Factors Affecting Development and Financing

Economic development is a continuous process of income generating in an economy over a long

period. It is a very big task, therefore economic development is affected by various factors such
as economic, social, political, technical, administrative, institutional and so on. In the process of
the economic development of underdeveloped countries, a tremendous effort should be made to
remove the poverty or bottlenecks or underdevelopment situation of a country. Prof. Lewis and
W.W. Rostow have made comprehensive determinants of economic development on the
economic side. According to Nurkse, “economic development has much to do with human
endowments, social attitude, political conditions and historical accidents.” In recent days Prof.
Baner has pointed out, “the main determinants of economic development are ability, aptitudes,
capabilities and facilities.” But the economic development of a country is affected by a host of
both economic and non-economic factors. Economic development depends upon its natural
resources, capital formation, enterprise, technology etc. which are economic factors. But
economic growth is not possible so long as social institutions, political conditions, and moral
values in a nation do not encourage development. In other words, non-economic factors such as
social institutions, political conditions and moral values and desire for development greatly
influence the process of economic development.

Factors Affecting Development

↓ ↓
Economic Factors: Non-economic factors:
i. Capital formation i. Social institution
ii. Natural resources ii. Political condition
iii. Human resource iii. Moral values
iv. Enterprise and iv. Desire of
technology development

1. Capital Formation and Financing of Economic Development

Meaning:
Capital is the most important factor of production. It is passive itself and a manmade factor of
production, which is important in the process of production. Noteworthy, economic development
depends upon capital formation. Capital formation implies the changes in the stock of
reproducible factors of production. Investment in such reproducible factors of production may
both the physical and human capital too. The physical side of capital formation includes the part
of making capital goods such as tools and instruments, medicine and transport facilities, plants
and equipment which are known as real capital which can be increased the efficiency of
productive effort. Then the process can increase stocks of capital to expand the output in future
consumption. The process of capital formation in earlier economists emphasised only the
accumulation of material capital and neglects human capital. A proper definition must include
both material and human capital. According, to Stigler, “capital formation consists of both
 tangible goods like plants, tools and machinery and intangible goods like high standard of living,
education, health, scientific tradition and research”.
Thus, the capital formation can be defined as the expenditure made on both physical as well as
human capital. Meanwhile, all these expenditures on tools and pieces of equipment, goods,
travels and transport, necessary and consumable goods, and outlays on education, recreation and
health contribute productive efficiency of individuals and all expenditures by society serve to
raise the morale of the employed population is known as capital formation. Unlike material
capital, the human brain is the capital of a nation. Thus capital formation is the change in the
stock of capital by investing in a certain period.

That is, capital formation=Δk by investment

Where Δk= change in capital accumulation.

2. Process of Capital Formation

Investment in capital goods leads to an increase in capital stock, national output and income of a
nation. The process of capital formation moves through three stages-
i. A creation of saving
ii. Mobilization of saving
iii. Investment of saving

Creation of ----→ Mobilization ---→ Investment of

saving of Saving Saving

i. Creation of saving
Saving is income over consumption. It directly depends upon the level of income of the
community. As the community’s income increases saving also increases in the same direction.
That is, S= Y-C ------------- (1)

Where, S= saving, Y= National income, C= consumption expenditure

As Y ↑↔S↑

Thus, saving is the first stage of capital formation depending upon the level of national income.
As the national income rose the level of savings will also increase in the nation which leads to
increased capital formation. The increase in the rate of capital formation depends upon the rate of
increase in capital formation. But it has been seen that the propensity to consume is high nearly
one in UDCs and the propensity to save is low in such countries. This is because; the rate of
saving depends upon the power and willingness to save the community’s people.

The power to save by the community will also depend on the average level of income. The
average level of income also depends on the average family size and their standard of living. The
level of family income is high if the size of a family is high. Again if people lean toward
conspicuous consumption power to save will be low. On the other hand, if people of the country
are employed by the use of local resources power of saving will be increased.

Saving also depends upon the will to save. People may themselves save if certain facilities or
inducements are available for people. People are also motivated to save if government policy is
stable; peace and security are maintained in the country. The existence of banking and financial
institution plays a vital role in a high rate of investment schemes for saving. A high rate of
progressive tax o income and property tax will be reduced savings. But concession on tax for
saving in provident fund, life insurance, health insurance etc. encourages saving.

ii. Mobilization of Saving

The second stage of capital formation is the mobilization of savings through banks, investment
trusts, deposit societies, insurance companies and the capital market. The decision of saving and
investment are made by different people and for different reasons. To bring the saver and
investor together there must be well- developed capital and money market in the country to
mobilize savings, attention should be paid to the starting of investment trust, life insurance,
provident fund, banks and cooperative societies. Such agencies will not only permit small
amounts of saving to be handled and invested conveniently but will allow the owners of saving
to retain liquidity individually and collect long-term financing.
iii. Investment in Saving
The third stage of capital formation is the investment of saving in creating real assets. The profit-
making classes are the important sources of capital formation in the agricultural and industrial
sectors of a country. They have the power and will to save in the form of distributed and
undistributed profits and thus can make investments in productive enterprises. Besides this,
entrepreneurs must be capable, honest and dependable. For this entrepreneurs needs firstly the
technical knowledge to produce new product and secondly, they should have the power of
disposal over the factor of production in the form of bank credit. To this, should be the existence
of infrastructure/social overheads such as transport, communication, power, water, educational
training etc. further, there should be the social, political and economic climate of the country
must be supported by the growing emergence of the investor of the country.

3. Sources of Capital Formation

Sources of capital formation are classified into two broad categories of domestic and external
sources.
A) Domestic Sources: A domestic source of capital formation occurs from the mobilization of
saving from different groups of people. Mobilization of saving from domestic sources is the most
reliable source of investment which helps to break down the vicious circle of underdevelopment.
These various domestic sources of capital formation are explained in the following points.

i. Increase saving: Increase in saving is depending upon the power and willingness to save.
Further power of saving can be increased by the increase in the level of income opportunity and
willingness to save should be increased by providing various facilities toward saving through
educational propaganda. There may be two types of saving adopted by a government. They are
voluntary saving and involuntary or forceful saving.
a) Voluntary Saving: Voluntary saving is the part that comes over consumption. These
voluntary saving further occurs from two sources. They are – saving in the household sector
and saving in the business sector.

In an undeveloped country, a large size of population lies below the poverty line. Their power to
save is low due to a higher propensity to consume. A few higher classes of people such as
merchants, landlords and traders are sources to provide saving groups. But their income is not
channelled to the capital formation process. They spent most of their income on prestigious
purposes like buying ornaments, expensive gadgets, luxurious buildings and automobiles. Their
contribution to capital formation is weak in UDCs. Another fixed class group of people heavily
spent dependent on it. This type of postponement of current consumption is not important for
productive investment. Another source of compulsory saving is business or corporate saving in
the form of distributed and undistributed profit. It is the most important source in agricultural and
industrial development but is depend on the power of investment in the productive enterprise.
But the level of compulsory saving is low in UDCs due to the large expenditure made on
administration, pension and interest payments. Similarly low per capita income and
demonstration effects are the main reason for low capital formation and saving in UDCs.

b) Involuntary or forceful saving: involuntary saving can be increased by heavy taxation on

luxurious goods, providing compulsory lending to the government and deficit financing.
Increasing heavy tax on luxurious goods will decrease the willingness to save the people. On the
other hand deficit financing is a necessary condition for economic development but it is fear of
inflation in UDCs.

ii. Perpetuation of income inequality: Perpetuation of income inequality is the major source of
capital formation in UDCs. In some countries, it is the higher income class groups with a higher
MPS that do the majority of saving. If there is an unequal distribution of income, the upper-
income groups who save more can invest in capital formation. But it will create class struggle in
the country. Since all developed, as well as underdeveloped countries, aims to reduce income
inequality in the nation. But this method is creating deliberately income inequality which is not
favourable for either developed or developing economies when all countries aim at reducing
income inequalities.

iii. Increasing profit: An increase in the share of profit is another factor which also affects the
process of capital formation. Profit is the income of proprietors and corporations which should be
increased by providing incentives to enterprises and protection from competition. Prof. Lewis is
of the view that the ratio of profits to national income should be increased by expanding the
capitalist sector of the economy by providing various incentives and protecting the enterprise
from competition. The essential point is that profits of business enterprises should increase
because they know how to use them in productive investment.
iv. Government Measures: Like private households and enterprises, the government also
increases saving by adopting several fiscal and monetary measures. These measures may be in
the form of a budgetary surplus through an increase in taxation (most direct base), reduction in
 government expenditure, expansion of the export sector and raising money by public loans. If
people are not saving voluntarily, inflation is the most effective weapon. It is regarded as
inflation is the most effective weapon. It is regarded as a hidden or invisible tax. When prices
rise, they reduce consumption and thus divert resources from current consumption to investment.
Besides, this government can increase saving by establishing and running public undertakings
more efficiently. So that, they earn larger profit and are the way to utilize for capital formation.
The government measure of capital formation are given as below-
 Deficit financing
 Internal public debt
 Use of idle resources
Other sources of the capital formation may be as
 Establishment of financial institution
 Mobilization of gold hoards
 Budgetary surplus through increasing taxation
 Reduction in government expenditure
 Expansion of the export sector
 Raising public loans by deficit financing
 Inflation
 Profit of public corporation
 Mobilization of rural saving

B) External Sources of Capital Formation

i. Foreign Aid: In the absence of a domestic source for capital, it is necessary to import foreign
capital in the form of loans and grants from advanced countries with any string. Foreign aid may
be tied or united foreign aid plays a vital role in the development finance of developed countries.
Foreign aid with joint venture is the best course for technical know-how along with capital and
they make trained local labour and enterprise.
ii. Restriction of Imports: An increase in domestic savings is, therefore, essential if the
restriction of luxury imports is to lead to increasing in net capital formation.
iii. Favorable Terms of Trade: If terms of trade are made in favour of UDCs, they should
increase the large volume of export by the production activities.
Reasons for Low Rate of Capital Formation

The rate of capital formation is low in LDCs due to the lack of factors determining capital
formation. The capital formation depends on the creation of solving, mobilization of solving and
proper investment of proper saving. The failure of these three stages of capital formation is
responsible for the low rate of capital formation in these countries. The rate of capital formation
of LDCs is about 5 to 10 per cent whereas 15-25 in advanced countries. The main reasons for
low capital formation in LDCs are the following reasons for low savings and low investment are
below-

1. Low income/per capita income: Saving is the function of income. Saving increases as the level
of income increases. But the size of national income and output is low due to the backward of
agriculture, industries and another sector in UDCs. Due to this reason, MPC is high near unity.
So that almost entire income is spent on consumption.
2. Low Productivity: level of productivity is low → growth rate of NI is low → low saving → low
capital formation.

3. Demographic Reasons: the growth rate of the population is high in UDCs leads to low per
capita income leads little saving a large number of children with a heavy burden and unable to
save, a shortage of life expectancy and low working age.

4. Lack of enterprise: Lack of entrepreneurial ability is another factor responsible for the low rate
of capital formation in LDCs. The small size of the market, deficiency of capital, lack of private
property, retarded enterprise and initiative are the main causes of the low rate of capital
formation.

Conclusion

Investment plays a vital role in the process of capital formation. Investment contributes to the
growth process by increasing the productive capacity, improving technology, enhancing the
competitiveness of an economy and also supplementing human development. The demand for
investment depends on the stability of exchange rates, fiscal prudence, the feasible structure of
the financial market, including the regulatory and supervisory framework and the size and
quality of the securities and bond markets, and continuity of a consistent investment policy. Two
types of the capital formation may be distinguished, viz., physical capital and human capital. An
investment decision, whether related to physical or social investment, is contingent on the
availability of sufficient domestic and external investible resources. The former comprise
voluntary and involuntary household savings, corporate savings, and government savings, and
are influenced by several factors including the level and growth of per capita incomes, time
preferences of individuals in the society, financial intermediation, and demographic structure,
fiscal policy, etc. The foreign investible resources comprising the overseas development
assistance and foreign private direct and portfolio investments are influenced by a host of factors,
most important of which are the strong fundamentals of the economy.