RBI shouldn’t overlook the savings slide

As the Reserve Bank of India approaches its October policy review, market participants are divided on its rate outlook. Will the first monetary policy under Governor Urjit Patel kickstart with a rate cut? Or will the governor/ policy committee acknowledge the disinflationary trend but lay the ground for a move in December instead? We lean towards the former.

More downside surprises in inflation will spur calls for more rate cuts. However, this easing cycle needs to be balanced off with the need to preserve positive real rates and reverse the decline in savings. According to the International Monetary Fund (IMF), India’s gross savings rate has fallen to 31 per cent of GDP from 37 per cent eight years ago. Official data, with limited historical reference, shows a drop to 33 per cent of GDP in 2014-15, from 35 per cent three years prior. This compares unfavourably to China’s 49-50 per cent, which ironically faces criticism for not consuming enough.

Our reading is that the slowdown in India’s savings rate is more cyclical than structural. Unlike most of Asia, where rising incomes have been accompanied by a fall in savings, India’s per capita GDP is amongst the lowest in the region. Despite these low incomes, savings have been falling. Tough economic conditions, falling real returns and high inflation are other cyclical factors that have dented the piggy-bank.

But structural forces, especially demographics, are in favour of the economy. While Japan, China and many western countries grapple with ageing populations, India’s dependency ratio is declining. The working age-group (15-64 years) makes up close to two-thirds of the overall population. Growth in the working age population will exceed overall population growth for at least two more decades, pointing to a sustained fall in the dependency ratio.

Hence, even as structural tailwinds are in place, the savings rate continues to stagnate due to cyclical hurdles.

To reveal where the problem lies, we need to examine the economy according to sector. The private sector (households plus corporates) is the main driver of total savings, while the public sector has been a drag. Within the private sector, households are the main source of savings. More recently, this sector has been the main drain.

Households now make up 60 per cent of overall savings, down from 70 per cent four years earlier. A combination of factors is behind this slowdown. Due to low incomes and extended periods of high inflation, households have been forced to set aside more of their income for consumption, and less for savings.

Not surprisingly, household savings now make up less than a quarter of their disposable incomes, down from above 30 per cent earlier.

Interest rates, inflation and demographics also affect household savings. India’s demographics are amongst the most favourable in the region, albeit negated by years of high inflation and negative real rates. Secondly, interest rates were raised in response to high inflation in 2011-13, but failed to turn negative real deposit rates positive. Moreover, WPI inflation was a policy target back then, rather than a much elevated CPI inflation today. This meant real deposit rates were deeper and longer in the red than earlier understood.

In addition to falling household savings, its composition is also imbalanced. In recent years, two-thirds of household savings comprised physical assets. This was driven by a need to offset inflation, but led to a ballooning current account deficit and lower investment. Last year, some of this imbalance was corrected, but physical assets continue to dominate the savings mix. The marginal increase in financial savings has also been concentrated in shares and debentures, insurance and retirement funds rather than bank deposits.

The drawdown in household savings is partly offset by smaller fiscal ‘dis-saving’ and higher private corporate buffers.

In the past, the Government was a persistent ‘dis-saver’ owing to sizeable fiscal deficits. As fiscal consolidation takes precedence, this segment became a smaller drag on total savings. At the same time, private corporate savings also improved, with non-financial entities offsetting the weakness in financial sector / bank profits.

Unlike in the past when private sector savings rose on strong profitability, today’s increases were attributed to delayed spending plans and a push to mend balance sheets.

Plainly, the fall in savings needs to be arrested given India’s investment needs. Relying on foreign savings puts pressure on the current account and the returns from that investment go abroad as well. India’s current account came under pressure in 2011-13 when investment growth rose at a much faster clip than savings. More recently, investments have decelerated in tandem with the savings rate, also reflected in the narrower deficit. In this light, the markedly narrower 2Q16 deficit was a mixed bag, as non-oil non-gold imports — often seen as a proxy for investment demand — continue to moderate.

Corrective measures are under way to lift savings and investment, but a quick turnaround is unlikely. First, rates fall across the board when inflation eases. Keeping an eye on preserving their margin incomes, banks would lower deposit rates first, before they pushed lending rates down. With more than half of financial savings in bank deposits, lowering rates can lead banks to further alienate savers.

Keen to mobilise deposits, the central bank wants to keep real rates positive, preferably within an ideal 1.5-2 per cent range. This has met with some success. With inflation declining faster than rates in the past two years, households have parked more funds in financial assets rather than in physical assets. But this increase has been painstakingly slow.

Second, in addition to real rates, nominal returns on term deposits also influence savings decisions. An effective inflation-targeting policy anchors price expectations, which in turn moderate expectations on nominal returns, and lead to a recovery in the savings rate. Higher incomes due to a good monsoon and public-sector wage increases will also be helpful.

Finally, an increase in currency in circulation has also hurt deposit growth. While this trend is logical in a high-inflation environment, higher demand for currency is occurring at a time when inflation is falling.

Various reasons have been cited for this anomaly, including intermittent State elections, festive demand, higher wages or, by contrast, uncertainty over employment outlook and so on.

The authorities will be keen to reverse this trend which can get a hand from the broader push towards financial inclusion, especially in the rural areas.

In sum, the overall push to steer household savings away from physical assets into financial avenues is bound to continue.

This is important not only to meet investment spending needs, but also to ensure efficient savings for growth and limit external imbalances. On policy, further significant rate cuts are unlikely in the interest of maintaining positive real and nominal deposit rates.

The writer is an economist and vice-president of DBS Bank, Singapore