Needed: UTI 2.0

Indian policymakers have gold on their mind.

In January, the government raised the tax on gold imports to discourage people from bringing in the yellow metal. India is this year expected to import around $40 billion of gold, a significant expense for an economy with a large import bill which is not adequately covered by export revenues, making India highly dependent on foreign capital inflows for economic stability.

Why are people buying gold? One reason is that it has proved to be a good hedge against high inflation in recent years, but perhaps the reasons run deeper.

The influential council of economists advising Prime Minister Manmohan Singh has pointed out in a recent report that there has been a shift of household savings from financial to physical savings such as gold and real estate in the past few years, equal to about 1.6 percentage points of gross domestic product. The quick estimates of national income for 2010-11 were released by the Central Statistics Office in January. The data showed that household savings in financial savings actually fell by Rs 67,867 crore while household savings in physical assets went up by Rs 1,78,139 crore. This is not the same as people putting their savings under the mattress, but one can think of it as an analogous problem.

This switch from financial to physical savings comes at a time when the gross savings rates of the government (including departmental undertakings such as the railways) and the private corporate sector have fallen, because of factors such as the increase in the fiscal deficit, the weakening of railway finances and the deterioration of corporate balance sheets, respectively.

The combined effect of these three changes—a higher fiscal deficit, lower corporate savings and the switch of household savings towards physical assets—has reduced the pool of domestic savings needed to fund our economic growth. “There is a need to alter the investment–savings dynamic in a manner that can lead to higher rates of fixed investment financed from a reduction in the government’s negative savings, less of surpluses being expended in subsidies in the public sector companies and improvement in the mobilization of household financial savings by organized savings institutions,” said the advisory council headed by former Reserve Bank of India governor C. Rangarajan.

The gold bug has deep roots in history. The fascination for physical assets is not some recent phenomenon. Indian households have traditionally put aside around half their annual savings in stuff such as gold and real estate. One reason for this is that the underdeveloped financial system in India ensures that households do not have a rich array of financial products to choose from. Another factor is financial repression, with the government having an incentive to keep interest rates low so that it can borrow cheaply from the banks to fund the fiscal deficit. Neither financial underdevelopment nor financial repression encourages people to invest most of their savings in the organized financial sector.

Another puzzle is the overall lack of interest in the stock market. Very few Indians have actually taken full advantage of the rise in equity prices over the past 25 years. The committee on investor awareness and protection chaired by D. Swarup mentioned in its report that the number of Indians with either direct or indirect exposure to equities was a mere eight million in 2009. And that figure has not increased over the past decade; perhaps it has even fallen. Ordinary investors have clearly gone into a shell thanks to volatile prices, misselling of financial products and scams. What this means is that very few Indians have an investment exposure to the recent growth story.

Getting more household savings into the financial system, and especially into risk assets, is an urgent task. My guess is that India currently needs a bridge financial product, between the riskless bank deposit that offers negative real returns and plain vanilla equity instruments that are prone of volatility. The Unit Trust of India (UTI) provided such a bridge at one point of time by promising stable returns backed by a quasi-sovereign guarantee. The US 64 scheme had design flaws that eventually led to an expensive collapse around 10 years ago, but there can be little doubt that its units were successful in getting middle-class savings into the stock market.

The mutual funds and insurance industries would do well to put some financial engineering skills on the job, perhaps through the use of the options market. Ordinary savers have good reason right now to keep a large part of their portfolios in physical assets. Not much will be gained by complaining about what seems to be rational behaviour from households that seek to protect their net worth when there is high inflation, low real returns on financial products and robust memories of stock market busts.

Can UTI 2.0 be the answer?

Niranjan Rajadhyaksha is executive editor of Mint. Your comments are welcome at cafeeconomics@livemint.com

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