Factors Influencing Capital Formation

Factors Influencing Capital FormationCapital formation is not an automatic process. The rate of capital formation is different in different countries. This shows that capital formation is condi­tioned by certain factors. The following are the chief facto

Factors Influencing Capital Formation

Capital formation is not an automatic process. The rate of capital formation is different in different countries. This shows that capital formation is condi­tioned by certain factors. The following are the chief factors that govern capital formation in a country: Savings

Savings are done by individuals or households. They do saving by not spending all their incomes on consumer goods. When individuals or households save, they release resources from the production of consumer goods. Workers, natural resources, materials, etc., thus released, are made available for the production of capital goods.

The problem of savings in under-developed countries is threefold:

(a) Generating savings;

(b) Mobilizing savings; and

(c) Channelizing savings into productive investments.

Generating Savings: A high rate of savings is possible if people are-prepared to put forth effort to maximize output even with the resources available and are willing to keep down their expenditure within reasonable limits. In other words, the level of savings in a nation relies upon the capability to accumulate and the willpower to save. The authority to save or cutback capability of a country chiefly depends upon the regular level of revenue and the sharing of national income.

But of all the factors, it is the factor of income which is the most important determinant of the total volume of savings in an economy. In an under developed country like India, the rate of capital formation is low mainly due to the low level of savings. Savings are low because the level of income is low. In fact, under-developed countries are caught up in the vicious circle of poverty.

Foreign trade constitutes another source of savings. Foreign trade is easily amenable to State control for revenue and other purposes. By suitable export and import measures, the Government can improve the country's terms of trade and thus increase the export earnings of each unit of goods exported abroad.

Mobilizing Savings

Next step in the process of capital formation is that the savings of households must be mobilized and transferred to businessmen or entrepreneurs who require them for investment.

Obviously, the prime pre-requisite for mopping up of existing savings resources is the availability of suitable agencies and institutions. Measures for the satisfactory mobilization of domestic savings should take into account the following criteria: safety of investment, yield, liquidity, accessibility, simplicity, divisibility and transferability.

In the urban areas, institutional facilities for savings are greater and the savings habit among the classes who can afford to save is quite well-developed. Measures to improve the mobilization of savings have, therefore, to concentrate on rural areas. Such measures can be listed as follows:—

1.  Promotion of Small Savings.

2.  Popularizing Government Bonds.

3.  Popularizing Insurance Habit.

4.   Encouragement to Co-operative Institutions.

Channelizing Savings into Investment

Given the rate of interest, if prospects about profit are quite bright, that is, when entrepreneurs expect larger profits from investment, investment will be made on a large scale. If profits are expected to be low, investment made will also be small. It is generally believed that at lower rate of interest, investment is more and at higher rate of interest, investment is less. In other words, it means that when credit is cheaper, businessmen will borrow more funds for investment purposes.


Government and Capital Formation

In these days, the role of government has greatly increased. In an under-developed country like India, government is very much concerned with the development of the economy. Government is building dams, steel plants, roads, machine-making factories and other forms of real capital in the country. Thus, capital formation takes place not only in the private sector by individual entrepreneurs but also in the public sector by government.

There are various ways by which a government can get resources for investment purposes or for capital formation. The government can increase the level of direct and indirect taxation and then can finance its various projects.

Another way of obtaining the necessary resources is the borrowing" by the government from the public.

Borrowing Funds from the Public

Also called public borrowing in some countries is a great way for a country, state, county or city to fund new projects. For example, when a state needs to build a new road or public buildings, they can borrow from the public in the form of selling bonds to the public.

When a local area like a state, county or city sells bonds for a project, they are usually called municipal bonds.

Selling bonds to the public and paying a set rate of interest on these bonds is a very popular way for public entities to fund many new projects. The buying public when then be paid the interest on the bond at a set period of time and then once the bond matures, the borrowing entity will pay the bond holder the amount that was loaned, the amount the bond sold for.

Investors buy many billions of US dollars in foreign bonds as a way to diversify their investment portfolios. Many times these municipal bonds and country bonds pay a better interest rate than the United States Treasury bills and bonds will pay. This increases the rate of return for the investor. A US Treasury bill is usually a short term obligation, under one year while the US Treasury bond is for the long term from 2 years to 30 years.


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