(Photo: Mint)
(Photo: Mint)

Opinion | A virtuous cycle to achieve a higher growth trajectory

Fiscal consolidation is a must to lower state borrowing and make better use of domestic savings

India’s most recent golden period of high economic growth was 2003 to 2008. The average annual real growth during this period was 8.7%. This period was marked by increasing investment, both by the public and private sectors, rising domestic savings, fiscal consolidation, moderate inflation and low interest rates. There was an element of a virtuous cycle between all these factors: i.e. a lower fiscal deficit leading to lower interest rates and public borrowing, which left extra room for private investment. These domestic macroeconomic developments were also blessed by a global boom in growth, with increased trade, liquidity and financial flows. This story is well known, and most recently reported in a persuasive and scholarly research report by Rakesh Mohan, titled Moving India to a New Growth Trajectory. The main thesis of the report is that, for India, it is imperative to achieve a sustained growth rate of 8 or 8.5% as an almost exclusive focused priority. The report also spells out what needs to be done to achieve that growth. Undoubtedly, the golden phase of 2003-08 was a confluence of both circumstances and conscious policy. For instance, the Y2K global phenomenon provided a shot in the arm to India’s blooming software industry. The domestic tax holiday for the sector provided crucial support. It must be added that what the government may have lost in terms of corporate taxes from software exporters due to this tax holiday was more than made up through income taxes from the sector’s employees. In its heyday, the industry claimed that nearly 40% of all individual income tax collections came from employees of this sector alone. Similarly, the national highway development programme got a huge impetus thanks to earmarked financing from a one-rupee-per-litre cess on diesel and petrol. This was a policy innovation that provided a direct and indirect boost to growth without denting the fisc. It’s ironic that the biggest contributor to the diesel cess was the Indian Railways, being the largest single-entity consumer. Thus, the Railways was contributing to the development of its rival. But all this worked well within a well-designed policy mosaic.

The lesson from that golden growth phase is that stepping up private and public investment is an inescapable prerequisite for high growth. This in turn is financed by both domestic and foreign savings, although the dependence on the latter should not be excessive. That’s because foreign inflows impact currency and financial stability, and are not as reliable as domestic savings. There can be sudden reversals, as seen during the taper tantrum.

This brings us to the question of how to raise India’s domestic savings rate. As Mohan’s report points out, during 1997 to 2003, the period just before the golden growth phase, aggregate savings saw a dramatic turnaround. There was a 4-percentage-point increase in private corporate savings, and a similar increase in those of the public sector. This, coupled with a 2.5-percentage-point increase in the household sector, led to a peak domestic savings rate of 36% of gross domestic product (GDP) in 2008. The peak investment rate was 38%, which meant a foreign dependence of only two percentage points. These numbers had begun to look like the “Chinese" high growth numbers. This was a matter of great distinction for India, since unlike its East or South East Asian peers, its current and trade accounts have always seen deficits. Hence, dependence on foreign capital is a given. India’s high savings rate was also a matter of satisfaction because it was achieved without the coercive element of contractual savings like in other Asian economies.

The one big lesson to be learnt from this phase is the reinforcing impact of fiscal consolidation, lower interest rates, higher savings and investment and high GDP growth. To this combo, if we add the prescription of improving the ease of doing business, and a priority focus on investment in human capital (health, education, and research and development), we will have an Indian version of the East Asian miracle. Even though the world’s growth may not be the same as the boom period of 2003-08, the smaller share of India in global exports and the recent success of countries like Bangladesh and Vietnam give us enough reason for export optimism. But achieving such growth needs a boost in savings.

And that is exactly where we have slipped badly. The aggregate savings rate has fallen by around 4 percentage points since 2008. But most worryingly, household sector savings have dropped by 4 percentage points. And almost all the slippage is in financial savings. Investments in gold, real estate and other non-financial savings have gone up. The scandals in capital markets and the broken promises of mutual funds are not helping. Bank deposit growth is in single digits, the lowest in more than a decade. On top of this, aggregate public sector borrowing is close to 10% of GDP. This means, it entirely eats up our already declining household sector savings. So, private investment has to fend for itself, or interest rates have to be higher to address the savings shortage. Or else, we will have to depend on fickle foreign flows, with the attendant risk of sudden stops. Unless we recommit and pledge ourselves to renewed fiscal consolidation, we won’t be able to return to that virtuous cycle of lower deficits and interest rates and higher investment and savings. Along the way, a depressed real exchange rate will help too. This is the first prerequisite for India to achieve a higher growth trajectory.

Ajit Ranade is an economist and a senior fellow at the Takshashila Institution