View: A push for consumption over savings can work well, too

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By Anish Tawakley
Head of Research, ICICI Prudential AMC
June 01, 2017
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The decline in savings rate is a symptom, and not the cause, of a sluggish economy


Over the past five years, the savings rate in the Indian economy has dropped significantly. This is widely perceived as a serious problem.

However, this concern is misplaced. Worries about the savings rate, at this point in the economic cycle, reflect fundamental misdiagnoses of cause and effect.


There are three things we need to be aware of while considering the relationship between savings rate and economic cycle.


One, the decline in savings rate is a symptom, and not the cause, of a sluggish economy. Specifically, low capacity utilisations and consequent low investment levels are the cause of the drop in the savings rate, not vice-versa.


Two, over the short term, an increase in consumption spending, which might imply an even lower savings rate, could actually help the economy recover faster. Trying to boost savings at this point in the cycle could be counter-productive.


Three, eventually the savings rate can recover automatically when capacity utilisations improve.


Decline in savings is a symptom of a sluggish economy


In an economy, actual investment always equals actual domestic savings plus external capital inflows (external capital inflows are relatively small compared to overall investment and domestic savings).


Over the past five years, both investment and savings rate have declined.So, the question is what caused the decline and what has been its resultant effect?


The economy today is saddled with excess capacity (i.e., the economy is operating below potential). Demand has fallen short of expectations that drove rapid capacity expansion during 2004-2011. Businesses today are sitting on excess capacity and hence, see no reason to make fresh investments.Simply put, businesses are avoiding investment not because they cannot finance the investment, but because they see no use for the additional capacity that the investment will create.


This lack of investment demand is also the reason for low industrial credit offtake even after the banking system has turned flush with deposits since demonetisation. So, the direction of causality is as follows: weak demand implies low capacity utilisation. Low capacity utilisation leads to soft investment activity.


The savings rate declines as a consequence of decline in investment rate, as actual investment and savings (domestic plus external capital) have to match.


Pickup in consumption spending desirable, even if it may mean weaker savings rate


Given that the economy has excess capacity, a pick-up in consumption demand would clearly help. It could raise capacity utilisation, output and income (one person’s spending is another person’s income).


Mathematically, of course, if consumption were to increase while investment and savings remained constant, this would show up as a drop in the savings rate (as the numerator — savings remains constant while the denominator — output — increases). This drop in savings rate could actually be healthy in the short run.


Another way to think of the current situation is to view it as an imbalance in the investment and savings market. With the economy operating at full capacity savers (generally households) desire to save more than businesses are willing to invest. However, actual savings have to be equal to actual investments.


So, the output and incomes slow till such a point that the supply of savings falls and becomes equal to what businesses are willing to invest (the ability to save falls as incomes are lower). Effectively, the savings and investment market is clearing with output below potential output. This, of course, is a bad equilibrium. However, this bad equilibrium is not inevitable.


A good equilibrium — where consumption picks up to fill the slack created by sluggish investment such that output does not fall below potential — can be much achievable. But for this good equilibrium to be achieved (i.e., income not falling below potential) people have to be induced to save less and spend more.


From a policy perspective inducing spending requires lowering interest rates and increasing government spending (or reducing taxes) temporarily.


Savings rate will recover, but only after economy picks up


As demand picks up, capacity utilisation can improve. High capacity utilisation could generate additional income and also could create the incentive to invest. Therefore, savings can rise in sync with investments.


Simply put the additional income that is generated as output, rises to full potential can create the additional savings pool to finance investment in the future.


From a policy perspective, of course, one is arguing for countercyclical monetary and fiscal policies.This means, stimulating spending when the capacity utilizations are low and restraining spending (and encouraging savings) when the capacity utilizations are high.In the long run, of course, high savings and investment levels are the key for output growth.But that does not mean that one should not spur consumption in periods where demand is falling short of capacity already created.


This article was first published in The Economic Times on June 01, 2017

 

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