Raising real interest rates has been cited as a way to increase private saving,and thus provide the resources for growth. But this may not be a viable approach in the poorest developing countries in which most people live at subsistence level. In these situations, consumption is not very responsive to fluctuations in real interest rates and financial liberalization my not be the catalyst to higher higher saving rates.saving development liberalization interest rates

Ostry, Jonathan

Reinhart, Carmen

English

Research Papers in Economics

  1
Saving and the Real Interest Rate in Developing Countries 
Jonathan Ostry and Carmen M. Reinhart 
December 1995 
 
 
 
Raising real interest rates has been cited as a way to increase private saving, and thus 
provide the resources for growth.  But this may not be a viable approach in the poorest 
developing countries in which most people live at subsistence level. In these situations, 
consumption is not very responsive to fluctuations in real interest rates and financial 
liberalization my not be the catalyst to higher higher saving rates. 
 
 
 
 
 
 
How does private saving respond to changes in real interest rates in developing 
countries?   
The answer will influence judgments about the effectiveness of a range of policies, 
For example, financial liberalizations, which generate  higher real interest rates, will 
result in greater savings by households only if the latter decide to defer consumption; in 
other words, if the sensitivity of consumption and saving to higher interest rates is 
significant. Similarly, when fiscal policy shocks contribute to movements in domestic 
interest rates, their impact on the external current account will depend on how responsive 
private saving is to changes in real rates of return. 
In this article, we present some evidence to suggest that raising domestic interest 
rates to stimulate saving if unlikely to be successful in the poorest developing countries, 
where consumption choices arc heavily inf1uenced by subsistence considerations. Indeed, 
the evidence suggests that the interest rate sensitivity of saving to real rates of return 
rises with a country's income level. Hence, the same policies undertaken in different 
countries could produce very different outcomes, depending on the country's level of   2
development. 
Is saving responsive? 
There is little consensus in the empirical literature on the interaction between 
saving and the real rate of interest in developing countries, Some studies have concluded 
that, for a large number of developing countries, there docs not appear to be any 
systematic relationship between rates of return and consumption/saving behavior; others 
have suggested that there may be considerable regional variation in this elasticity. 
One reason may simply be the poor quality of the data in general and, more specifically, 
the fact that there is considerable variation in the economic significance and 
informational content of the data on real rates of return. Lack of sophistication and 
depth in domestic financial markets or direct regulation may result in interest rates that 
do not adequately reflect expectations about the underlying economic fundamentals. In 
many low-income developing countries, there arc few banks, and there is little scope 
for true market determination of in rates. This feature of credit markets in the 
least developed countries may itself make saving Jess responsive to interest rates. 
Another reason that might explain the failure of existing studies to detect 
significant effects of interest rates on household saving in developing countries relates to 
the fact: that particularly in the poorest countries, subsistence considerations arc likely 
to he a significant factor determining consumption behavior. Given that, to be able to 
save, households must first achieve a subsistence consumption level, the interest rate 
sensitivity of private saving will be close to zero for countries where a large share of the 
population lives at or near subsistence consumption levels, Indeed, a subsistence model 
would predict a nonlinear relationship between saving behavior and the level of   3
development, with the most significant changes occurring when countries move from 
low-income to low-middle-income status, and relatively minor changes between middle 
income and high-income countries. Of course, the interest rate sensitivity of saving could 
be low even in middle-income countries if the income distribution were sufficiently 
skewed so that a large proportion of the population lived at or near subsistence levels, 
A frequently used proxy for the importance of subsistence in household budgets is 
the budget share going to food. It is indeed noteworthy that food consumption accounts 
for a markedly lower share of total expenditure in high-income than in low-income 
countries. As shown in Table 1, food consumption accounts for an average of 13 percent 
of total expenditure in high-income countries and for only 8 percent of total consumption 
in the United States. For middle-income countries, such as Mexico and Thailand, the 
share is often 30--40 percent while, for the poorest countries, the share of food is over 50 
percent; it is in the 60-70 percent range in some countries, such as Sierra Leone and 
Sudan. The very sharp differences in food expenditure across countries with different per 
capita income levels suggests that subsistence considerations may indeed be important in 
understanding saving behavior, particularly in low-income developing countries.   4
 
There are, however, additional reasons why saving may be less responsive to 
changes in real interest rates in low-income than in middle-income countries. Some have 
argued that low-income countries are characterized by pervasive liquidity constraints, 
which implies that changes in consumption will be heavily influenced by changes in 
current income, rather than by changes in rates of return.    5
Savings and income  
Subsistence considerations offer two main predictions about saving behavior. 
First, saving rates should increase with the level of real income at the initial stages of 
development, with the largest increases in the saving rate occurring as a country moves 
from low- to middle-income levels. Second, saving should become more responsive to 
changes in real interest rates as countries become richer. The first prediction follows 
directly from the role of subsistence consumption in the low income developing countries, 
and the fact that the share of subsistence in total consumption as perhaps proxied by the 
food share----declines as income increases.  
The second prediction may also be related to subsistence considerations, since 
incentives to save over time should affect only that portion of the budget left over after 
subsistence has been achieved, that is, discretionary income. Among countries in various 
income groups, the patterns of saving rate. that emerge are broadly consistent with the 
predictions of the subsistence model. As Table 2 shows, private saving is, on average, 
considerably lower for the poorest developing countries, where the saving rate is about 
one half that of the high income group, In fact, such differences also 
appear within regions. World Bank data show that median gross domestic saving as a 
percentage of GDP (1987-91 average) was 5.6 percent for low-income African countries 
and 19 percent for middle-income African countries.     6
 
Furthermore, the relationship between the level of income and the saving rate 
appears to be nonlinear, as the largest increases in saving rates occur in the transition 
from low- lower-middle-income levels, where the average personal saving rate rises by 
5.5 percentage points. The average for the upper-middle income countries is still 2.8 
percentage points above that of the lower middle-income group, but there appears to be 
relatively little difference between the average saving rates in the high-income and upper-
middle-income countries in the sample. 
It is noteworthy that liquidity constraint and precautionary motives for saving 
could produce the opposite pattern in saving rates. If poor consumers who borrow but 
face an uncertain income stream, the demand for precautionary saving rises. Hence, the 
liquidity-constraint precautionary saving hypothesis would predict that it is the poorest 
consumers, who have no access to credit market, who would save the most 
Still, there appear to be marked cross-country differences in saving rates that cannot   7
be accounted for by a subsistence explanation. For example, saving rates tend to be 
higher among the Asian countries than among the Latin American countries 
in the sample, despite similar income levels. The more equitable income distribution 
that characterizes the Asian countries may be a factor behind those differences. 
Institutional arrangements (such as pension funds), which play a more prominent role in 
several Asian countries may also be conducive to fostering higher saving rates. 
The role of real interest rates in saving behavior is more difficult to gauge. One 
problem--which is particularly important in Africa--is that financial markets remain thin 
and governments often set interest rates at nonmarket levels. Nevertheless, there is some 
evidence that "financial saving increased as a result of the increase in real interest rates 
associated with liberalization of financial markets in developing countries, both in Africa 
and elsewhere. For example, increases in saving rates have been associated with higher 
real interest rates in Indonesia and the Republic of Korea and, more recently, in 
Argentina, Chile, and Pakistan. There is also some evidence that reform programs in 
Africa-·-which caused real interest rates to move from sharply negative to mildly positive 
levels-were successful in mobilizing domestic savings. 
Empirical findings 
When households are assumed to maximize utility, or welfare, subject to a 
resource constraint, the interest-rate sensitivity of household saving depends on how 
easily households can substitute future consumption for current consumption (technically 
known as the intertemporal elasticity or substitution (IES) in consumption). If a given 
change in real interest rates induces large shifts in consumption, then the IES—one of the   8
parameter; describing household preferences—will be correspondingly large. In our work 
on this issue, macroeconomic data from a sample of countries were used to evaluate 
the magnitude of the IES for households from developing countries with diverse income 
levels. The low-income countries in the sample were Egypt, Ghana, India, Pakistan, and 
Sri Lanka. The low-middle income countries were Colombia, Costa Rica, C6te d'Ivoire, 
Morocco, and the Philippines. Three upper-middle-income countries also were included 
in the analysis: Brazil, Korea, and Mexico. In addition to not requiring that the lES be 
equal across countries with very different per capita incomes (consistent with the 
subsistence model), our methodology allowed relative prices (of imports and home 
goods) to enter into households' saving decisions. To take one example, a temporary 
reduction in 
import prices should reduce saving. Other things being equal, because the price of 
imports is a factor whose changes over tic (like the changes in interest rates) affect 
incentives to consume today or in the future. Estimation of the IES for countries with 
different per capita incomes is, however, an intermediate step. Ultimately, the aim of our 
analysis is to quantify the responsiveness of saving to policies that alter domestic interest 
rates, that is, the elasticity of saving with respect to the interest rate. 
 It is possible to simulate how saving responds to changes in real interest rates 
using our empirical estimates of the IES. By estimating how these vary with income level 
within our sample of 12 countries, we can infer values of the IES outside the sample 
(using information on the per capita income levels for other countries) and thereby 
simulate the interest rate elasticity of saving for a broad range of countries.   9
Our results (see Table 3) suggest that a 1 percentage point rise in the real rate of 
interest should elicit a rise in the saving rate of only about two tenths of 1 percentage 
point for the poorest countries in the sample. For the wealthiest countries, by contrast, the 
rise in the saving rate in response to a similar change   in the real interest rate is about two 
thirds of a percentage point. As Table 3 shows, the results are not very sensitive to the 
initial level of the real interest rate.  
   10
   
In general, the cross-country variation in the responsiveness of saving to a change 
in the real interest rate is wide, consistent with the predictions of the subsistence 
consumption model and the wide variation in income levels in the sample of countries 
included in our study. As with saving rates, the relationship between a country's income 
level and the interest elasticity of saving varies as one move up the income scale. 
Specifically, in low-income countries, the IES (and hence the interest rate elasticity of   11
private saving) is close to zero.  In low-middle-income countries, there is a marked rise in 
the IES. The IES is found to increase again in the upper-middle income countries, though 
1l1crcis little difference between this group and the high-income countries.  
Implications 
The main conclusion that emerges from this analysis is that much of the 
considerable variation among countries in both the level of saving and the responsiveness 
of saving to the real interest rate can be systematically explained by the country's income 
level.  Specifically, the hypothesis that the saving rate and its sensitivity to interest rate 
changes is a rising function of income finds considerable empirical support.  In particular, 
our results may help to explain why the rising real interest rates that typically accompany 
financial liberalization have failed to elicit an appreciable rise in private saving in many 
countries. Though financial liberalization policies---·and the resulting increase in interest 
rates---may  have a number of positive effects (including increasing both the efficiency of 
investment and economic growth),the results  suggest that the direct impact of such 
policies on household saving behavior is likely to be relatively small in low-income 
countries.  
Other policy questions—for example, the relationship between government 
deficits and the current account of the balance of payments will also depend on the 
responsiveness of private saving to real interest rates, to the extent that changes in public 
saving (increases or decreases in the budget deficit or surplus) alter domestic rates of 
return. Hence, our findings may shed some light un the wide variation among countries in 
the response of the current account to fiscal policy changes that alter interest rates.   12
The failure of saving to respond to changes in real interest rates in many low-
income countries is particularly problematic, since these are also the countries that have 
the least access to international capital markets and foreign savings. But even for 
developing countries that can obtain foreign financing, achieving or maintaining adequate 
domestic savings is essential for sustained growth. As the turbulence at the end of 1994 in 
Mexican and other emerging financial markets highlighted, foreign financing can be 
volatile and reversals can be quite abrupt. 
Increasing national saving in lower income countries may therefore require 
an alternative strategy. A recent World Bank study of high-performing Asian economies 
highlights the role of lower public sector deficits (achieved through expenditure cuts 
rather than tax increases) as an important means of achieving higher national saving. 
Reducing the level and volatility of inflation, and promoting macroeconomic stability 
more generally were also seen as useful ways of promoting saving.  Mandatory saving 
program may also have been effective in boosting saving in some Asian countries. In 
contrast, in upper-middle-income developing countries, the household saving rate is 
likely to increase significantly as interest rates move up, and the response is unlikely to 
be very different from what would typically be observed in industrial countries.   13
References: 
 
Ogaki, Masao, Jonathan Ostry, and Carmen M. Reinhart “Saving Behavior in Low- and 
Middle-Income Developing Countries: A Comparison,” (with IMF Staff Papers, 
Vol. 43 No. 1, March 1996, 38-71. 
 
Ostry, Jonathan, and Carmen M. Reinhart, “Private Saving and Terms of Trade Shocks: 
Evidence from Developing Countries,” IMF Staff Papers, Vol. 39 No. 3, 
September 1992, 495-517. 
 
 

Saving and real interest rates in developing countries

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