The following points highlight the three main stages of capital formation. The stages are: 1. Creation of savings 2. Conversion of savings into investment 3. The actual production of capital goods.
Stage # 1. Creation of savings:
Capital formation depends on savings. Saving is that part of national income which is not spent on consumption goods. Thus, if national income remains unchanged more saving implies less consumption. In other words, in order to save more and more people have to curtail their consumption voluntarily. If people reduce their consumption savings will increase. If consumption falls some resources used in the production of consumption goods will be released.
Those resources can be reabsorbed in the industries producing capital goods. If a country devotes its entire resources to the production of consumer’s goods, there will be no resources for making producers’ goods. So, the making of producers’ goods involves the creation of savings or the curtailment of present consumption.
The creation of money-savings in a country depends mainly on the people’s ability to save and partly on their willingness to save. These two factors depend on a large number of factors like total income of the people, consumption expenditure, various individual motives as those of family affection, foresight, prudence, avarice and social prestige, the law and order situation in the country, investment facilities, rates of interest, etc.
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Similarly, the corporate saving is determined by the factors like taxation laws, legal requirements regarding reserve fund, profits, etc. Government saving is determined by the factors like government’s economic policy, needs for development expenditure, price level, tax resources, etc.
Stage # 2. Conversion of savings into investment:
However, generation of savings is not enough. Often people save money but this saving largely goes waste because saving is hold in the form of idle balance (as in rural areas), or to purchase unproductive assets like gold and jewellery. This is why society’s actual savings falls below its potential savings.
Thus, the generation of savings is just a necessary and not a sufficient condition of capital formation. To accelerate the rate of capital formation it is absolutely essential to convert savings into investible resources. Thus, the second stage of capital formation is concerned with channelizing the savings of the household sector and convert these into loanable funds.
These activities depend on money market, capital and share markets, banking and other institutional facilities, government machinery for ‘the mobilisation of savings, insurance and investment facilities. The greater the institutional facilities and greater the efficiency of these institutions are, the larger would be the mobilisation of the savings for productive activities.
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Banks and other financial institutions collect the savings of the community and make loans there-from to business firms. Thus, one of the preconditions of capital formation is the existence of a strong financial network consisting of banks and other finance companies which help to mobilise the savings of the public and enable investors to claim them.
Like individuals, companies also save. Most progressive organisations do not distribute their entire net profit after tax as dividends. A certain portion is retained for investment purposes. In fact the major portion of undistributed profit is ploughed back for expansion and diversification. In this case, banks and other financial institutions have hardly any role to play. Companies utilise their own surplus for investment purposes, i.e., to set up a new plant or factory or to buy a new machine.
Stage # 3. The actual production of capital goods:
This stage involves the conversion of money-savings into the making of capital goods, or what is known as investment. The latter, in turn, hinges on the existing technical facilities available in the country, existing capital equipment, entrepreneurial skill and venture, rate of return on investment, rate of interest, government policy, etc.
Banks and financial institutions convert the savings of the household sector into loanable funds. Such funds are acquired by business funds to purchase capital goods like plant, equipment, machinery, etc. When business firms borrow money at interest they do not keep the funds idle.
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They place order for machines and structures and make advance payments to the suppliers of capital goods. Thus the third stage of capital formation is concerned with the actual production of capital goods. The process of capital formation is not complete unless business firms acquire capital goods so as to be able to expand their production capacity.
Financiers live in a word of illusion. They count on something which they call capital of the country which has no existence. This is why in economics the term ‘investment’ is used to mean additions to the stock of tangible capital goods such as plant, equipment, structures or inventories.
When Kanoria Chemicals Ltd. builds a new factory or when Mr. X builds a new house, we say that an act of investment has taken place. In fact, capital formation refers to net investment in fixed assets, additions to the stock of real capital. Gross fixed capital formation includes depreciation; net capital formation excludes it.
However, in our day-to-day conversation we use the term investment rather loosely to mean buying a piece of land, an old security, or any title to property. In the true sense of the term, such purchases are to be treated as financial transactions or portfolio changes, and not as acts of investment. This is because what one is buying the other is selling. Thus, in economics investment refers to the creation of real capital.
Strictly defined, investment is expenditure on real capital goods. In this sense, it is the amount by which the stock of capital of a firm or economy changes, once we have allowed for replacement of worn-out capital. This simply means that the money savings of the community should be mobilised by the banking and financial institutions. Otherwise, these savings would remain idle or go waste and would not result in the creation of real capital (which could step up the volume of production in the country).
However, the mere existence of banks and financial institutions is not enough. This is no doubt important but does not guarantee an increase in the rate of capital formation. In the ultimate analysis capital formation depends on the existence of genuine entrepreneurs who are eager to make use of the savings of the community to create capital (investment) goods.
It is often said that the scarcest resource in developing countries like India is neither land nor capital but entrepreneurship. Due to shortage of this most important factor, savings of the community often remain idle. Since there is not sufficient demand for funds, commercial banks sometimes have excess reserves.
Conclusion:
It may be noted at the end that, all the three stages of capital formation are interdependent. The third stage assumes importance when the first two stages are complete.
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It is to be noted that, a high rate of capital formation is essential for accelerating the rate of economic growth, as the production of a larger amount of capital goods constitutes and strengthens the infrastructure of an economy. But, the rate of capital formation is found to be low in the developing countries like India owing to inadequate facilities for high rate of savings and investment.
In such countries the government, however, plays an active role in promoting capital formation through the expansion of public enterprises and through the increase in institutional facilities for saving and investment. The construction of roads and bridges, factories, canals and irrigation centres, soil conservation, transport system, etc., by the government can accelerate the rate of capital formation.
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