Let us make an in-depth study of the problems, supply and demand of capital formation in LDCs.
Problems of Capital Formation in LDCs:
Physical capital formation plays a very important role in the process of economic development. In fact, the level of output or GNP and its composition depends to a great extent of the amount of capital available in the country.
Capital here refers to not only private physical capital such as factories, structures, transport equipment’s but also to social overhead capital such as bridges, highway, irrigation dams, power projects, rail, roads, etc.
Economic development is not possible in the absence of these tangible assets. Industrialisation, as also agricultural prosperity, depends on use of modem machines and capital goods. At the same time, economic development is largely conditioned by the existence of an integrated infrastructure (or social overhead capital).
However, most LDCs find it difficult to accelerate the rate of capital formation so as to be able to achieve a faster rate of economic growth. The rate of capital formation is low for various reasons. In other words, there are various obstacles to capital formation. Such obstacles operate both from the demand side and the supply side. We may now discuss the problems of capital formation from both the sides in order to get a complete picture of what Nurkse calls the vicious circle of poverty (or in a broad sense, the vicious cycle of underdevelopment).
Supply of Capital in LDCs:
It is anybody’s knowledge that due to low per capita income and widespread poverty most LDCs cannot save much. Moreover, whatever little is saved is not used for productive purposes. The proximate reason seems to be international demonstration effect.
Most people in LDCs have a tendency to imitate the consumption pattern of people of advanced countries, so, when income increases, saving does not increase much. Instead, the major portion of additional income is utilised to purchase luxury goods or non-essential items of consumption. This is partly attributable to long colonial heritage and partly due to the strong desire to catch up with the West or in brief, consumerism, in no time. This is true not only of the urban people but also of the rural people.
However, things are changing of late. Some developing countries have adopted a number of measures for raising the rate of saving and have succeeded in their effort to some extent. Fiscal measures such as taxation, borrowing, including small savings schemes and deficit financing have proved to be quite effective in some countries. In certain other countries public sector enterprises have succeeded in generating surplus and have stepped up the rate of capital formation.
Another major obstacle to capital formation from the supply side is the underdeveloped or rather the fragmented nature of financial (money and capital) markets. Due to the absence of banking facilities in most parts of the rural sector and non-existence of stock exchanges, most people in rural areas cannot save much even if they desire. A major portion of saving goes waste or IS utilised to purchase unproductive assets like gold and jewellery. A certain portion of saving is hoarded.
Thus, it is quite obvious that only by setting up a strong and sound financial infrastructure, i.e., by establishing a strong network of commercial banks and public financial institutions or development banks (such as IFCI or IDBI), as also stock exchanges and insurance companies in rural and semi-urban areas, is it possible to mobilise inactive savings for productive purposes.
Demand for Capital in LDCs:
There are certain obstacles to capital formation which operate from the demand side. It is to be noted at the outset that the demand for capital is a derived demand, i.e., it actually depends on the demand for consumption goods. Thus, in a country where demand for consumption goods is large, a huge quantity of capital good is required to expand the production capacity in the concerned industries.
If the demand for the product is large, producers can hope to make large profits and this will naturally induce them to make large investment in plants, equipment’s, machinery, etc. However, in LDCs, most people live under sub-human conditions.
Moreover, the majority of the population lives in rural areas and depends on agriculture as a means of live-hood. In such countries adequate demand for manufactured article or industrial goods is unlikely to exist. Even people belonging to the so-called middle class do not have sufficient income to buy industrial goods. Whatever little is spent by urban and rural elites is not quite sufficient to produce adequate inducement to investors. In short, in most LDCs, the demand for non-agricultural goods and services is limited. This seems to be the main reason why there is not much demand for capital in these countries.
The fact is that the inducement to invest is limited by the narrow size of the domestic market. Nurkse, following Adam Smith’s analysis of limits to division of labour set by the size of the market, first brought into focus the concept of the vicious cycle of poverty in 1953. He pointed out that underdeveloped countries face a shortage of purchasing power and, as a consequence, the size of the domestic markets is limited. Due to low demand for consumer goods and services, the demand for capital is also small.
It is quite obvious that, in order to break the vicious circle of poverty in an LDC, it is absolutely essential to increase the inducement to invest. This can be achieved only by increasing the size of the market. According to Nurkse, the size of the domestic market cannot be increased just by artificially increasing money supply. It will have the effect of causing inflation from the demand side.
The only way to increase the size of the market is to increase the productivity of resources (or total factor productivity). The amount of output not only determines the extent or the size of the market, it also sets a limit to the expansion of the market. An improvement in factor productivity increases both the flow of goods and automatically increases income level.
The increase in income automatically stimulates consumption. This, in its turn, will stimulate production further. Therefore, it is absolutely essential for LDCs. to raise the productivity level—both in agriculture and in industry—if they are to break the poverty trap.
Productivity can be increased by using modem technology also. Adoption of modem technology is also related to capital formation because technological knowledge is often embodied in new machines and equipment’s. But, there is a practical problem. Most LDCs are labour-surplus countries. So the adoption of capital-intensive methods of production is likely to create the problem of unemployment—both in urban and rural areas.