12 Factors Affecting Capital Formation In Developing Countries

There are some factors affecting capital formation in developing countries. Capital Formation or capital accumulation is essential for the economic development of a country. Capital formation means “net increase in the stock of real capital of a country during a period of time. It is the capital formation that determines the economic development of a country. Advanced countries attained economic growth and stability due to the high capital formation.

On the other hand, economic development in developing countries is low because capital formation is very low. There are some Factors Affecting Capital Formation In Developing Countries.

Factors Affecting Capital Formation In Developing Countries

Capital formation in a country is governed or influenced by the following factors

1. Savings: Capital formation depends on the level of savings of the people. Capital formation can be increased when people save a major portion of their income. People can save more of their income if they reduce their consumption expenditure. The larger the savings of the people, the greater will be the capital formation in a country. Hence, capital formation depends on the level of savings to a great extent.

2. Income: Level of income is the second determinant of capital formation. People can’t save when their income is low. As their income increases, their level of savings also increases. One of the reasons for high capital formation in advanced countries is the high level of income of the people. Educational and employment opportunities help in increasing the level of income of the people.

3. Willingness to save: Savings depend not only on the level of income but also on the willingness to save. The willingness to save depends on the following factors : a)Family affection, b) Provision for future, c) Provision for old age, d) Social status, e) Provision for education, marriage etc. f) Nature of individuals. People may not save if they lack the willingness to save.

4. Banking and financial Institutions: Savings can’t be channelized into investment when people kept it with themselves. Capital formation will be high when there exists several banking and financial institutions in a country. These institutions inspire the people to save a portion of their income. They mobilize the savings of the people. They provide different kinds of loans to the businessmen and enable them to run the industries. Capital formation remains low when there does not exist adequate banking and financial institutions. So, the government has to establish banking and financial institutions at several places in the country.

5. Rate of interest: Capital formation is also governed by the rate of interest. Normally individuals and institutions like to save at higher rates of interest. When the rate of interest is low, they consider it useless to save and spend their income on different heads. On the other hand, they sacrifice their immediate desires and save considerable portion of their income if the rate of interest is high. Hence, the rates of interest and capital formation are directly related. The higher the rate of interest, the greater will be the accumulation of capital

6. Dynamic entrepreneurs: Besides the above factors, capital formation also depends on the existence of entrepreneurs in a country. if a country has dynamic entrepreneurs, savings available in that country can be used for investment purposes. This increases the capital formation in a country.

7. Existence of stock exchanges: Capital formation is also influenced by the stock exchanges. Capital formation is promoted by the S tack Exchanges The stock exchanges provide information regarding the shares and debentures of various companies. They promote saving habits and make the people as investors, Hence capital formation is influenced by the existence of well developed stock exchanges.

8. Taxation policy: Taxation policy of the government also influences capital formation. When the government imposes high taxes, when, entrepreneurs will not come forward for starting industries. When the Government gives tax-incentives, investment will increase. Increase in Investment leads to an increase in capital formation.

9. Deficit financing: Deficit financing has become an important source of capital formation. Especially the developing economies have been adopting this method for promoting their capital stock. These countries find it difficult to raise capital from taxation, pubic borrowings and public savings. But deficit financing is useful for a country for achieving economic development to some extent only. So the government must take steps for the proper utilization of the deficit financing.

10. Security: Savings also depend on the conditions prevailing in the society. If there is no security to life and property, people will not save. The government must give protection to the life and property of the people. Political stability and peaceful atmosphere encourage savings.

11. Foreign Capital: Foreign capital also facilitates capital formation. It may he in the form of a) direct private investment by foreigners, b) loans and grants by foreign governments, c) loans by international financial institutions. It helps several nations to achieve rapid economic growth.

12. Disguised unemployment: Disguised unemployment affects capital formation. It is prevalent in agricultural sector in developing countries. Surplus agricultural workers contribute nothing to production. Their marginal productivity is zero. So they must be transferred to non-agricultural sectors. They can be employed on various projects like construction of roads, Land and buildings etc.

Capital goods suffer from wear and tear. They cannot work forever.  They lose their efficiency in course of time. Hence it necessitates replacing them by new capital goods. Capital formation can take place only when the existing capital is maintained intact.

Capital formation in developing countries

Capital formation in developing countries like India is very low. Capital formation in these countries is very low because demand for and supply of capital are very low. The demand for capital is low due to the absence of :

  • a) adequate entrepreneurs,
  • b) skilled laborers,
  • c) transport and communications,
  • d) infrastructural facilities,
  • e) sound political conditions,
  • f) capital intensive methods,
  • g) effective demand,
  • h) extensive markets.

The supply of capital is low in these countries due to several reasons like,

  • a) low per capita income,
  • b) low level of savings,
  • c) poor banking and financial facilities,
  • d) absence of well developed stock exchanges
  • e) people hesitation to save,
  • f) presence of conspicuous consumption and demonstration effects.

 Hence, capital formation in developing countries remained very low.

Role of government in capital formation:

Capital formation can be increased by individuals and institutions. Besides, it can also be increased by the Government. In fact the government has to take a leading role in mobilizing and investing the savings m productive activities. In advanced countries capital formation can be promoted by individuals because standard of living, per capita income, entrepreneurial ability etc are very high. But the conditions prevalent in developing countries are entirely different. Majority of the people in these countries are very poor. Their per capita income, standard of living and level of savings are very low.

Hence, capital formation in these countries is low in these countries have to take steps for promoting capital formation. It has to take steps for encouraging the people to save. It has to establish banking and financial institutions for mobilizing savings and channelizing them into investment process. It has to frame a Proper tax policy for the promotion of industries. It must also develop infrastructural facilities for the promotion of industries. Thus, the government has to play a significant role in the economic development of under developed countries.

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