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Shankar Acharya: The Savings-Investment miracle

A PIECE OF MY MIND

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Shankar Acharya New Delhi
Many factors contribute to economic growth of a country. Most economists would agree that one key determinant is aggregate investment. (Remember the famous Harrod-Domar growth model of the 1940s?). The faster the capital stock of a country increases the more rapid will be its rate of growth of national output. And investment, of course, depends crucially on the level of savings in the economy. India's remarkable growth of the last five years, at around 8.5 percent a year, certainly supports this view. Both savings and investment have recorded extraordinary buoyancy in this period. It's a largely untold story. So let's spend a little time on the basic numbers.
 
The table presents two-year averages of savings and investment (as a percentage of GDP) at five year intervals over the past two decades. A brief inspection of the table brings out the following highlights. First, the total investment rate hardly changed between the early 1990s and the first years of the current decade, holding steady at about 24 percent of GDP. In the next five years it surged dramatically to about 36 percent in 2005-07 (according to the government's "Advance Estimates" the level rose further to 38.4 percent in 2007/8). Second, this unprecedented increase in aggregate investment by 12 percent of GDP in five years was matched by an almost equal spurt in domestic savings from 23.6 percent of GDP in 2000-02 to 34.5 percent in 2005-07. Third, India has had very little recourse to net foreign savings (equivalent to the current account deficit on the balance of payments) throughout the entire period, especially in the present decade.
 
What explains this truly exceptional boom in aggregate savings and investment in India? To get a proper understanding, we need a good deal of serious research on this phenomenon. Till the scholars do their stuff, let me offer some preliminary thoughts. Let's approach the matter from the savings side and look at the components (see table, Fig 1 and Fig 2). The most important component of domestic savings in India is households (including unincorporated enterprises). The ratio of household savings rose fairly steadily from about 13 percent of GDP in 1985-87 to 22 percent in 2000-02, when it accounted for 93 percent of total savings. This steady increase may be attributed to several factors, including rising average incomes and the demographic dividend of a growing share of the population in the working age group. Yet, somewhat surprisingly, household savings contributed only an additional 2 percent of GDP over the most recent five years. The remainder of the 11 percent (of GDP) increase in total savings came from private companies and the public sector (government and enterprises).
 
Private corporate savings (consisting of depreciation provisions and retained earnings) more than doubled from 3.6 percent of GDP in 2000-02 to 7.6 percent in 2005-07 (in 2007/8 it may exceed 8 percent). This is an astounding increase, especially in view of the fact that this ratio never exceeded 5 percent of GDP in any year prior to 2004/5. It is, of course, consistent with the extraordinary growth in corporate earnings that has been witnessed in recent years. Even more impressive has been the surge in corporate investment from under 6 percent of GDP in 2000-02 to nearly 14 percent in 2005-07. By 2006/7 private companies accounted for over 40 percent of total investment, exceeding the peak share attained in the mid-1990s investment boom. Indeed, it is very likely that surging corporate investment was a powerful driver of much higher corporate savings. Either way, this exceptional episode should keep the seekers of causation busy for a long time.
 
The biggest contributor to the savings explosion after 2001/2 has been the public sector. Public savings went from minus 1.9 percent of GDP in 2000-02 to plus 2.9 percent in 2005-07, a massive turnaround of nearly 5 percent of GDP. As the table shows, the bulk of this improvement occurred in "government" (at all levels), with only a modest increase in the enterprise sub-sector. Among the factors responsible for this very welcome improvement in government savings were: the central fiscal responsibility law passed by Parliament in 2003; the proliferation of similar laws in state governments, triggered largely by the debt relief inducements recommended by the Twelfth Finance Commission; the buoyancy of state tax revenues resulting from the switch-over to VAT; and the tremendous increase in central direct tax revenues spurred by the massive growth of corporate earnings and fast-growing pay packets among the urban salariat.
 
To put it simply (and eliding over the complexities of a richer causal story), India's aggregate investment rose by an unprecedented 12 percent of GDP after 2001/2 because of an 11 percent increase in domestic savings, which came from the public sector (5 percent), private companies (4 percent) and households (2 percent). And all these numbers might look even more impressive after official data for 2007/8 become available.
 
The big question today is will this massive surge in savings and investment ratios continue into 2008/9 and beyond? The chances are that it won't and here's why. The household savings ratio will probably continue to increase gradually for much the same reasons that have prevailed over the last two decades, except that in 2008/9 we might see some moderation due to negative wealth effects stemming from lower asset prices (equity and real estate). The corporate savings boom is more likely to peter out as the industrial economy continues to slow in the face of global headwinds from the international credit crunch, domestic business cycles and high interest rates. Depending, obviously, on earnings performance, the ratio of corporate savings to GDP could easily drop below 8 percent. Central government savings will be impacted by the Sixth Pay Commission, the budget's income tax bonanza, slower growth in company taxes, farm loan waiver costs and rising major subsidies. Public enterprise savings will bear the brunt of growing oil sector "under-recoveries". On balance, public savings is likely to dip below 3 percent of GDP. Taken together, aggregate savings in 2008/9 may be in the range of 34-35 percent of GDP, compared to the 36-37 percent peak probably achieved in 2007/8. So aggregate investment could also drop one or two percentage points from the 2007/8 advance estimate of 38.4 percent of GDP.
 
In a nutshell, we are more likely to see a leveling off (or even a small decline) in the record levels of aggregate savings and investment attained by the Indian economy, rather than a continuation of further increases. Of course, we won't know for another 2 years when the official data for 2008/9 savings-investment estimates become public!
 
The author is Honorary Professor at ICRIER and former Chief Economic Adviser to the Government of India. Views expressed are personal

 

Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper

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First Published: Mar 27 2008 | 12:00 AM IST

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