during 1960-1965was inversely associated with (A/M) in both a 40-country sample and in a 12-country sample of Latin American nations. Moreover, in a regression of the rateof growth of per capita income on (A/M), he obtained a negative association inLatin America and a barely positive association (0.01) in the 40-country sample.Thus the hypothesis that aid promotes growth would appear to be untruewhether we look at Latin America alone or at the underdeveloped world as awhole, whether growth is measured net or gross of population increase, andwhether dependence is measured as the ratio of aid to imports or, as I have doneelsewhere, as aid to income. If nothing else, we should be able to agree that thereis a problem to be explained.

Part of the explanation why aid has not led to faster development is that itis not designed for this purpose. That is, the major purpose of aid is to furtherthe interests of the donors rather than those of the recipients. This is hardly asufficient explanation, however. Growth, after all, could be a by-product ofpolicies designed for other purposes. I argue that there are theoretical andpractical reasons why this is unlikely. My critics do not agree. I propose, inwhat follows, to discuss our major points of disagreement under four headings:the definition of domestic savings, the role of capital imports in supplementingconsumption, the effect of foreign aid on the pattern of investment, and theextent to which capital imports alleviate or aggravate balance of paymentsdifficulties.

I. The definition of savingsEconomists are accustomed to thinking that aggregate consumption depends,

among other things, upon national income. In a world in which capitaltransfers occur, however, it is reasonable to assume that consumption will be apositive function of total available resources, i.e. national income plus netcapital imports. Especially when capital transfers are firmly expected, they willbe treated as part of total income when expenditure decisions are made. Un-anticipated capital transfers will be treated as transitory phenomena and maybe largely saved, but in the case of anticipated capital transfers the normalmarginal propensity to consume will apply. If this is accepted, it follows assurely as night follows day thatunless the marginal propensity to consume iszerocapital imports will raise total consumption and reduce domestic savings.

'Keith Griffin, 'Foreign Capital, Domestic Savings and Economic Development' BULLETIN,May 1970, p. 100.

M. Keilman, 'Foreign Assistance: Objectives and Coiisequences--Comment', forthcomingin Economic Development and Cultural Change.

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Assume our consumption function is of the form

C=d+a(Y+A)Since S=YA by definition, it follows that

S=d+fiY--aAwhere fi=1 a. In other words, given the level of income, the larger the inflow ofcapital the lower the level of domestic savings. Equation (2) can be written inratio form. The easiest way to do this is to suppress the intercept and dividethrough by Y:

S A- = fi - aY Y

Equation (3) does not imply a constant level of income; it tells us that the higheris the ratio of aid to income the smaller will be the rate of domestic savings.Failure to understand this simple point is the cause of much confusion in Mr.Esliag's Comment on my paper.

Most of the cross-section regressions I presented were similar to equation (3).Time series equations rather similar to equation (2) have also been run, however.'The results confirm my expectations.

A hasty reader of Mrs. Stewart's note may receive the impression that thedecline in domestic savings is merely a semantic trick, i.e., 'that domestic savingswill fall because of the way they are defined'. This is not true. The definition ofdomestic savings (S) I have used is identical to that employed by nationalincome statisticians, viz., the difference between total net investment (I) andthe surplus of imports (M) over exports (X). The import surplus is, of course,equal to the net inflow of foreign capital (A).2SI (M--X)I A

Mr. Eshag makes a rather different point from those we have considered sofar. He claims that 'in the great majority' of underdeveloped countries 'thereexists not only a substantial reservoir of unemployed labour resources but alsovarying amounts of unutilised land and equipment which could often be put touse . . . but for the presence of foreign exchange constraint. . . .' Yet he fails toexplain why under such circumstances the economy is unable to earn or saveforeign exchange, and thereby overcome the constraint, by implementingpolicies of import controls, tariffs, export subsidies, devaluation and the like.Mr. Eshag's views are the reverse of my own. He argues that 'there is in factevery reason to expect that domestic savings will increase' as a result of foreignaid. Given his assumptions it is, of course, true that the rise in savings due tothe multiplier may counteract the fall due to consumption out of aid. I have noquarrel with his algebra, but I do dispute his economics. The evidence I haveseen tends to support my interpretation. If Mr. Eshag has better evidence Iwould certainly like to see it.

Sec Thomas Weisskopf, 'The Impact of Foreign Capital Inflow on Domestic Savings inUnderdeveloped Countries', a paper presented at the Second World Congress of the Econom-etrics Society, Cambridge, England, September 1970.

2 At several points Mrs. Stewart seems to have confused domestic savings with total netinvestment and national income with the flow of total available resources. See, for example,

. 141.

FOREIGN CAPITAL, DOMESTIC SAVINGS AND ECONOMIC DEVELOPMENT 159

II. Capital imports and consumptionOur results, and those of others, e.g. Thomas Weisskopf, are quite Clear:

capital imports tend to supplement consumption as well as investment, andmodels which predict or assume that all resource transfers from abroad will beused to accelerate capital accumulation are likely to exaggerate the impact ofcapital imports on investment and growth.

This does not imply that a rise in consumption is undesirable. Indeed, in sofar as capital imports permit a more egalitarian distribution of consumption in theworld, they are to be welcomed. On this point, Mrs. Stewart, Professor Kennedy,Mr. Thiriwall and I are in agreement. The 'ambivalent, and even inconsistent,attitude' which Kennedy and Thirlwall detect stems from my doubt that inpractice capital imports have been used to reduce inequality. For example, inPakistan, a major aid recipient, per capita income has been rising quite rapidlyfor about a decade. Moreover, between 1963-4 and 1969-70 the share of con-sumption in GNP increased by nearly two and a half per cent. At the same time,the per capita availability of food grains has remained roughly constant and theper capita availability of cotton cloth and other wage goods has declined. Inother words, the consumption of the poor declined, whereas that of the richincreased. Thus before one argues that foreign aid improves the distribution ofconsumption goods one needs to have much more evidence as to precisely whoseconsumption is increased by capital imports.

The three critics mentioned above note that some forms of consumption mayhelp to raise productivity, and Mrs. Stewart cites a passage in one of my booksto the same effect, but she then chides me for largely ignoring the point in mydiscussion of the role of capital imports. The major reason why I did so is thatthere is little evidence that capital imports have financed an increase in con-sumption of those specific goods which would accelerate development. The mostprobable exception to this statement is the provision of food supplies under theAmerican P.L. 480 programme. Yet it is far from certain that even this aidprogramme contributed to a net long run increase in per capita food consumption.It is quite possible that in several important countries, e.g., India, food aidenabled the government to neglect agriculture and turn its attention elsewhere,with the result that domestic production increased more slowly than wouldotherwise have been the case.

Generally speaking, it appears unlikely that additional consumption willraise the productivity of labour unless the increased consumption is directedlargely toward the poorest groups in the community. In other words, if theincreased consumption which capital imports finance is to accelerate develop-ment, two conditions must be satisfied: first, aggregate consumption of specificitems must increase (e.g. animal proteins) and, second, these items must bedistrihuted to groups where their impact on productivity will be maximized.If capital imports enable the rich to drive more Mercedes, they will not accelerategrowth; if they enable the poor to improve their diet, enjoy better health andhave smaller families, they may make a significant contribution.

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Aid and ¿he pattern of investmentSeveral of my critics seem to have misunderstood what I was trying to say

about the relationship between capital imports and the effectiveness of invest-ment. My views are easily summarized. First, capital imports do not lead to asignificant increase in total investment. Thus the net addition of foreign capitalto other investment efforts is slight. Second, a project financed by foreign aid islikely to have a higher capital-output ratio than the same project financed bydomestic savings. Because of tied aid, a low nominal cost of capital and apreference of donors to finance onlythe foreign exchange costs of assisted projects,an aid financed scheme is likely to use resources less efficiently than a domesticallyfinanced scheme. Third, and most important, a country which relies heavily onforeign aid is likely to have a completely different set of investment projectsfrom one which relies on domestic savings to finance development.

Whenever the preferences of donors for projects differ from those of recipients,foreign aid agencies may alter the pattern of investment without affecting thetotal very much. Suppose, for example, that in the absence of capital imports acountry would undertake a £200 million investment programme consisting of afertilizer plant, a series of small factories producing pumps for tubewells and aflour mill Assume the ICOR for these projects is 4, so that output rises by 50million in the first instance. Alternatively, the country may be able to obtain£60 million of foreign aid tied, say, to investment in a large dam, an atomicenergy station and a super-highway. As we have seen, consumption is likely torise by approximately two-thirds of this aid, so that total investment is unlikelyto rise to more than £220 million. If the ICOR on this larger set of projects ishigher than 4.4 the inflow of aid will cause a decline in the rate of growth ofoutput.

In some cases foreign aid may finance the marginal project and leave all otherprojects unchanged. More frequently, however, the donors are able to preemptdomestic resources and alter the entire investment programme, thereby sub-stituting their preferences for those of the recipient government. When aid'leverage' is used in this way it is almost certain to affect the aggregate incre-mental capital-output ratio. The hypothesis put forward in my paper is that itwould raise it.

The balance of payments burdenIn my article I argued that in the long run the foreign exchange gap is a

pseudo-gap.' None of my critics refutes this proposition, although Mr. Eshagdescribes it as 'highly doubtful' and all four claim that in the short run capitalimports can alleviate a foreign exchange constraint. I agree that in the shortrun, i.e., a period during which the economy is unable to reallocate resources,additional foreign exchange may enable a country to increase investment at amuch lower cost than would otherwise be possible. Before one uses this as ajustification for aid, however, it is important to consider the long run conse-quences.

1 The asnimptions underlying the foreign exchange gap are ably analyzed by Vijay Joshi,'Saving and Foreign Exchange Constraints', in P. P. Strecten, ed., Unfashionable Economics:Essays in Honour of Lord Balogh.

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One of the important facts of the contemporary world economy is tuegrowing number of underdeveloped countries that are unable to service theirforeign debt. Many of the largest aid recipients, in fact, have had to renegotiatetheir debts, some more than once. Argentina and Indonesia have rescheduledtheir external debt three times; Turkey, Brazil and Ghana, twice; Chile, Indiaand Peru once.1 How does the two-gap model, or any other model, account forthis? It doesn't, and the reason it doesn't is because it is assumed that capitalimports are productively used and generate a surplus out of which the debt canbe serviced. If this assumption were relaxed the facts could readily be explained.

Using the same notation as in my original essay, assume a country receivesa net capital inflow of A and invests a certain fraction of it (1a). Ignoring thepossible effects of increased consumption on the productivity of labour, andassuming an incremental output-capital ratio of 'k', foreign capital will raisetotal output by A (1 a)k. Interest (r) must be paid on the entire loan, however,not just on that part which is invested. 1f

A (ia)k<rAthe additional output generated by capital imports will be insufficient to servicethe debt.

Countries which are forced to borrow at relatively high rates of interest andyet have a strong tendency to consume a large proportion of their capitalimports may well find that their repayment obligations exceed the value of theextra output produced. For example, if a=O.8 and k=O.3, the balance ofpayments effects of foreign borrowing will be negative if r>O.06.

The above illustration is unrealistic, however, because it is assumed thatpart of the capital import is consumed but all of the additional output can besaved. In practice, some fraction of the additional income will be consumed, say,a again. It is only out of the rest that debts can be serviced. In these circum-stances, a country will encounter debt servicing problems even if the rate ofinterest is quite low. Specifically, the balance of payments effects will heunfavourahie if

(1 a)2k<r.If a and k have tile same values as assunied in the previous paragraph, repaymentobligations will exceed additional savings unless the rate of interest is no higherthan 1.2 per cent. The country will then appear to have a foreign exchangeconstraint, and some observers may attribute this to a 'transformation problem',but in fact the difficulty is caused by a combination of excessive consumptionand insufficiently productive investment.

It should be evident from these examples that even if the balance of pay-ments is a constraint on long run growth, capital imports may make mattersworse rather than better unless (i) tile government has firm control over thelevel of consumption, (ii) investment is allocated efficiently and (iii) the rates ofinterest on foreign borrowing are low. If conditions (i) and (ii) are fulfilled,capital imports will be unnecessary, although they should be welcomed ongrounds of equity. If the first two conditions are not fulfilled, capital importsother than grants create more problems than they solve.

1 I,ester B. Pearson, Parincys in Deeemopment, Table 20, pp. 3S3-38

Magdalen College, Oxford