Resource Mobilization, Financial Liberalization, and
Investment: The Case of Some African Countries
Mohammed Nureldin Hussain, Nadir Mohammed and Elwathig M. Kameir
Introduction
The role of interest rate in the determination of investment and, hence economic
growth, has been a matter of controversy over a long period of time. Yet, what constitutes an
appropriate interest rate policy still remains to be a puzzling question. Until the early 1970s,
the main line of argument was that because the interest rate represents the cost of capital, low
interest rates will encourage the acquisition of physical capital (investment) and promotes
economic growth. Thus, during that era, the policy of low real interest rate was adopted by
many countries including the developing countries of Africa. This position was, however,
challenged by what is now known as the orthodox financial liberalization theory. The
orthodox approach to financial liberalization (McKinnon-Kapur and the broader McKinnon-
Shaw hypothesis) suggests that high positive real interest rates will encourage saving. This
will lead, in turn, to more investment and economic growth, on the classical assumption that
prior saving is necessary for investment. The orthodox approach brought into focus not only
the relationship between investment and real interest rate, but also the relationship between
the real interest rate and saving. It is argued that financial repression which is often associated
with negative real deposit rates leads to the withdrawal of funds from the banking sector. The
reduction in credit availability, it is argued, would reduce actual investment and hinders
growth.
Because of this complementarity between saving and investment, the basic teaching of
the orthodox approach is to free deposit rates. Positive real interest rates will encourage
saving; and the increased liabilities of the banking system will oblige financial institutions to
lend more resources for productive investment in a more efficient way. Higher loan rates,
which follow higher deposits rates, will also discourage investment in low-yielding projects
and raise the productivity of investment. This orthodox view became highly influential in the
design of IMF – World Bank financial liberalization programmes which were implemented by

of saving (investment) to income is given, the growth rate can be increased by improving the
efficiency of investment which will raise the productivity of capital (p). To do this, it is
necessary to promote investment that support efficient production in sectors where rapid
growth in effective demand can be expected (Okuda 1990).
The orthodox approach to financial liberalization suggests that, financial liberalization
will both increase saving and improve the efficiency of investment (Shaw 1973). By
eliminating controls on interest rates, credit ceilings and direct credit allocation, financial
liberalization is said to lead to the establishment of positive interest rates on deposit loans.
This, in turn, is said to make both savers and investors appreciate the true scarcity price of
capital, leading to a reduced dispersion in profits rates among different economic sectors,
improved allocative efficiency and higher output growth (Villanueva & Mirakhor 1990).
Figure (1) provides a diagrammatic illustration of the theory backing financial
liberalization programs. The figure exhibits the behavior of savings (S) and investment (I) in
relation to the real rate of interest (r). The savings schedule slopes upwards from left to right
on the (classical) assumption that the rate of interest is the reward for foregoing present
consumption. The investment schedule slopes downwards from left to right because it is
assumed that the returns to investment decreases as the quantity of investment increases,
which means that a lower real rate of interest is therefore necessary to induce more investment
as the marginal return to investment falls. If the interest rate is allowed to move freely (i.e., no
interest rate controls), the equilibrium rate of interest would be r* and the level of saving and
investment would be at I*. If the monetary authorities impose a ceiling on the nominal saving
deposit rate, this will give a real interest rate of, say, r
1
. If this rate is also applicable for
loans,
1
saving will fall to S
1
and investment will be constrained by the availability of saving to
I

financial saving. The relationships suggested by the Harrod-Domer result, between saving,
investment and growth, are complicated by the fact that a significant portion of domestic
saving may be held in the form of real assets (e.g., real estate, gold and livestock), exported
abroad in the form of capital flight, or claimed by informal markets such as the informal credit
market, the underground economy and the black market for foreign exchange. The fact that
financial saving is only one form of saving, raises many important issues regarding the theory
of financial liberalization. In what follows, a simple conceptual framework is developed to
restructure the debate on financial liberalization and to articulate the arguments against the
financial liberalization theory. It puts into focus some of the worries, criticisms and
limitations of the financial liberalization theory which are important to bear in mind when
evaluating the implementation of policies in the context of African countries.
Total Saving, Financial Saving, and the Leakage
The flow of total national saving can be decomposed into public saving and private
(household and enterprise) saving:
S
T
= S
G
+ S
P
(2)
Where S
T
, S
G
and S
P
are total, public, and private savings respectively. The flow of
private saving can be divided into two major components: private financial saving which
comprise the portion of private saving that is kept in the form of financial assets in the formal

G
(5)
On the assumption that all government saving is kept in the form of financial assets
(so that F
G
= S
G
) and substituting equation (5) in (4), and rearranging we have:
L = S
T
— (F
G
+ F
P
) (6)
and,
F
T
= S
T
– L (7)
Dividing equation (6) by S
T
, we obtain:
FT/ST = 1 – s (8)
Where, s = L/S
T
, which measures the proportion of total saving that is leaked out of, or
not captured by the formal financial sector. If equations (6), (7) and (8) are expressed in stock
rather than flow terms, they can be interpreted as giving the condition for the case of what can

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the portion which is kept in the form of real assets including
livestock and gold (R); the portion which is claimed by the informal financial sector (N), the
proportion which is claimed by the underground economy including the black market for
foreign exchange (U), the portion which goes into capital flight (C) (this is usually kept
abroad in the form of foreign currency deposit accounts, financial assets or physical assets)
and; the portion which is hoarded by households in the form of domestic or foreign currency
holdings (H). Using these definitions in equation (8), we obtain:
F
T
= S
T
— (R + N + U + C + H) (9)
Equation (9) is a restatement of the fact that financial saving is only one type of
saving. The main other types of saving are represented by the components of the leakage on
the right hand side of the equation. According to the equation, if saving is stagnant (i.e., s
S
T
=0), financial saving can still increase — keeping other things constant — by reducing the
stock of saving which is kept in real assets (i.e., sR<0); by reversing the process of capital
flight (i.e., sC<0); by attracting the resources of the informal sector into the formal sector (i.e.,
sN<0); by reducing the amount of saving claimed by the underground economy and; by
encouraging dishoarding of foreign and domestic currency by households (i.e., sH<0).
Conversely, large additions to total saving might not increase financial saving if they are
offset by an equal increase in any of the components of the leakage, say, capital flight. Also,
substitution among the components of the leakage might occur without affecting financial
saving. An increased dishoarding of domestic and foreign currency, for instance, might be
offset by an equal increase in capital flight (i.e., -sH=sC) leaving financial saving unchanged,
and so on.
The Orthodox Versus the New Structuralist

(10)
where B
C
is the supply of bank loans, T is the required and excess reserves ratio held
by banks and F
T
is financial saving. Thus, while reductions in any of the components of the
leakage in equation (9), keeping all other parameters constant, will bring about an equal
increase in financial saving, the supply of bank loans will not increase by the same amount
because of the leakage caused by banks’ holdings of reserves.
As for the second reason, according to Van Wijnbergen’s (1983) new structuralist
model, if the increase in financial saving occurs through the reduction in hoarded cash
balances [-H in equation (9)] and other intrinsic unproductive assets, then it will have a
positive effect on output. If, however, it is at the cost of informal credit market (-N) it will
lead to a fall in total private sector credit, working capital and output. The loss of informal
sector credit without an equal compensating increase in formal sector lending, is said to bid
up the informal sector lending rate and reduce net working capital causing a decline in output.
The new structuralist argument rests, therefore, on the contentions that the
intermediation of the formal sector is not full and that informal sector resources, and not the
other components of the leakage in equation (9), are likely to be the closest substitute for time
deposits. However, it has been argued by Serieux (1993), that less than full intermediation can
only occur if we assume away the money creation capacity of banks. That is, most informal
sector loans are essentially cash loans. It follows that a shift from informal sector resources to
bank resources would imply a surrender of cash to the formal banking sector. This, will
increase banks’ reserves and hence their credit creation capacity. Accordingly, bank
intermediation might be complete or even multiplicative. Also, an increase in bank deposit
rates, may lead to shifts among the components of the leakage such that the available informal
credit remains intact.
The Real Interest Rate and the Determinants of Saving and Investment
in Africa

financial liberalization theory.
Total Saving and Financial Saving: Empirical Models
The financial liberalization theory postulates that saving is positively related to the
real interest rate. The theory, however, does not make clear distinction between total savings
and financial saving. Total domestic saving consists of private and public savings of which
financial savings is a part. While financial saving is the portion of total saving that is
channeled through financial assets which comprise short and long-term banking instruments,
non-bank financial instruments such as treasury bills and other government bonds and
commercial paper. It is prudent, therefore, to examine the role of the real interest rate in the
determination of both total saving and financial saving. To this end, the following two
equations for total saving and financial saving are specified:
T
S
= s
0
+ s
1
+ s
2
Y (12)
F
S
= T
0
+ T
1
+ T
2
Y + T
3

As it has been noted before, the financial liberalization theory suggests a differing
effect of the real interest rate on investment, depending on whether the real interest rate is
below or above the equilibrium rate. It is also noted that, on Keynesian grounds, the real

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