Despite India's high savings to GDP ratio, every effort is made to attract foreign capital. There is obviously a problem of financial intermediation of domestic savings.
There are many paradoxes attached to Indian savings. At over 30 per cent, India has one of the highest savings/GDP ratios in the world. Yet, firms have been raising cheaper capital abroad, in the low-saving economies of the West. Small firms also find it difficult to finance their needs, while exclusion from the formal financial system is widespread.
What is equally paradoxical is that our policymakers point to the high domestic savings to also calculate a high potential growth rate. An incremental capital-output ratio of 4, with capital availability of 40 per cent of GDP (based on a peak savings achievement of 36 per cent plus a current account deficit of 4 per cent), gives a 10 per cent rate of growth.
At the same time, despite these high savings, every effort is made to attract foreign capital. If it is domestic resources that is making growth possible, why is more foreign capital so essential? A figure of Rs 40 lakh crore is floated as required for infrastructure investment over the next five years. But since the safe level of the current account deficit is about 3 per cent of GDP, not more than one-fourth of this can come from abroad. Foreign borrowing could be large in absolute numbers, but is dwarfed by the share of domestic resources required.
What this means is that the Government should be spending most of its energy on improving the financial intermediation of domestic savings.
More household savings should pass through the formal financial sector. Financial inclusion can increase the share of financial savings. Large mobile penetration offers the opportunity to develop complementary institutions and finally achieve inclusion. But these opportunities are poorly utilised as yet. In the absence of financial inclusion, the government's large rural spend has actually reversed financial intermediation. The currency-deposit ratio, which had been steadily falling, increased over 2008-10, as more income went to people excluded from the banking system.
After 20 years of financial reforms, the percentage of household financial savings in stocks and debentures, including through mutual funds, have shrunk from a pre-reform 20 per cent to as low as 5 per cent. Physical savings constitute half of domestic savings and the large household stocks of gold are not even part of measured physical savings.
Intra-day trade and foreign portfolio flows dominate Indian equity markets. Allowing pension and insurance funds to invest in stocks could be one way of increasing household savings that are invested in markets. This type of savings also provides essential long-term finance for infrastructure.
INSTITUTIONS AND SYSTEMS
Technology cannot deliver alone. There have to be other institutions and systems to suit and adapt to Indian conditions. For example, deeper thought should be given to why the mutual fund model is not bringing in household savings. What is the proper role of brokers and of commission fees?
Can competitive fees for genuine services be combined with tighter systems? One could probably increase the time for cheque clearance in relation to IPOs, thereby reducing households' need to authorise brokers, which can be misused.
Information on low-cost financial alternatives such as index funds could be made available on websites. These websites on financial products can be ranked or rated by the Government or a rating agency.
The mobile equivalent of savings instruments, which works because it meets real needs, is yet to be developed. Households need secure inflation-indexed instruments that deliver decent returns. Despite rising interest rates, inflation gives households negative real interest rates on their savings.
The private sector under-provides financial innovations, since copying reduces returns to the risks on costly product innovation and development. Households associate government securities (G-secs) with security. Government-led product innovation, more clearly linked to G-secs, may work. It is also the most stable way for the government to borrow. In Japan, government debt is domestically held – unlike in Greece, where it is with foreign banks.
The supply of G-secs is very large in India, but banks hold the bulk of this as a statutory requirement (SLR). Since it is not marked-to-market (MTM), interest rate risks are not hedged, preventing an active debt market from developing.
It illustrates how a valid practice gets locked in, even when it has become dysfunctional. A system designed for one regime continues in another.
In 1985, the Reserve Bank of India (RBI) provided for valuation of held-to-maturity securities at cost prices in order to facilitate movement to-market determined interest rates.
This would mitigate the erosion in value of SLR G-secs from the expected rise in rates. But the system continues even in 2011, when two-way movement in interest rates is established. There is strong resistance from some banks to a fall in the MTM share of SLR securities.
The absence of an active G-secs market also makes it difficult for the RBI to conduct Open Market Operations and fine-tune liquidity. As domestic savings do not enter and interest gaps widen in narrow markets, firms borrow abroad. India's short-term debt, as a proportion of its total external debt, has reached 40 per cent in terms of residual maturity, at a time when international markets are stressed.
(The author is Professor of Economics, IGIDR, Mumbai. email@example.com)