Home / Opinion / Columns /  Opinion | The slump that threatens to hold the economy to ransom

Early development economists made three important arguments about the trajectory of developing countries. First, economic growth is held back by low domestic savings in these countries. Second, the inability to export means that there is not enough foreign exchange to fund the import of capital goods needed for rapid industrialization. Third, countries facing these two structural constraints will need to absorb foreign savings to keep their economic engines running.

There is a faint whiff of these themes in some of our recent economic debates about the decline in the domestic savings rate, new-age export pessimism and the quest to float a sovereign bond in the international market to fund the fiscal deficit.

The Indian savings rate has declined by nearly seven percentage points since the North Atlantic financial crisis of 2008. The decline has been particularly sharp in recent years. The financial savings of households has also fallen as a percentage of gross domestic product, and the combined borrowing of the Union government, state governments and public sector entities such as the Food Corporation of India is already absorbing almost the entire flow of household financial savings. Given the domestic savings constraint, the proposed sovereign bond is a risky gambit to fund the fiscal deficit from foreign savings.

Meanwhile an overvalued exchange rate, stagnation in global trade and rising protectionism have stopped Indian exports in their tracks. The Indian balance of payments is susceptible to external shocks in these circumstances. The two swaps done by the Reserve Bank of India for $10 billion were as much about building a buffer as they were about expanding the central bank’s balance sheet to create more domestic liquidity.

A lot of Indian economic policy thinking in the 1950s was induced by a sense of export pessimism—till economists such as Manmohan Singh questioned these beliefs in the next decade. A more modern variant of export pessimism is now taking root.

India is right now in the midst of a sharp cyclical slowdown. Economic growth in the fourth quarter of fiscal 2019 was at its lowest in five years. The numbers for the first three months of the current fiscal year seem unlikely to be any better, especially if one goes by recent high-frequency data. The immediate problems associated with the cyclical slowdown—from low indirect tax collections to job losses—tend to overshadow the bigger problem of a structural slowdown in the Indian economy.

The country’s declining savings rate is a key risk here. There is no doubt that part of this is explained by the slowdown itself. Government as well as corporate savings tend to be pro-cyclical. Governments save more during episodes of rapid economic expansion because robust tax collections bring down the revenue deficit. Companies tend to save more during booms because of strong free cash flows. So it is quite likely that the overall savings rate will rise from current levels once the economy gets back onto the fast track.

However, household savings continue to be a mystery. As with almost every bit of Indian economic data, part of the decline may be explained by the savings of unincorporated enterprises that have formalized their operations having been reassigned from the household to the corporate sector. But that is unlikely to be the entire story.

The household savings rate is sensitive to demographics. The savings rate of a country tends to bulge when its working age population is at its peak. As reported in TheEconomic Times on 22 July, India moved into a demographic sweet spot in 2018. The working age population is now more than the dependent population. The newspaper added that this bulge in the country’s working age population will last till 2055, or for 37 years.

The fall in the Indian savings rate even as its demographic profile improves is puzzling. The most immediate explanation, as mentioned earlier, could be that lower savings are a result of slower economic growth. Families could also be saving less to maintain consumption levels, especially given the recent policy-induced shocks to the economy. But is that all?

There are several other potential explanations for the lower savings rate, ranging from a decline in inequality (which is unlikely) to a change in cultural attitudes to consumer debt (which is more likely). There is not enough research work done right now on the decline in the Indian savings rate. The government should be worried, because this is the old domestic savings constraint making a reappearance. In case the savings rate does not recover, then the next uptick in the investment cycle will quickly lead to current account pressures.

As this column had argued in August 2017, India has some similarities with East Asia and some with Latin America. The former model is clearly the more sustainable one. Which path India follows in the coming years will profoundly depend on its savings behaviour. The next instalment of this column will deal with this issue in more detail.

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

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