Issue: July/Sept 2010
Back to basics 2

Savings’ critical role

Why are savings so vital to us all? Rian le Roux, head of economic research at Old Mutual Investment Group SA, explains the reasons.

To understand the role of savings, one must consider who the savers are and how savings can affect the overall performance of the economy.

Who saves and why?

Savings are done by three ‘entities’:

  • Households save essentially to cover future expenses (e.g. children’s education, buying big-ticket durable goods such as a car) and for retirement;
  • Companies, as that part of their profits they do not pay out to shareholders as dividends, but retain to finance future investment in the business (expansion of existing facilities and replacement of outdated equipment);
  • Government saves when its tax revenues exceed its expenditures on recurring items
    (e.g. wages, social-security payments, fuel, schoolbooks, medical supplies for hospitals). If its tax revenues exceed these current expenses, it has money left to spend on the building of new roads, bridges, hospitals, schools etc.

What are the implications for each entity, and for all of us combined, of not saving enough?

If households fail to save sufficiently for future expenses, they will not have sufficient funds to cover planned future big expenses and/or they will struggle financially during retirement. They will eventually become dependent on others or on government. This is unfortunately common in SA.

If companies do not or cannot save sufficiently, they will not have the capital available to finance replacement or expansionary investment. This will restrict the company’s efficiency and growth potential, as well as its ability to employ more people.

If government does not save, it will have no money available for fixed investment in social infrastructure (schools, hospitals, low-cost housing etc) or physical infrastructure (roads, bridges, harbours, airports etc).

In practice, entities in need of capital (e.g. businesses or government) will access available savings (from households or other companies saving for future investment) through financial intermediaries (banks, capital market) by borrowing or issuing paper to investors. The trouble starts if we as a nation do not save enough to meet the country’s financing (and therefore investment) needs.

If we save too little, for households it will mean that they will eventually struggle financially and for the broader economy it will mean that there will be insufficient funds available to finance investment in physical and social infrastructure. Insufficient investment also means sub-optimal economic growth, sub-optimal job creation and inferior overall living standards relative to nations with better savings performance.

SA today suffers from decades of underinvestment in social and physical capital. To make matters worse, these three entities’ respective savings behaviour is not independent of each other.

On the contrary, they are closely interlinked. For example, low-saving households will eventually increase the burden on government to provide social services, limiting government’s ability to rather spend money on social and physical infrastructure (ports, roads, bridges, schools, hospitals, etc).

Of course, government could raise taxes to generate additional revenue to cover the additional social expenditure. But this will further limit households’ ability tosave and spend. If the additional tax burden falls on companies, it will reduce their profitability and limit their ability and willingness to invest (as overall demand prospects worsen owing to the higher tax burden).

So there is unfortunately no easy answer. South Africans at all levels -- households, companies and government -- need to develop a much stronger savings culture.

What about capital inflows from abroad?

Relying on the savings of foreigners in the form of capital inflows can provide us with a limited solution. The key word is ‘limited’. SA has enjoyed strong capital inflows over the past decade or so. This has played a key role in providing capital for much-required investment in the economy.

But we cannot rely indefinitely on a large volume of foreign capital as a key source of finance for local investment. Foreign investors tend to be fickle. Any bit of bad news or concern over the health of the economy, or worries about future policy direction, can result in sudden withdrawal of these funds. This typically causes a currency slump (weaker rand), higher inflation, higher interest rates and an economic downturn.

What typically suffers the most in such an outcome are new investment and employment. These are two things we can least afford.

SA simply has to save more

Over the long term the only real solution to our capital needs is to provide it ourselves through a higher level of savings. Experience elsewhere, especially in Asia, has shown that high savings rates typically tend to be associated with higher economic growth and employment, and less cyclical economic volatility.

While a sufficient level of savings is a prerequisite for higher economic growth over time, it is not the only condition. On their own, high savings ratios do not guarantee higher economic growth. All the other conditions must also be in place. These include business-friendly economic policies, political stability, adherence to the rule of law and secure property rights.

Yet, even with all the latter in place, a dearth of domestic savings can seriously constrain the economy’s growth potential. This is where SA finds itself today.

Last word on households

SA households save way too little. Most assume their pension funds will provide sufficient retirement capital, but few bother to check whether this is true. In an environment where many employees are nowadays on defined-contribution pension funds, the onus is entirely on members themselves to ensure that they will one day have sufficient capital to be able to retire comfortably.

Many discover far too late that they are underprovided. They then find themselves having to work way past normal retirement age or they eventually struggle badly during their supposed

‘golden years’. In a worst case, they become dependent on others for survival.