The policy constraint

Several generations of economics students have been taught that a defining characteristic of an underdeveloped economy is a low savings rate.

Left to itself, such an economy cannot raise enough resources to invest its way to faster growth and quicker affluence. Development strategies have therefore been built around ways to fill the "savings-investment gap".

Many of these strategies have been debunked by the comparative growth experience of the last four decades, which have showed that appropriate domestic policies can create a viable environment for foreign investment, which would then break the domestic savings constraint.

However, the concern about a low domestic savings rate has not fully disappeared and many people still keep close tabs on it as an indicator of future growth performance.

Against this backdrop, the latest numbers on savings and investment released by the Central Statistical Organisation (CSO) last week throw up something of a paradox.

For the year 2003-04, savings were estimated to be 28.1 per cent of GDP, up from 26.1 per cent in the previous year. This was largely a result of a significant reduction in negative savings by the consolidated public sector.

However, the most striking feature of this series of numbers is that gross domestic capital formation""which reflects resources invested in both preserving the capital stock in the economy and expanding it""was 26.3 per cent of GDP in 2003-04, up from 24.8 per cent in the previous year, but lower than the savings rate in both years.

The CSO's press release attributes this difference to the fact that there was a net capital outflow of close to Rs 50,000 crore. In other words, far from savings being a constraint to investment, there simply aren't enough investment opportunities in the economy to absorb the money that people save.

They have to look outside the country for such opportunities. There are, of course, quibbles about how these variables are measured, but this particular pattern is consistent with a number of other pieces of evidence and, therefore, rings true.

Looked at in terms of the growth pattern over the last few years, the main reason for this is the contribution of services to growth. This sector is both the largest and the fastest-growing, contributing upwards of two-thirds of overall GDP growth since the late 1990s.

By and large, services have a much lower incremental capital output ratio (ICOR) than industry, meaning that they require less money to generate an additional unit of output.

Because the economy's growth has been so skewed towards services, the investment required to fuel a pretty respectable 6 per cent rate of growth has been, if anything, declining.

This means that the country has become a net exporter of capital, which was something that was typically a characteristic of rich countries.

Why can't domestic savings find adequate returns within the economy and why does it have to look elsewhere? The answer is that, despite a decade and a half of sustained reforms, the investment climate remains hostile.

This, rather than low savings, is the constraint to accelerating growth beyond the current equilibrium.