Savings and investments go together

The Economic Survey sets the tone for the Union Budget. One of the key areas discussed in the Survey this year is GDP growth. For FY18, the survey has projected growth at 6.75 per cent in contrast to the Central Statistical Office (CSO) advance estimate of 6.5 per cent released on January 05, 2018. This shows that the same government within a period of three weeks has two figures. Apart from this, the RBI has another set of estimates with a growth rate of 6.7 per cent. There is a lack of coordination within the government and between the policy makers. This is a serious credibility issue. Which figure should you believe? While providing a forward guidance, the Survey has set out a growth rate at a higher level at 7.75 per cent. Thus, there is a lot of optimism from the government to move the Indian economy to a higher growth trajectory of 8-10 per cent,   as the Survey analysis points out.

In the above context, the moot question is how do we move to a higher growth trajectory? Simply speaking, economic growth is a function of investment limited by savings. Therefore, both savings and investment contribute to growth. The authors of the Survey, taking shelter of theoretical literature and country experiences and episodes, have given a key message, which is that the standard solution that says savings and investment both need to be tackled simultaneously does not work successfully and a simultaneous pull is not necessary.

It is pertinent to note that the investment slowdown started in 2012, intensified in 2013 and 2014 and is continuing as of 2016. Similarly, a savings slowdown started in 2010 and that, too, seems to be continuing. The Survey argues that the cross-country experience suggests that the investment slowdown does have a significant impact on growth, while the impact in the case of savings slowdown is insignificant. India’s investment slowdown has unfolded much more gradually than in other countries, keeping the cumulative magnitude of loss at moderate levels so far. India’s investment decline stems from balance sheet stress, making it particularly difficult to reverse. In view of this, one of the key messages from the Survey is that raising investments is more important than raising savings to reignite growth. The argument thus follows: “The ‘animal spirits’ need to be conjured back”.

A low level of investment in recent years has been associated with many structural weaknesses. One such is the ‘Twin Balance Sheet’ (balance sheet of the banks and balance sheet of the corporates) problem and this is being addressed by the government and the RBI. However, it is important to recognise that any increase in investment rate (Gross Capital Formation as a percentage of GDP) needs to be accompanied by enhancement of savings rate (total savings as a percentage of GDP). In other words, investment needs financing and financing is savings.

Savings is the source of investments. Investments cannot happen in a vacuum. The former will feed the latter. The cart cannot be in front of the horse if the wagon has to move, let alone pick up pace. We may therefore say that the argument put forth in the Survey that investment may happen without savings is erroneous.

At a technical and conceptual level, the issue is not investment vs savings as the Survey has highlighted but the sustainability of the magnitude of foreign savings in terms of current account deficit (CAD) in the external sector and financing of CAD through foreign equity flows. As technical studies in RBI point out, in India’s case, 3 per cent of the CAD-GDP ratio is sustainable for achieving 8 to 9 per cent growth and 60 per cent of this level of CAD should be financed by FDI.

Furthermore, a higher magnitude of investment itself does not ipso facto translate into higher growth. It is important to recognise that the underlying issues relate to productivity. In this context, efficiency and productivity of capital employed is critical. One such concept in this context is Incremental Capital Output Ratio(ICOR) which measures the productivity and efficiency of capital. In the Indian context, ICOR at its historical level is four, implying that four units of capital (investment) produces one unit of growth. Globally, ICOR varies between two and five. In India, authorities should therefore also focus on the efficiency of investment and certainly not investment per se as the survey has argued.

Since savings finances investment, the authorities cannot in an operational sense ignore savings.  Enhancement of domestic savings from three sources viz; households, private corporate and public sector is critical. In this context, it is important to mention that in the public sector, the government is a major ‘dis-saver’ as it perennially records a revenue deficit. Therefore, in order to enhance savings, on a priority basis, the government should eliminate revenue deficit. Secondly, CAD as mentioned above, will be growth supportive if it is recorded at sustainable levels, not taking in to account oil and gold imports. Thirdly, the increase in household savings critically depends upon higher (post tax) positive real interest rate. This critically hinges on a) inflation management and b) a level playing field in personal income tax exemptions offered in various savings instruments. For an example, capital gains on mutual funds attract zero tax while bank deposits incomes are taxed at source.

To conclude, for the Indian economy to move to a higher growth trajectory, it is not a debate of savings vs investment, as the Economic Survey has tried to present. Truly, it is savings and investment complementing each other.

(Pattnaik is a former central banker and faculty member at SPJIMR)