The Importance of Capital Formation in Developing Economies: Sources, And Solutions

 

Capital is the lifeblood of production. No country in the present world can claim to develop without capital. It has led to increased output in countries, and it has helped raise the productivity of factors like labor.

Increasing the stock of capital in the economy is known as capital accumulation or capital formation. Thus, capital formation means a situation where society does not spend the whole of its current income on immediate consumption but rather directs a part of it to make capital goods like instruments, machines, plants, equipment, transport facilities, finished and semi-finished goods. Economists also add intangible goods like education, health, and research to capital formation. Thus, capital formation includes both physical and human capital.

According to Singer, "capital formation consists of both tangible goods like plants, tools, and machinery and intangible goods like education, health, scientific tradition, and research.

Importance of Capital Formation

Capital formation is the driving force behind any country's economic development; it's like the backbone. It helps improve the growth process by providing basic infrastructure. Infrastructure is the basic physical and organizational structure needed for an economy to operate. By increasing savings, the volume of investment and the productivity of all sectors of the economy can be increased. It is stated that the greater the proportion of savings in an economy, the greater the proportion of resources diverted to investment, and this helps break the vicious cycle of poverty.
According to The Economist, Harrod and Domar, "Capital has a double role to play. On the one side, it generates income, and on the other side, to increase the production capacity of the economy."

Capital formation also leads to an increase in the stock of capital in the country. The increase in stock means expansion in economic activities, increasing the country's employment opportunities.
Public debt refers to borrowing by the government from within the country or from abroad. The debt burden of LDCs is gradually increasing. Capital formation helps reduce the burden of foreign debt by adopting a self-reliance policy.
Capital formation provides a nation with self-sufficiency. It means that a country engaged in capital formation will produce a variety of manufactured and semi-manufactured goods. It will reduce a country's dependence on foreign countries. It also raises the welfare of a country by providing the people not only material goods but also immaterial goods like health, education, water, sewerage, clean water supply, roads, power, energy, gas, the system of communication and transport, etc. 
Capital formation leads to economic development through technological change in every economic sector, which leads to balanced economic growth. 

Main Sources of Capital Formation

There are two sources of capital formation: domestic resources and external resources.

Domestic Resources

To meet the country's capital needs, the government prefers compulsory saving through taxes and compulsory borrowing from the public and government servants. Through saving drives, the government must try to increase saving by postponing household and business consumption. Prize bonds, savings certificates, and taxes may drive reduced consumption and increased saving.
To mobilize resources for capital formation, the government issues short- and long-term bonds of various denominations to the public and financial institutions. The public debt collected is therefore invested in public enterprises and the rural sector of the economy.
Deficit financing is also a domestic source of capital formation, to finance some new public projects by printing new currency notes against Zero gold security and cash reserves from Central bank are called Deficit financing. It may lead to inflationary pressure in the economy, but a certain measure of deficit financing can be accomplished without creating such pressure.
Disguised or hidden unemployment means surplus agricultural workers, who have zero marginal productivity in the agricultural sector. The surplus workers can be transferred to non-agricultural sectors such as roads, buildings, canals, etc., without diminishing agricultural outputs.

External OR Foreign Resources

Foreign Direct Investment is the most important source of inflow of foreign capital in a developing country. A foreign direct investment is a financial investment made by a company or individual from one country into an organization in another one. In general, FDI occurs when a foreign organization develops international business activities or acquires foreign business assets.

 

Investors from another country purchase securities and other financial assets, known as foreign portfolio investment. Stocks, bonds, mutual funds, exchange-traded funds, and global depositary receipts are examples of foreign portfolio investment.

A developing country receives a good amount of foreign capital in loans and grants from other developed countries and international financial institutions like the IMF, World Bank, Asian Development Bank, etc.

Developing countries have high population growth rates. Developed countries can utilize surplus labor, and workers send foreign remittances to their homeland. These remittances increase capital accumulation.

Solution to Increase Capital Formation

 
The rate of capital formation can be increased by adopting the following methods or measures

Utilization of Resources:

The first step to increase the rate of capital formation is to efficiently use existing techniques and technology and to utilize available resources that are unused or underutilized in every economic sector in LDCs. Also, encourage people and businesses to save more through attractive interest rates, saving schemes, and financial education.

Reduction of Public Expenditure:

The reduction of government expenditure is a very important instrument of fiscal policy. The government should cut its non-productive expenditure. Accordingly, it will be a source of capital formation. To encourage saving, particularly in rural areas, the savings banks will have to be set up. Post office savings banks can be introduced effectively on a large scale in both rural and urban areas.

Private and Public Sector

The public sector enterprises (PSCs) or state-owned enterprises are a heavy burden on developing countries. The only solution is to privatize these institutions without wasting time and money. The profitable public corporations are established as state enterprises, and their profits can be utilized for capital formation. The PSEs play a great role in moblizing the saving by issuing shares in the capital market.

 

 Foreign Investment:

Foreign investment is the most important source of inflow of foreign capital in a developing country. Private foreign companies have an important role in capital formation by investing in the private sector directly. Attract foreign direct investment by simplifying regulations and improving the business environment.

Restriction on Import:

Restricting the import of consumer and luxury items may also affect capital formation. The import of capital goods must not be reduced for the rapid development of the country.