For GDP growth to revive, we must win back households into financial savings

Economic Times, 12 February 2015

How do we judge the coming budget? Getting back to high GDP growth will require more investment. This is partly about `doing business' constraints. Even if all those problems were solved, there is a gap in financing. The magnitudes involved (about 8 per cent of GDP) are well beyond the possibilities for public investment. Financial reforms are required to get the required increase in flows of household and foreign capital into productive investment.

Private corporate investment fell by 8 percentage points of GDP in the downturn from 2007 onwards. Our hopes of economic revival hinge on getting this back up. In a very optimistic scenario, public investment can go up by 0.5 to 1 per cent of GDP. Hence, the main story lies in private investment. Much has been written about problems like land acquisition, regulatory problems, etc. But assuming we make progress on those fronts, we will hit the financing constraint, when firms try to obtain external financing.

Financial savings have also declined, from 11.87% in 2005-06 to 7.09% in 2012-13. Households have reduced their engagement with the financial system, for good reason. For many years, we have cheated households in three ways. We have mistreated households through unexpected inflation (e.g. a fixed deposit at 8% yielded 0% in real terms when inflation turned out to be 8%). We have mistreated households by capturing their financial savings and putting them into low yield government bonds (e.g. a fifth of bank deposits are forcibly put into government bonds, which hurts the interest rate). We have mistreated households on questions of consumer protection with an array of scandals and misbehaviour, ranging from ULIPs to ponzi schemes.

It is not surprising that households have turned away from financial savings to physical assets like gold or real estate. For GDP growth to revive, it is essential that we address this problem.

A formal inflation targeting framework will hold RBI accountable for delivering low and stable inflation. This will largely rule out bouts of high inflation, and reduce the fear of households.

The Ministry of Finance requires a professional `Public Debt Management Agency' for its investment banking. Such a capability will make it possible to phase out forced investments in government bonds by banks, insurance companies, pension funds, etc., and reduce the fear of households.

Indian finance has a long tradition of abusing consumers. As an example, banks and insurance companies cheated households through ULIPs. Halan, Sane, Thomas (2014) estimate that Indian households lost $28 billion owing to ULIPs sold between 2004 to 2011. This is vastly bigger than the money lost in the famous financial scandals of recent years. Our existing financial laws and regulators are largely unconcerned about the woes of consumers. The draft `Indian Financial Code', by the Srikrishna Commission, puts consumer protection at the heart of financial regulation. This will reduce the fear of households.

Once we solve these three problems -- inflation, forcible investments in government bonds and consumer abuse -- households will trust the financial system more and financial savings will go up. This will give increased financial savings.

Where will these financial savings go? If they merely become bank deposits, this is a problem, as banks are only able to give out short dated loans. In addition, Indian banking is facing difficulties and this is not a time for banks to borrow more. A blossoming of pensions, insurance, mutual funds, etc. is required, which will take household money, and invest it in long-dated debt and equity. This requires the Indian Financial Code, and fixing long-term savings mechanisms such as EPFO, NPS, etc.

All this requires a bond market: the channel that connects up institutional investors to the places where investment is done. In India, we have an important failure on bond market development. RBI has tried to do this for 20 years and failed. The equity market is working well; we can use this machinery for the bond market.

The bond market is also required for increased foreign capital inflows. There is headroom for no more than 1 or 2 per cent of GDP (per year) of an increased current account deficit. But these are still good sums of money worth working for. At present, total outstanding foreign investment in corporate and infrastructure bonds is capped at 2.5% of GDP. This calls for reform of the capital controls on bond investment. Alongside this, foreign investors need the ability to hedge currency risk.

By this logic, the essential financial reforms are: (a) Formal inflation targeting at RBI (b) Setting up PDMA and phasing out financial repression (c) Enacting the Indian Financial Code to do consumer protection and properly regulate long-term contractual savings (d) Setting up the Bond-Currency-Derivatives Nexus, drawing on the success of the equity market (e) Fixing the capital controls for rupee bond inflows and (f) Reforms of NPS, EPFO, and other long-term savings mechanisms.

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