If India is to grow at the rate the government wants, it will need to invest more and invest wisely. A long list of financial sector reforms to make this possible are desirable and feasible, as I argued in my last column. The current process of identifying and implementing financial sector reforms has been going on for almost two decades, although earlier efforts began soon after the original trade and industry reforms of 1991. But the cost of capital in India is considerably higher than it needs to be. This reinforces the point that financial sector reforms in India have to do more. What is effectively a penalty or tax for India’s firms that seek productive investment was more tolerable when the global cost of capital was unusually low. That situation has changed, so reducing the investment cost penalty in India is becoming more urgent.
Many governments are running higher deficits than before the Covid pandemic, and there is an enormous demand for funds to finance a rapid buildout of AI infrastructure. India will have to work harder to attract foreign investors than in the recent past. Perceptions of increased geopolitical risks, mostly the result of decisions taken by the current US administration, will encourage capital to stay closer to home. India also has to tap domestic sources of capital. The government invests in key components of public infrastructure, though it is a net dissaver. Firms also invest from their retained earnings. Both also rely on the savings of the population at large, that is, households.
The Raghuram Rajan report of 2008 formed the basis for later financial sector reforms, especially when Rajan became RBI governor in 2013. A month before he stepped down from that job in 2016, a Committee on Household Finance, headed by Tarun Ramadorai, was established, and submitted its report the next year. Many of that committee’s recommendations echoed other ideas for financial sector reform — streamlining regulation, improving financial sector technology and adopting it more widely, improving financial literacy, and so on. But a core emphasis of the report was the desirability of shifting household savings from physical assets to financial assets.
The underlying idea is, of course, that when households put money into bank accounts, pension funds, stock markets, and insurance policies, this money becomes potentially available to private firms that can make productive investments. There is no guarantee that this will occur, but if household savings are locked away as gold jewellery, that potential is zero. Physical holdings of gold by households are culturally important, so changing that behaviour will take time. But in any case, the largest category of physical assets within household savings is real estate — that is, housing. Like gold, real estate is a traditional hedge against inflation. This is true not just in India. As long as rental and sales markets for housing function well (so that buildings do not sit empty), having a better housing stock can have major positive welfare consequences, so sacrificing those benefits for investment in private sector firms comes at a cost.
A major development in India has been the opening up of housing finance, so that households do not have to wait most of their lifetimes to save enough to buy or build a house. This has contributed to a fall in the net savings of households, since they are borrowing more to have their own places to live. But households are now also able to buy a wider range of goods and services on credit. What they can do depends on their income levels, of course. Buying a vehicle or a refrigerator on credit may also have significant positive welfare effects, so these new opportunities for “consumption smoothing” should not be dismissed. These kinds of consumptions can also increase individual productivity, although this is hard to measure.
Given all these nuances, if the government wants to make household savings a bigger part of the investment needed to finance growth, what can it do? The answer, in the abstract at least, is surprisingly simple. Households will save if they have opportunities to do so that have low transaction costs, low risk, and reasonably high returns. Indian policymakers can do much more, and act much more quickly, to expand the options for pension plans and “defined contribution” retirement savings plans. Providing tax advantages for retirement savings is an important part of this policy imperative.
The Ramadorai committee also emphasised the importance of new and expanded vehicles for retirement savings. The details of making this happen are non-trivial — new risks can arise for savers and for the custodians of these funds if institutional design is deficient. But there is so much domestic and global experience to draw on, that institutions and policies can be crafted and implemented quickly. Well-designed retirement savings plans will compete more effectively with physical assets as destinations for household savings.
To the extent that individuals are rational economic decision-makers, the current state of household savings in India is a message to the government that its policy mix is not what it should be. Households need to be incentivised to increase their long-term savings in financial assets that have the risk-return characteristics they seek. This increased saving can help finance the growth that the government is seeking.
The author is Professor of Economics, University of California, Santa Cruz.
Disclaimer: The views expressed are the author’s own and do not reflect the official policy or position of Financial Express.