Improving The Savings Performance
The double task of alleviating poverty and keeping up with fast-growing Asian neighbours prompted the Indian government to announce a target of seven per cent or more annual GDP growth over the next 10 years. A key question is whether India will be able to finance the investment necessary to reach this target through increased domestic saving and avoid a much greater recourse to foreign saving with its associated risks on the external front.
In the past few years, studies of savings in developing countries have found that tax and interest rate incentives have been largely ineffective. Moreover, empirical studies suggest that higher growth generally tends to precede higher saving. In the light of this evidence, it may be more effective to increase domestic saving by raising public saving and implementing a strong structural reform programmes, including financial liberalisation.
Measuring saving
Indias savings rate is relatively high, compared with many other countries. It has shown an uneven upward trend over the past four decades and there have been considerable changes in its composition. Historically, domestic saving has been dominated by household saving in physical assets. However, the recent increase in saving has been driven mainly by financial household saving, partly reflecting a continuing expansion of financial institutions networks into rural areas, and more recently, the increasing availability of alternative investment opportunities. Private corporate saving has also shown a steady increase over the last 20 years, although it remains below five per cent of GDP. Public saving weakened in the early nineties to reach a low of 0.5 per cent of GDP in 1993-94, a significant reduction compared with the levels of four-five per cent of GDP seen in the early eighties.
Econometric regression analysis suggests that private saving is likely to continue to increase albeit gradually over the coming years, driven by rising per capita income and continued financial deepening. In addition, a lower share of agriculture in the economy and an increase in the age dependency ratio would tend to increase private saving. Taking into account likely developments in public saving, this would result in a saving rate of about 28 per cent of GDP after 2000.
But this is not likely to be enough to finance the investment needed to reach the governments growth objective. Even assuming some improvement in investment efficiency, the growth target implies that the investment rate would need to increase to well above 30 per cent, which even with higher recourse to foreign saving would require a domestic saving rate of 30 per cent by the turn of the century. If the growth target is to be achieved, stronger action on both the public and private saving fronts is called for.
Strategy for higher saving
While higher domestic saving is needed to finance faster growth, policies aimed directly at mobilising saving are not necessarily the best instruments to achieve this target. In the case of India, it has been argued that growth has suffered less from a low saving rate than from inefficient investment, partly because of the dominant role of the public sector in the economy. There is also a growing literature that, based on cross-country studies, has found little evidence that policy efforts to boost saving have been very effective. This research suggests that the main policy focus should be on initiating a virtuous growth-saving circle by fostering growth through fiscal consolidation and strong structural reforms, including privatisation and financial liberalisation. Under such a strategy, initially, growth would need to be financ-ed mainly through high-er public saving. Private saving, which eventually would have to provide the bulk of additional inv-estment financing, wou-ld follow with a lag, res-ponding
to higher growth. Financial liberalisation in particular, reform of long-term saving instruments would help to ensure that private saving was efficiently allocated.
The case for an indirect approach to higher private saving is supported by recent findings that traditional saving policy instruments fail to raise the private saving rate in the long-run. Although these results were established mainly for industrial countries, they are likely to apply just as forcefully in developing countries.
Moreover, Raja Chelliah and others have pointed out that most Indian households do not pay income tax, either because their income is too low or because they fail to report to the tax authorities. Changes in the tax regime would therefore affect only a small part of the population, and would be unlikely to significantly alter overall saving behaviour.
Public saving: Studies suggest that the most direct way to raise domestic saving is by generating higher public saving. However, India has seen a steady decline in public saving over the past two decades, both at the central and state government levels. This trend has been partly reversed since 1993-94, but further strong efforts would be needed to restore public saving to the level of the early eighties. Such efforts would need to involve a series of actions in the areas of tax policy, expenditure management, centre-state relations, and public enterprise reform.
To some extent, higher public saving may be offset by lower private saving. However, judging from an estimated long-run relationship between private and public saving, the offset factor for India could be as low as 25 to 30 per cent. Nevertheless, in the short-run, the trade-off could be somewhat larger, as fiscal consolidation would have to be achieved partly through higher taxation.
Incentives for private saving: While instruments to directly raise private saving have proven largely ineffective, structural reform measures could have a large impact on growth and, indirectly, on private saving. Broadly, the reform agenda for India would include public enterprise restructuring and privatisation; increased private involvement in infrastructure; agricultural reform; labour market reforms and exit policies; lifting of privileges for smaller enterprises, especially, financial reform.
In India, the link between low growth and the inefficient allocation of saving has beco-me increasingly relevant, particularly in infrastructure. Although overall investment has in-creased in recent years, investment in infrastructure has declined, and worsening infrastructure conditions have become a major obstacle to growth. The Rakesh Mohan Committee on infrastructure development concluded that the lack of long-term financing was a substantial hindrance to such investment, and listed the development of domestic debt markets and the effective use of long term saving among the highest reform priorities.
Consequently, efforts to raise private saving should focus on financial liberalisation, particularly on the development of long-term saving instruments, such as pensions, life insurance, and mutual funds. While providing an attractive investment vehicle for individual savers, their main role would be to improve the allocation of savings, ensuring that funds would flow to the most productive investment projects, thus generating the highest rate of growth for a given amount of investment. As a result, the virtuous growth-saving circle would become more dynamic, and savings could accumulate faster.
Provident funds:The Indian provident fund system consisting of the EPF and a number of smaller PFs provides fully funded defined-contribution retirement schemes for about eight per cent of the labour force. Those not covered under these schemes rely mainly on extended family networks and informal saving arrangements for old-age security.
The system could be reformed to follow the examples of countries like Chile that have successfully raised their saving rates through pension and financial market reforms. Key aspects of reforms would involve providing an increased role for private pension fund management and substantially liberalising portfolio allocation rules, with an appropriate regulatory structure to ensure prudent investment allocation.
Looking to the future
How should India raise its domestic saving rate? Traditional tax and interest rate incentives are unlikely to lead to a strong response of the private saving rate. Instead, the most promising way to boost domestic saving is through increased public saving and a strong structural reform programme, incl-uding financial liberalisation, which would initiate a virtuous circle in which higher growth would prompt further increases in private saving. With a view to increasing the efficiency of savings allocation and financing the heavy infrastructure needs of the Indian economy, particular attention should be paid to long-term saving instruments.
A sustained increase in long-term saving would require two major policy changes. First, the government would need to sharply reduce its recourse to captive financing from pension funds and the LIC, thus giving market participants greater flexibility in their portfolio allocation. At the same time, greater private sector involvement would be required to help boost competition and more innovative product development, which would make saving instruments more remunerative and thus attractive to individual investors.
(Martin Muhleisen is an economist in the IMFs Asia and Pacific Department. This is an extract from an article he wrote in the quarterly publication of the IMF and World Bank.)
The most promising way to boost domestic saving is through increased public saving and a strong
structural reform programme, which would initiate a virtuous circle in which higher growth would prompt further increases in private saving.