Encourage domestic savings to facilitate capital formation

By

Randeep Wadehra

At the micro level, savings are essential “account heads” of average Indian household budgets. Savings provide for various contingencies even as they act as hedge against inflation. At the macro level, savings are a reliable and affordable source for Gross Fixed Capital Formation (GFCF), which is so essential for the growth of not only big business houses but also for increase in production of goods and services by various medium and small scale business enterprises, not to mention the development of infrastructure and other national assets through government spending.  

It is estimated that households account for nearly two-thirds of gross domestic savings in the country. While nearly half of these household savings are in the form of financial assets 50% of the financial assets are in the form of bank deposits. Therefore, banks deposits play a vital role in the facilitating of a wide range of economic activities, which not only add to the Gross Domestic Product but also help generate employment opportunities for the county’s youth. Consequently, in order to raise its investment rate, the country should encourage household savings. The resultant mobilization of resources can help in the prevention of huge current account deficits in our national budget. Of late, certain policy decisions have adversely affected the momentum towards the formation of gross fixed capital through domestic resources. In order to check high inflation the Reserve Bank of India resorted to fiscal measures like raising bank rates which resulted in the increase in the cost of capital that has hurt private consumption, and adversely affected investments in various sectors of the economy. All these have led to a deceleration in gross fixed capital formation. It has been the experience that if the GFCF fall by 1% the potential GDP output declines by .02%.

We need to understand that the Gross Domestic Savings have fallen from the high of about 37% in 2008 to the present 32% or so – a trend that should be reversed proactively. Even as disposable incomes have been rising by 13% annually bank deposits have increased by about 5% only, thus indicating a decline in the popularity of traditional instruments of household savings like debentures, bonds and bank deposits. Clearly, people are hesitating from saving in financial assets because policies are not favorable. The trend has been reinforced by the high rates of inflation; hence greater preference for gold, which is considered a better bet against the onslaught of inflation.

The government has not been very imaginative in its policies to harness, sustain and employ the domestic resources for capital formation. For instance, it needs to be recognized that India’s household sector has been contributing substantially to the economy’s growth. The Gross Domestic Savings, at 32%, are among the highest in the world. 70% of these savings come from the household sector. These could have been used more efficiently to develop capital-formation instruments and structures. Instead, the focus has been on wooing foreign investors. Let us not forget that the media-hyped Foreign Direct Investments have never crossed the 5% mark of the Gross Domestic Savings; this, when incentives to the household sector have been measly when compared to those given to the FDI sector. For example, interest earned up to Rs. 10,000 on savings account has been made tax-free. But with average interest rate of 4% one will have to keep about Rs. 2,00,000 in the account to earn this interest – not a very attractive proposition. Instead, it would have been a better incentive to fully exempt interest on savings accounts, irrespective of the amount earned. Some of the other incentives, too, fall short of encouraging household savings, viz.,

1. An ungenerous amount of Rs 5000 on preventive health checkup will be available for deduction.
2. New investors with income below Rs 10 lakh investing up to Rs 50000 directly in equity markets will be able to claim a deduction of 50% under Rajiv Gandhi Equity Linked Scheme. 100% exemption would have been a better incentive. As it is, domestic savings are seldom mobilized for optimum use in the industrial and tertiary sectors.

Average Indian households have always shown a strong preference for investing in gold; given the inexorable rise in its market value the popular inclination makes sense. However, it is strange that investment in gold is categorized by our government as “consumption” and not savings! This may be because investment in gold is considered non-productive. It doesn’t, therefore, surprise us that the government not only does not encourage purchase of gold but has, of late, made attempts to discourage it altogether by levying excise duty etc. Nevertheless, it is an asset that acts like ballast to the economic security of families in the country.

A more imaginative approach would be to devise such policies as would encourage migration of gold from private lockers to corporate investment portfolios. A template already exists in the form of gold loans provided by some private banks and other financial institutions. It could be refined and made into an instrument for rewarding investments. This would mean providing for returns that offset both inflation as well as increases in prices of gold in the long run and, in the process, make various financial assets more attractive.

Published in Tehelka’s Financial World on June 6 2012