Finance - VII
Savings and Investment Process
6 Jan 2025
Nations try to achieve economic growth, high employment, and price stability, which are reflected in indicators such as GDP. When a nation produces goods and services, some of those goods and services are consumed, while others are saved or invested to produce future goods and services, or to construct infrastructure to support future production. The process of saving and investing is called capital formation, and it is essential for economic growth.
Gross domestic product
A nation's GDP is composed of several components:
Personal consumption expenditures indicate expenditures by individuals for durable goods, nondurable goods, and services. We consume all the time: we eat good, wear clothes, pay for rent, drive cars, receive education, travel, get haircuts, and so on. Government expenditures include spending and investment by the government on public services, such as education, health, security, roads, transportation, and so on. Gross private domestic investment includes spending by businesses on capital goods, such as machinery, equipment, buildings, inventories, and so on. Net exports of goods and services are the difference between exports and imports.
Government receipts and expenditures
Government spending are either mandatory (based on existing laws) or discretionary (based on the passage of appropriation bills). The primary expenditures of the government are on social security (pensions), health care, defense, welfare, law enforcement, education, and so on. In Singapore, for instance, the Central Provident Fund (CPF) is a mandatory savings scheme that requires both employers and employees to contribute a portion of their salaries to the fund, while MediShield Life is a mandatory health insurance scheme that provides coverage for life. Governments rely heavily on taxes to finance their expenditures, though they may also borrow money by issuing bonds. For example, the Singapore government imposes a Goods and Services Tax (GST) on goods and services, income taxes on individuals and corporations, property taxes, and so on. The Singapore government also issues various types of bonds, such as Savings Bonds, Singapore Government Securities (SGS), and Treasury Bills, to finance its expenditures.
(Public borrowing is a relatively modern phenomenon, made possible by the development of effiicent financial institutions and markets to facilitate the transfer of funds from savers to borrowers).
Role and major sources of savings
The most significant source of capital is personal and corporate savings. Financial intermediaries and governments can also save, but their primary role is to aid in the savings-investment process, and to meet economic objectives (e.g. to operate in a deficit to stimulate economic growth), respectively.
Businesses are often unable to meet their investment needs from undistributed profits/retained earnings, and so they need to acquire funds from other sources, called savings surplus units. A savings surplus unit is an economic unit whose income exceeds its expenses.
Personal savings
Personal savings is income minus taxes and any outlays on consumption:
Voluntary savings are savings that are set aside by individuals for future consumption or investment. Contractual savings are savings accumulated under contractual arrangements, such as insurance policies and pension funds. Contractual savings are not determined by the individual's discretion, but by previous commitments that the individual has some incentive to fulfill.
Individuals are inclined to save for various reasons:
There are many options for individuals to save their money, such as cash, bank deposits, insurance policies, pension funds, mutual funds, and so on. Three factors that influence the choice of savings instruments are: liquidity, safety, and return.
Corporate savings
Corporate savings (or retained earnings) are the undistributed profits of a (nonfinancial) corporation. When a corporation receives revenue from selling goods and services, it incurs expenses, such as wages, rent, utilities, and so on. The difference between revenue and expenses is called before-tax profit. Before-tax profits are usually adjusted for depreciation (e.g. wear and tear, obsolescence). After adjusting for depreciation, the remaining profit is then taxed, generating revenue for the government. After-tax profits are either distributed to shareholders as dividends, or retained by the corporation for future investment.
Corporations save to meet short-term and long-term capital needs. Short-term capital is required due to seasonal business changes, such as fluctuations in demand for goods and services. Corporations typically hold short-term savings in the form of cash, or other liquid assets, such as checkable deposits, or short-term securities issued by the government or other corporations. Long-term capital is required for long-term investments, such as constructing new facilities, purchasing new equipment, acquiring other companies, maintaining or repairing existing facilities, and so on. Savings committed to these purposes are often invested in long-term securities, such as government bonds, or corporate bonds and stocks. We see in both cases that these savings do enter the financial system, and are used to finance the capital needs of other economic units.
Factors affecting savings
Several factors influence the level of savings in an economy:
Capital market securities
Capital market securities include long-term debt securities that mature in more than one year, as well as equity securities. In contrast, money market securities are debt securities that mature in one year or less (e.g. Treasury bills, certificates of deposits, commerical paper, banker's acceptances, repurchase agreements, etc.). Capital market securities are key to the savings-investment process, especially for individuals looking to finance a home, or for corporations looking to finance their operations.
A mortgage is a loan secured by real property. When an individual borrows money to buy a home, the lender (e.g. a bank) provides the funds, and the borrower agrees to repay the loan, plus interest, over a specified period of time. If the borrower fails to repay the loan, the lender can take possession of the property and sell it to recover the loan amount. Mortgages are a key source of financing for home purchases.
Bonds are long-term debt securities issued by governments and corporations to finance their needs. Corporations can also issue stocks to raise funds. Bonds have different maturity periods, ranging from short-term (e.g. 6-month or 1-year Treasury bills) to long-term (e.g. SGS bonds, available in 2, 5, 10, 15, 20, 30, 50-year terms).
Mortgage markets
A key element in the savings-investment process is the availability of financing for home purchases. Most individuals cannot afford to buy a home outright, and therefore need to borrow money to finance the purchase. Mortgage markets are markets where loans are originated, funded, serviced, and traded.
House purchases are typically financed with fixed-rate long-term loans. Down payments are also required, usually ranging from 5% to 20% of the purchase prices. Borrowers benefit from fixed-rate loans because they know in advance how much they need to pay each month, and can budget accordingly. Thus, fixed-rate loans are less risky for both borrowers and lenders.
Adjustable-rate mortages (ARMs) are another type of mortgage, where the interest rate is adjusted periodically based on some index (usually government securities). ARMs are riskier because the interest rate can increase, leading to situations where borrowers cannot afford to make their monthly payments, if the interest rate rises too high, for instance.
Mortgage loans originate from various sources, such as mortgage brokers, and banks. These financial institutions can either hold the loans on their balance sheets, or sell them to other financial institutions through the secondary mortgage market. Financial institutions also engage in securitization, where they pool mortgage loans together, and sell them to investors as mortgage-backed securities (MBS). MBSs are created because they allow financial institutions to transfer the risk of default to investors, and to free up capital to make more loans. When the borrower makes their monthly payments, the institution that services the loan collects the payments, and distributes them to the investors who own the MBSs.
Financial institutions use credit ratings to predict the likelihood of default on a mortgage loans. Credit ratings are assigned by credit rating agencies (typically not part of the financial institution itself), and they reflect the borrower's capacity to repay the loan, to generate income, and to manage their debts. These agencies look at the borrower's credit history, income, employment status, and other public records to determine the credit rating. Credit ratings are used to differentiate between prime and subprime borrowers. Prime borrowers are those predicted to have the lowest risk of default.
Mortgages are somewhat signifcant because they contributed to the subprime mortgage crisis in the US in 2007-2008. Prior to the crisis, many lenders issued subprime mortgages to borrowers with poor credit histories. Since loans are readily available, many borrowers took out loans they could not afford, which drived up housing prices. The housing bubble eventually burst, leading to other problems in the financial system. Banks holding MBSs found the value of their assets plummeting, which resulted in them becoming highly illiquid and insolvent, and a credit crunch ensued. Other sectors of the economy were affected: they were unable to borrow money to finance their operations, and the economy went into a recession. The scale of the crisis was so large that the US government had to step in to bail out the banks (i.e. provide them with funds to stay afloat, by literally creating money out of thin air, or by buying their toxic assets at a discount), so that the financial system would not collapse.