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Shyamal Banerjee/Mint
Shyamal Banerjee/Mint

What we owe the world; what it owes us

To get a better return out of our foreign assets, private citizens (including companies) should start investing in high return assets abroad

Buried deep in the current account statistics that the Reserve Bank of India (RBI) releases, is an innocuous looking item called “investment income". This number was a negative $26.6 billion for the year gone by. This is the net amount India paid to attract foreign capital last year. As a percentage of our gross domestic product (GDP), it has nearly tripled since 2008. Should India’s growth strategy and prosperity be determined by the benevolence of strangers from foreign lands?

We can do one of the two things with the income we make. We can either spend it or save it. Most of us would like to spend it as it gives us immediate joy and makes our quality of life better. But more than that, we tend to fear what could happen in the future when we stop earning. So, many of us sacrifice consuming our income now and save it for the future. The amount that one decides to spend versus save is quite complex, and not many have been able to unravel this mystery. Zhou Xiaochuan, the governor of People’s Bank of China, commented a few years ago that many factors, such as tradition, family features, demographic structure and social security system, determine the amount of money people save.

The reason the savings ratio—savings as a percentage of income—is important because if we spend more than we save, we will soon run out of things to buy. This is because the things we buy are produced in factories, which require savings to build them. When we run out of things to buy, inflation kicks in and we start spending our income faster as savings won’t generate enough returns to outpace inflation. At such times, interest rates are increased to incentivize people to save more, and the money is then used for capacity creation, eventually leading to increased supply of goods and services. Simultaneously, since we are unable to produce what we want to consume, we end up importing those goods. This means we need to also import foreign capital—either to pay for imports or to use it to set up factories. This foreign capital has a cost, which the country needs to pay to keep it within its shores.

The item called “investment income" is the amount of money we earn on our investments abroad less the amount of money we pay to attract foreign capital. At the turn of the century, our savings ratio was low and we needed a lot of foreign capital. Investment income then was nearly -1% of GDP (a negative figure means investment expense or the cost of keeping foreign savings within India). As our savings ratio improved, this number improved to -0.4% of GDP in 2007-08. Unfortunately, since then our domestic savings ratio dropped quite precipitously and our need for foreign capital has increased, resulting in the investment income dropping to -1.3% of GDP today. To put this number in context, it costs every Indian nearly $2 per month to keep this foreign capital in India.

One can imagine, unless we correct the course we are on, we remain vulnerable to global financial events. Currently, for every $100 we have invested abroad, foreigners have invested $170 in India. But we generate $1.4 for every $100 we have invested, and pay $3.8 for every $100 we attract. Now compare this with the US. For every $100 the US has invested abroad, foreigners have invested $128 there. But every $100 the US has invested abroad generates $3.3 and it pays only $1.8 on every $100 of foreign capital. Hence, it is not just important that India improve its savings ratio and generate surplus that can be invested abroad, but the way India invests abroad also needs to change. As of now, most of our investment abroad is done by the RBI, which holds foreign exchange reserves and conservatively invests it globally. To get a better return out of our foreign assets, private citizens (including companies) should start investing in high return assets abroad. This can then negate the negative balance in the investment income of the country.

Some would argue that we should not allow foreign capital to enter India. That would be quite detrimental to our growth. Foreign capital helps reduce cost of capital, generates jobs and income, and finally, brings technology. Why would we want to deny ourselves? The answer then is to not restrict foreign capital coming in, but to increase domestic savings and invest it judiciously abroad.

To improve domestic savings, the policymakers need to initially reduce the growth in consumption. Savings have to grow faster than the economy, which, in turn, must grow faster than consumption, in order to alter the ratio. To do this, taxes on consumption relative to savings have to be increased. Inflation needs to be controlled. Efficiency of financial services needs to be improved. Once these measures are taken, savings will increase rapidly. These can then be channelled into productive assets which will not only aid economic growth but will also support consumption due to improved returns on savings. Hence, for a better future, a little ‘consumption’ sacrifice in the near term is essential.

History is replete with ill-consequences of nations relying too much on foreign capital. Greece is a recent example, but a review of history will show nations that have lost their sovereignty due to their profligacy. As India is aspiring to be a nation for the world to admire, it is important that it implements sustainable economic policies. One such policy is to increase its savings, for no country can become prosperous by merely promoting consumption.

Huzaifa Husain is head-equities, PineBridge Investments.

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