India is too reliant on foreign hot money. The reason: it doesn't give savers enough reason to put their money in the bank. That is now becoming a pressing concern. The outmoded state-built apparatus of financial repression needs to be junked.
Domestic savers aren't getting their dues. While consumer prices shot up 9.9 per cent in June, year on year, one-year bank deposits earn 8.25 per cent on average. That's a negative real interest rate of almost two per cent, the second-worst in Asia after Hong Kong. Adjusted for inflation, savers' money is gradually disappearing.
Repressed Indian savers can't easily take their funds overseas because of capital controls. But they can invest in other things, like gold. India's annual gold imports more than doubled in two years to $62 billion in the financial year that ended in March last year. Measures like higher import duties on gold would merely address the symptom, but not the root cause of financial repression. The collapse of a pooled wealth or "chit fund" company in April showed that savers were also being lured by Ponzi scheme-style products that promised them a decent return, something they couldn't get from the banks. That creates new risks for the financial system.
Financial repression has its role. Subsidising borrowers at the expense of savers is supposed to lead to more investments and higher GDP growth. An artificially low cost of capital is part of the story behind China's very high investment rates. But in India, that doesn't seem to have worked so well. Between December 2009 and November 2011, producer price inflation was greater than the 10-year government bond yield - which means that the real borrowing rate was actually negative. Since then, it has averaged a very reasonable 1.6 per cent. Yet private corporate investment in factories, machinery, stores and other fixed capital slumped 3.5 per cent in real terms last fiscal year. Industrial production fell 1.6 per cent from a year earlier in May.
The government's spending habits are one reason why financial repression has backfired in India. The state requires banks to park 23 per cent of depositors' funds in government bonds and other approved securities, over and above the four per cent of deposits they have to surrender to the central bank as cash reserve. The result of this "statutory liquidity ratio" is that the benefits of those inexpensive savings funds are parcelled out to the state. New Delhi gets its budget deficits financed on the cheap.
It would be one thing if the government used this power benevolently to build infrastructure and to provide health, education, policing and contract enforcement services. But the reality is otherwise: repression of savers and the assured financing of deficits have only led to a costly expansion of the welfare state, the most recent example of which is the food security ordinance. Excessively loose fiscal policy has led to entrenched double-digit inflation, which has further eroded returns for savers on their bank deposits.
There are several reasons why India's deposit rate repression is bad policy. India's daunting infrastructure needs can only be financed if local households willingly save more, and make their savings available for building roads, ports and power stations. Besides, as markets mature, repression tends to get less effective. In China, higher-yielding wealth management products have provided savers an attractive alternative to vanilla bank deposits that pay regulated interest rates - and the growth of that sector has become a big worry for policy makers.
Hot money from abroad has filled some of the gap from India's inadequate savings, but it is a poor replacement because it's fickle. The rupee has depreciated 10 per cent since early April amidst growing investor expectations of an end to years of cheap global money. The US Federal Reserve's tough talk on liquidity withdrawal is now making foreign investors - which includes overseas Indians lending to those at home in foreign currency - nervous about financing India's yawning current account deficit of five per cent of GDP.
A by-product of negative savings interest rates is that they make monetary policy impotent. The central bank can cut overnight interest rates all it wants to lend a helping hand to a slowing economy, but if banks are short of excess deposits, they won't pass on the benefit to borrowers. Deposit growth in the Indian banking system has run short of credit growth since the middle of 2010. The gap finally closed last month - not because depositors have resigned themselves to receiving negative real interest rates and put their funds back in the bank, but because credit expansion has slowed to a trickle.
About 15 years ago, India seemed to be moving in the right direction. At the cusp of India's economic reforms in 1990, the part of deposits banks were required to park in government bonds had been as high as 38.5 per cent. But by 1997, the statutory liquidity ratio had fallen to 25 per cent. The sharp decline raised hopes that in another 10 years or so, financial repression would become a thing of India's socialist past. But that didn't happen, and the shabby treatment of savers is now a heavy burden for the economy.
It's time the government paid households a fair compensation, just like any other borrower. The recent launch of inflation-protected government bonds is a good first step. Drastically reducing statutory liquidity requirement will be a major improvement, but that will require the fiscal authority to commit itself to long-term budgetary prudence. Unless savers believe in such a commitment, they will keep rebelling, and the financial resources India desperately needs for economic revival will remain in short supply.