Effect of Domestic Saving on Capital Formation in Kenya

Mukhongo Wafula ,Obange Nelson ,Alphonce Juma Odondo

doi:10.7176/jesd/10-16-17

Abstract

Kenya’s average rate of gross capital formation of 20.13% of GDP over the period 2006-2017 falls short of at least 25% necessary for developing countries to experience sustainable growth. The attendant effects of low capital formation have entrenched unemployment rate above 39% line and consigned more than 65 per cent of the country’s population to living on less than $ 2 a day. The statistics suggest the need for urgent policy intervention aimed at accelerating capital formation in Kenya. But whether the government should respond by mobilizing more domestic saving or not is the question which this study sought to answer. This is because majority of the previous studies that investigated the effects of domestic saving on development indicators limited themselves to growth-saving nexus. Those that investigated the effect of domestic saving on capital formation either restricted themselves to a bivariate framework or controlled for a few sources of capital formation. This implies that the effect of domestic saving on capital formation is not clear. Besides, the response of capital formation to shocks in domestic saving is not clear. The purpose of this study was to investigate the effect of domestic saving and the response of capital formation to shocks in domestic saving. The study was anchored by Solow’s capital accumulation model within a correlational studies research design. Data over 1974-2017 period was sourced from the World Bank. ARDL bounds test found the existence of cointegrating relationship among gross capital formation, gross domestic saving and the controlled variables when gross capital formation was specified as the target variable. The short-run dynamic model estimates indicated that ECM term corrects 39.56% of deviations from long run equilibrium in one year. ARDL estimation indicated that in the long run, gross domestic saving has positive significant effect on gross capital formation. The results were robust for IRFs analysis which found the response of gross capital formation to innovations in gross domestic saving to be positive and significant. The study concluded that in the long-run, Kenya’s capital formation will be driven by domestic saving. Therefore, to achieve high capital formation in the long-run, the study recommended policies that enhance positive effects of domestic saving for consideration by the government of Kenya. Keywords: Kenya, Capital Formation, Domestic Saving DOI : 10.7176/JESD/10-16-17 Publication date : August 31 st 2019

Highlights

Low capital formation in developing countries and the search for its solution has been a dominant theme in academic and policy discussions for centuries since the inquiry into the sources of the wealth of nations by Smith (1776)
The results indicate that domestic saving does not directly enter the short run model, rather it enters via the Error Correction Mechanism (ECM) term
The purpose of this study was to investigate the effect of domestic saving and the response of capital formation to shocks in domestic saving

Summary

Introduction

Low capital formation in developing countries and the search for its solution has been a dominant theme in academic and policy discussions for centuries since the inquiry into the sources of the wealth of nations by Smith (1776). According to Lewis (1954) and Kuznets (1955), capital formation is a critical factor in the transformation of an economy from a less developed to a developed one. Citing the ‘growth miracles’ of China and Japan and the Newly Industrializing Countries (NICs) of East Asian Tiger economies of Singapore, Malaysia, South Korea, Hong Kong and Taiwan, Krugman (1994) and Stiglitz (1996) demonstrated how capital formation can transform an economy’s growth from a low path to a higher one within a very short period of time. The United Nations (2006) supports the views of development economists, affirming that structural transformation towards high productivity in developing countries cannot be possible without sufficient capital formation. It implies that any developing country that aspires to achieve high economic growth and sustainable development should prioritize enhancing capital formation process on her development agenda

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