Savings and Investment Trends in India : Impact of external finance (savings) on Indian investment and its implication for India?s macro-economic fundamentals

By Akhil Raj Gupta

This paper attempts to highlight the growing impact of external savings on India’s investment and thereafter analyze the positive and negative consequences of this financing arrangement. This analysis becomes extremely pertinent in the backdrop of the 2008 financial crisis, following which loose monetary policy and loss of business confidence abroad led to a flurry of Foreign Direct Investment (FDI) and Foreign Institutional Investment (FII) in emerging-market economies such as Brazil, Indonesia, and most importantly India. This is measured largely by the widening current account deficits of these nations, which also captures a ‘stock’ representation of the savings-investment gap, necessitating the inflow of foreign capital towards this lacuna. However, a closer look might also reveal that ‘hot money’ from abroad can have a debilitating effect on the economic stability of a nation, as measured by the veritable  ‘free-fall’ of the nominal value of the Indian rupee upon announcements of the quantitative easing taper by the United States Federal Reserve. This section also encompasses the notion of allocative efficiency for this external capital and whether it is higher investment or overconsumption that is continuously driving the current account chasm wider. Accordingly, I have divided the analysis into the following subsections –

1. 1.     Trends in external investment in India (Post 1991 under the framework of the New Economic Policy)
2. 2.     Favorable impact of external investment in India
3. 3.     Negative impact of external finance in India

1.     Trends in external investment in India – Equity flows

Source – Handbook of Statistics on Indian Economy, Reserve Bank of India (www.rbi.org)

2.   Trends in external investment in India – Debt flows

Source – Handbook of Statistics on Indian Economy, Reserve Bank of India (www.rbi.org)

3.     Indices of International Finance

3.a Current account Deficit / Savings- Investment Gap

 To prove that the current account deficit is identically equivalent to the savings-investment gap, we start with the basic macroeconomic identity of national income-

Y = C + I + G + (EX – IM)

 YD = C + I + G + TR – T + CA                                                (CA = EX – IM by definition)

 YD – C = I + (G – T) + CA                                                       (TR = 0 by assumption)

S_pvt = I + ( – S_govt) + CA

CA ?  S_national – I

 Accordingly, if current account is in deficit, it implies a savings-investment gap and necessitates a requirement of international borrowing.

Current Account Deficit in India – Historical Trends

Source – Planning Commission Data, dated 10/03/2014

(-ve sign indicates surplus)

3.b NER (Nominal Exchange Rate of Rupee v/s SDR, Dollar)

Source – Handbook of Statistics on Indian Economy, Reserve Bank of India (www.rbi.org)

3. Inflow of foreign reserves

Source – Handbook of Statistics on Indian Economy, Reserve Bank of India (www.rbi.org)

 Conclusion

The data in the preceding tables unequivocally suggests an increasing AND accelerating trend of international capital as a mechanism of investment finance in India.  This has coincided with a generic rise in gross-domestic capital formation (GDCF) in India with very high rates of economic growth, implying a strong causal link between the two. However, quantitative numbers do not present the whole picture. One has to undertake a detailed qualitative assessment to determine whether productive capacity has been increased through an increase in investment. Some evidence points to the contrary. For instance, price of gold has surged recently due to increased imports. If household financial savings are being channelized towards such ‘unproductive assets’ due to inflation-hedging tactics, it reduces the pool of funds available for private corporate investment who are then forced to seek assistance from international capital markets.

The next section of the report deals with beneficial and negative impacts of external finance in India.

Appendix I – Analysis of the above data

1. The years 2006-07 and onwards (highlighted) represent an inflexion point across all categories. There is a sharp difference in CAGR that has been analyzed and presented below

1. In the years post 2005-06, all economic indices seem to move in the direction corresponding to an increase in foreign investment, as predicted by economic theory. The specific trends are listed below –
2. Current account deficit increased from -0.3 to 1.2 percent and stood at 4.8 percent in the last fiscal to represent savings-investment gap.
3. Rupee appreciated significantly in 2006-07 against the dollar, registering an increase of approximately 10%. This can be attributed primarily due to the increase in supply of dollars on account of positive capital flows.
4. A slightly worrying signal is the increase of debt-financing, especially short-term debt that has risen proportional to concessional debt. This increases the probability of a bankruptcy in case of a sudden loss of business confidence prompting a situation similar to a bank run.
5. RBI has slowly but steadily accumulated foreign exchange reserves upto 294 billion dollars, with the greatest upswing being generated predictably in 2006-07 when reserves grew at 51% y-o-y.

Akhil is currently in his second year at college, pursuing a Bachelor of Arts degree in Economics (Hons) at Sri Ram College of Commerce, University of Delhi. He has been passionate about writing since an early age and is currently involved with the official College magazine and Economics Department magazine at SRCC. His areas of interest include behavioural economics / finance, econometric analysis, macroeconomic policy, and political theory. He spends his free time reading extensively, watching interesting videos on YouTube, and trying to convince everybody around him that he really does know a thing or two about economics in the midst of all the pontification!

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