Year

2008

Degree Name

Doctor of Philosophy

Department

School of Economics

Abstract

The main objective of this thesis is to examine the short and the long-run interrelationships between savings, investment, foreign capital inflows and economic growth in India for the period 1950 to 2005. The analysis firstly tests for the short-run dynamic effects of savings and investment on growth (consistent with the Solow-Swan model) and the long-run effects of savings and investment on growth (in line with the endogenous AK models of growth). Secondly, the investigation is extended to examine the interrelationships between sectoral savings and investment and their roles in the growth process.

Since independence, the Indian economy has been subject to numerous wars, structural changes, regime shifts and economic reforms during the sample period. Therefore, there is a need to apply unit root tests which take into account endogenously determined structural breaks. This study not only applies the traditional unit root tests of the Augmented Dickey-Fuller and the Phillip-Perron, it goes further by applying Perron’s (1997) innovational outlier and additive outlier model tests; and the Lee and Strazicich (2003) Minimum Lagrange Multiplier unit root test. These tests determine endogenously the likely time of the major structural breaks in the Indian economy which removes the bias of incorrectly non-rejecting the null of unit root.

Unit root tests indicate that the variables under consideration are of mixed stationary and non-stationary order. Furthermore, these tests reveal that the major economic changes in the country occurred during the 1960s and 1980s with the Green revolution (starting in 1967), along with the wars with China (1962) and Pakistan (1965); the severe droughts (1965-1967); the balance of payments crisis (1966); the economic reforms that took place under Rajiv Gandhi’s tenure in the mid-1980s and the balance of payments crisis of 1990, before the formal deregulation of the Indian economy which started in 1991.

Endogenous growth models are estimated to examine the interrelationships between gross domestic product (GDP), gross domestic savings, gross domestic investment and foreign capital inflows. The analysis is further extended to include the three sectors of savings and investment, household, private corporate and public. The estimations are undertaken with both cointegration and error-correction modelling, in the presence of structural breaks. These empirical estimations combine the short-term information with the long-run, consistent with the Solow and the endogenous AK models of growth.

As the variables under consideration are of a mixed order of stationarity and non-stationarity, this study uses the bounds testing approach to cointegration to determine the long-run relationship between variables. The study also examines the long-run and short-run coefficients using the autoregressive distributed lag approach through the error correction mechanism.

The empirical estimations indicate firstly, that neither savings nor investment, including the three sectoral measures of savings and investment, have any positive impact on GDP growth in India. This result is robust in the short-run and the long-run, providing no evidence for both the short-run dynamic affect of savings and investment on growth (the Solow model) and the long-run (permanent) affect of savings and investment on growth (the AK model of growth) in India.

Secondly, foreign capital inflows is the only variable found to affect GDP growth, in the both the short and long-run. A feedback effect exists between foreign capital inflows and GDP growth, although it is much smaller than from GDP growth to foreign capital inflows.

Third, the Carroll-Weil hypothesis and a strong accelerator effect of GDP are supported in the Indian context, only when gross savings and investment are disaggregated into the household, private corporate and public sectors. GDP growth is affecting household and private savings in the long-run; and GDP has a large effect on household investment in the long-run and public investment in the short-run.

Fourth, foreign capital inflows are found to be negatively related to gross domestic savings, indicating a substitution affect between the two. But a feedback effect exists between gross domestic investment and foreign capital inflows, in both the short and the long-run, with domestic investment attracting foreign capital inflows much stronger than the reverse.

Lastly, as per the Feldstein and Horioka (1980) proposition, gross savings are driving gross investment in the long-run; however evidence of perfect capital mobility is found in the short-run. There is also evidence that household savings has a positive effect on private sector investment in the long-run; and public sector investment in both the long and short-run. While the direction of these relationships from savings to investment is consistent with the growth models, there is the serious missing link from investment to economic growth.

Overall, these findings do not support policies designed to increase household, private or public savings and investment in order to promote economic growth in India. This is further strengthened by the findings that GDP has large elastic affects on household investment in the long-run and public investment in the short-run. Further to this, public investment has a negative impact on GDP growth in the long-run; however it is only significant at the ten percent level. There is therefore, no statistical evidence of the popular endogenous explanation that investment is the driver of long-run economic growth in India.

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Unless otherwise indicated, the views expressed in this thesis are those of the author and do not necessarily represent the views of the University of Wollongong.