Why financial savings are losing out

What will make Indian savers abandon their fascination for gold and real estate, and put some faith in financial avenues such as shares, small-savings schemes and bank deposits? This has been the problem exercising India’s financial regulators in recent times.

The RBI’s Annual Report released this week tells us why there is so much anxiety on this subject. In 2011-12, financial savings of Indian households, as a proportion of GDP, plummeted to 7.8 per cent, a 20-year low. The financial savings pool has shrunk by nearly Rs 91,000 crore in the last two years, effectively diverting this money away from productive uses.

Evidence suggests that money being pulled out from financial products is being poured into the two quintessential favourites — gold and real estate.

It’s the returns, silly!

This trend may be disturbing, but there aren’t very many ways to reverse it. This is because what investors are doing is perfectly rational.

With inflation soaring, they are allocating more money to assets that have convincingly beaten inflation and less to those that are proving unequal to the battle.

Take small-savings schemes, mutual funds and shares, which have seen an outflow of money this past year. Small-savings schemes offer interest rates of 8.5-9 per cent, after their deregulation last year. That is lower than what bank deposits offer and falls well short of consumer price inflation, which hovers at 10 per cent.

Equities are supposed to be a great inflation-beater over the long-term. But that claim is wearing a bit thin, given that the Sensex has returned barely 4 per cent per annum over the last five years. The average equity fund has yielded only a slightly better 5 per cent.

Even bank deposits, which have been offering rates of 9-10 per cent in the last one year, aren’t particularly attractive, post-inflation. But individual savers have continued investing in them, probably for safety and the lack of other avenues.

In contrast to these, gold and real estate have been splendid at trouncing inflation. Gold, in rupee terms, has delivered a 23 per cent annual return for five years. Property prices, as captured by the NHB Residex, have delivered a 14 per cent return in the same period. Rents from property have added 2-3 per cent to those returns.

In fact, low interest rates and tax exemptions on home loans make leveraged property investments a sure-fire way to create wealth. Inflation makes the loan repayments more affordable over the years. Tax exemptions on the loan instalments reduce your taxable income. Your property value as well as rent gains, as inflation rises.

Taxes make it worse

The battle between real and financial assets is made even more unequal by tax policies which punish financial instruments.

Today, the interest you earn from fixed income avenues such as bonds and corporate or bank deposits is subject to tax at your tax slab.

After a 20 or 30 per cent tax, a 10 per cent return dwindles to 7-8 per cent, falling substantially short of inflation.

The systematic phasing out of tax exemptions on small-savings schemes in recent years has made these schemes even more unattractive than bank deposits.

Of the various financial products, equity investments alone enjoy favourable tax treatment, with short-term capital gains taxed at 15 per cent and long-term gains completely exempt from taxes.

But this tax ‘benefit’ can be used by investors only if stock markets deliver capital appreciation. At a time when most investors are sitting on capital losses, tax breaks on capital gains don’t seem so hot.

Contrast this with gold and property investments. Even if the investor is particularly scrupulous and declares his gold or property transactions to the taxman, capital gains on these assets are subject to tax, only after costs are indexed to inflation. This indexation benefit on real assets automatically reduces tax and lifts returns when inflation rules high. In practice though, gains made on investments in jewellery and real estate mostly escape the tax net.

After all, investing in jewellery or property does not require one to go through complicated Know Your Client norms or suffer deduction of taxes at source, as financial investments do.

It is common knowledge that a good portion of gold and property transactions happen in the grey market, completely escaping the tax net.

In a nutshell, therefore, the choice that Indian investors face is this: Buy financial assets, which offer uncertain returns, are taxed at high rates and make you walk over hot coals to qualify as an investor.

Or simply buy property and jewellery, where returns are hefty and it is possible to reduce or even completely side-step the scrutiny of the taxman. Can you blame them for their choice?

Bringing them back

What all this suggests is that bringing Indian savers back to financial products may require three kinds of regulatory action. One, reduce the tax arbitrage between financial and physical assets by reducing taxes on the former. Preferably, offer the benefit of inflation adjustments on returns from all financial products.

Two, improve tax compliance on jewellery and property transactions by plugging loopholes.

Three, don’t worry so much about what investors are doing and focus on the big picture instead.

A revival in the equity markets (or related vehicles such as initial public offers or mutual funds) cannot come about without a revival in corporate prospects. That in turn depends on the state of the economy.

Then there is inflation — not just the official numbers but what is actually being experienced by consumers. Bring that down and people will automatically save more.

Once the savings pool expands, there would obviously be less of a tug-of-war between financial and physical assets.

But given that these are precisely the problems that policymakers have been grappling with for well over two years now, the solutions may not be all that easy to come by.

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