THE IMPACT OF CAPITAL FORMATION ON ECONOMIC GROWTH IN NIGERIA

ABSTRACT

Capital formation is one of the major determinants of economic growth. Literature is replete with the extent to which capital formation can engineer the growth of nations. There is a conventional perception that the most pertinent obstacle to economic growth is shortage of capital. This work analyses capital formation and its impact on the Nigerian economy. The work studies the extent to which capital formation effects economic growth in Nigeria. Making use of the classical linear regression model (CLRM) through the ordinary least square (OLS) method, the impact of capital formation on the Nigeria’s economic growth was examined. The result showed that capital formation has a significant impact on economic growth.

The work goes further to analyse the determinants of capital formation in Nigeria as understanding these determinants is a crucial prerequisite in designing a number of policy interventions towards achieving economic growth. This is important because the level of impact of capital formation on economic growth depends on the intensity of its determinants. The result showed that the significant determinants of capital formation in Nigeria are the level of financial development (proxied by the market capitalization of the Nigerian Stock exchange) and gross domestic product (GDP).The work also makes some important policy recommendations.

CHAPTER ONE

INTRODUCTION

1.1           BACKGROUND OF THE STUDY

Capital information refers to the proportion of present income saved and invested in order to augment future output and income. It usually results from acquisition of new factory along with machinery, equipment and all productive capital goods. Capital formation is equivalent to an increase in physical capital stock of a nation with investment in social and economic infrastructure.

Capital naturally plays an important role in the economic growth and development process. It (capital) has always been seen as potential growth enhancing player. Capital formation determines the national capacity to produce, which in turn, affects economic growth. Deficiency of capital has been cited as the most serious constraint to sustainable economic growth. It is therefore not surprising that the analysis of capital formation has become one of the central issues in empirical macroeconomics. One popular theory in the 1970s, for example, was, that of the “Big Push” which suggested that countries needed to jump from one stage of development to another through a virtuous cycle in which large investments in infrastructure and education coupled with private investment would move the economy to a more productive stage, breaking free from economic paradigms appropriate to a lower productivity stage. Growth models like the ones developed by Romer (1986) and Lucas (1988) predict that increased capital accumulation can result in a permanent increase in growth rates.

The relationship between capital formation of the nation and economic growth has been documented in a number of empirical investigations. The result which has been found in several analyses is that causality exists between capital accumulation and economic growth.

Nevertheless, understanding the determinants of the capital formation is a crucial prerequisite in designing a number of policy interventions towards achieving economic growth. The process of capital formation is cumulative and self-feeding. It involves three inter-related conditions; (a) the existence of real savings and rise in them; (b) the existence of credit and financial institutions to mobilise savings and to direct them to desired channels; and (c) to use these savings for investment in capital goods (Jhingan, 2006). Therefore, we can understand that savings is the major determinant of capital formation. It is widely believed that an increase in the proportion of national income devoted to capital formation is only one avenue for growth. Therefore people are encouraged to save more than to consume more, because a growing economy requires a constant flow of fund for investment in other to assure a supply of capital goods adequate for production of consumer goods and replacement of obsolete equipment.

However, government restrictions imposed on financial institutions such as interest rate ceiling, high reserve requirement, etc, restrain the process of financial intermediation and consequently, impede economic growth. Greenwood and Jovanovich (1990), stressed the role of financial intermediaries in pooling funds and acquiring information that enable them to allocate capital to its highest use-value, thereby, raising the average return to capital.

1.2     STATEMENT OF PROBLEM

Capital formation is a concept used in macro-economics, national accounts and financial economics. It can be defined in three ways:

Ø It is a specific statistical concept used in national accounts statistics, econometrics and macroeconomics (Wikipedia Encyclopaedia). In that sense, it refers to a measure of the net additions to the (physical) capital stock of a country (or an economic sector) in an accounting interval, or, a measure of the amount by which the total physical capital stock increased during an accounting period.

Ø It is used also in economic theory, as a modern general term for capital accumulation, referring to the total “stock of capital” that has been formed, or to the growth of this total capital stock (Wikipedia Encyclopaedia).

Ø In a much broader or vaguer sense, the term “capital formation” has in more recent times been used in financial economics to refer to savings drives, setting up financial institutions, fiscal measures, public borrowing, development of capital markets, privatization of financial institutions, development of secondary financial markets(Wikipedia Encyclopaedia). In this usage, it refers to any method for increasing the amount of capital owned or under one’s control or any method in utilising or mobilizing capital resources for investment purposes. Thus, capital could be “formed” in the sense of “being brought together for investment purposes” in many different ways. This broadened meaning is not related to the statistical measurement concept nor to the classical understanding of the concept in economic theory.

Economic growth, on the other hand, is the increase of per capita gross domestic product(GDP) or other measure of aggregate income. It is often measured as the  rate of change in real GDP. Economic growth refers only to the quantity of goods and services produced. Economists draw a distinction between short-term economic stabilization and long-term economic growth. The topic of economic growth is primarily concerned with the long run. The short-run variation of economic growth is termed the business cycle.

The long-run path of economic growth is one of the central questions of economics; despite some problems of measurement, an increase in GDP of a country is generally taken as an increase in the standard of living of its inhabitants (Snowdon, B. And Vane, H., 2005). Over long periods of time, even small rates of annual growth can have large effects through compounding. A growth rate of 2.5% per annum will lead to a doubling of GDP within 29 years, whilst a growth rate of 8% per annum (experienced by some Four Asian Tigers) will lead to a doubling of GDP within 10 years. This exponential characteristic can exacerbate differences across nations (Miles D. and Scott A., 2005).

Capital has always been seen as growth enhancing player. There has been a problem of vicious circle of poverty that tend to perpetuate the low level of development in LDCs and it stems from the fact that there is low level of productivity in LDCs due to deficiency of capital. The classical economists who were interested in the development problems of their time specified capital as one of the crucial variables in the development process. They specified that high productivity could be achieved only if more tools and machinery were made available for production. Thus Nurske (1951), states that the vicious circle of poverty in underdeveloped countries can be broken through capital formation. Also Richard Lipsey (1979), on the other hand, recognised capital as one of the factors affecting development. He states that “as long as a society has unexploited investment opportunities, productive capacity can be increased by increasing the stock of capital”.

Over the years, the growth rate of capital formation in Nigeria has not been satisfactory. It has always been very low and often negative. Capital formation as a percentage of GDP has also been very low. This brings about capacity under-utilization as resources (human and material) will not be adequately mobilized to bring about substantial economic growth. In the drive towards rapid economic growth and the Nigerian vision of being one of the twenty biggest economies in the world come 2020, expert opinion is that the economy should be growing at the rate of at least 15 percent per annum (Soludo C. C., 2010). Such growth can only be possible if there is continuous increase in the capital stock of the nation to be brought about by massive public and private investment in the country.

The table below and the charts that follow is a summary of the performances of output (represented by the GDP at current prices) and capital formation (represented by Gross Fixed Capital Formation) in Nigeria for the periods under study.

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