Borrowing to consume
Unlike many developing countries, India is blessed with a high rate of domestic savings. The ratio of gross domestic savings (GDS) to gross domestic product (GDP) rose from 15 per cent in the 1960s to peak at 35 per cent of GDP in 2012. It has since fallen to settle at around 30 per cent.
This has meant that India is able to afford high rates of investment. Hence, despite low productivity, we can expect the floor growth rate to be around 5 per cent. It also means that the government can borrow entirely domestically to finance the fiscal deficit (and can counter attempts like in 2019 by anti-national Cassandras to incur sovereign foreign debt and fall into a debt trap like so many other countries).
However, structural rigidities in the Indian economy mean the composition of GDS is fragile. The savings that enter the financial system (and is, therefore, available for borrowing by the organised sector and by the government) is a fraction of GDS.
The rest (historically called physical savings) is deployed in various assets like housing, land, agriculture, and gold, but despite countless committees, we can only guess at the precise composition. What we do know is that today physical savings constitute more than 60 per cent of household GDS despite the increased financialisaton of the economy. This means that the “modern” economy has to compete for a much smaller pool of savings than the GDS number indicates — raising the cost of capital considerably, or resorting to financial repression with interest rates on savings administratively kept low relative to their scarcity market value.
This conundrum can be resolved only when the share of financial savings rises appreciably. But this has not happened despite occasionally hopeful trends. Unable to address the root cause, policy has sought to manage the consequences. Using administered interest rates and the government’s privileged position as borrower of first resort, the Reserve Bank of India (RBI) has kept lending rates at reasonable levels though this has eroded the value of financial savings and reinforced the incentive to undertake physical savings. Cognizant of this problem, various Fiscal Responsibility and Budget Management (FRBM) committees have placed restraints on government borrowing (contrary to the Whatsapp myth, FRBM limits are set based on macroeconomic analysis, not by mimicking Maastricht, etc). In addition, using instruments like priority-sector lending, the RBI also effectively deploys a credit-rationing mechanism. All these things have helped keep the cost of capital at reasonable levels. Enhanced inflows of foreign investment over the past 40 years have also helped manage the situation.
There are now new challenges on the horizon as work by the brilliant economist Nikhil Gupta[1] makes clear. Better-off households are the major net savers (savings minus borrowings) in any economy. In recent years there has been a sharp rise in household borrowings, currently 5.8 per cent of GDP. It seems that this happened because there was weak income growth in FY23 and so households maintained their investment and consumption aspirations by reducing savings and borrowing more in FY24. Mr Gupta expects this to persist in FY25.
Most household liabilities are bank loans, up from 3.1 per cent of GDP in FY19 to 4.4 per cent in FY23 and projected at 4.8 per cent in FY24. This rise in household borrowings puts pressure on macro management because it raises the cost of capital for capital formation by the government as well as the private sector. It is bound to hit the limits of the Rbiadministered financial repression and rationing system, which is not designed to cope with rising household borrowings.
If these borrowings were largely for housing mortgages that would be an ameliorating factor. But Mr Gupta shows that the bulk of the rise in debt is nonmortgage household debt, used to finance purchases of things like cars and consumer durables, weddings, health emergencies etc. This is largely unsecured debt.
This incremental debt is financing consumption spending, and, therefore, like borrowing to finance government consumption, is reducing the pool of funds available for investment and raising the cost of capital. Thus, household mortgage debt, at 10 per cent of GDP, is lower than in most emerging economies, but non-mortgage household debt at 25 per cent of GDP is higher than in many emerging economies.
This has many macroeconomic implications but the most important one for the authorities to recognise immediately is this is a structural fallout of the changing composition of the Indian economy, which further points to a middle-income trap. The low ratio of mortgage lending reflects the narrow base of market-based real estate activity, especially in rural areas. Consumption-based borrowing by the household sector makes investment capital even more expensive. Thus, with the lowest per capita income in the G20, both the government and households are now increasingly borrowing to consume — the government to provide basic services and compensatory subsidies and households to finance consumption. This eats into an already limited and declining flow of financial savings to put upward pressure on the cost of capital.
The situation is amenable to policy action. I have earlier argued extensively about addressing the root cause, but if that is too much to expect, then at least the fallout needs to be managed. The recent defensive posturing by the authorities reading these trends as positive is both foolish and irresponsible. They need to get an urgent grip on the situation. The economy cannot afford another delusionary Battle of Panipat moment.