As savings continue to decline, does India need a rate hike?

India’s savings rate is declining. The private sector, including households and corporates are the main driver of total savings, while the public sector has been a drag. Within the private sector, households are the main source of savings. This component has, however, emerged as a key drain, with its share in total savings falling to 60% in FY2014-2015 from 70% four years earlier.

In a report, DBS Bank Ltd, says, "The fall in savings needs to be arrested given India’s investment needs. Relying on foreign savings puts pressure on the current account and the returns from that investment go abroad as well. Corrective measures are underway to lift savings and investment, but a quick turnaround is unlikely."

There is a combination of factors are behind this slowdown, the report says adding, low incomes are one, which along with extended periods of high inflation, pushed households to set aside a bigger proportion of incomes for consumption, thus impinging on savings. Not surprisingly, household savings now make less than a quarter of their disposable incomes, from above 30% earlier, it added.

DBS says, besides incomes, interest rates, inflation and demographics also drive household savings. Even though India’s demographics are amongst the most favourable in the region, years of high inflation and negative real rates have dented savings.

While interest rates were raised in response to high inflation in 2011-13, real deposit rates were still negative (see chart below). Back then, wholesale price index (WPI) inflation was a policy target, rather than a much elevated consumer price index (CPI) inflation, which meant real deposit rates were deeper in red and for longer, than earlier understood.

In addition to falling households’ savings, DBS says, its composition is imbalanced. In 2012-13, two-thirds of household savings comprised of physical assets like gold and property. This was driven by a need to offset inflation, though it led to a ballooning current account deficit (CAD) driven by gold imports. Not only did this hurt the current account, it lowered investment into the real economy.

"More recently, some of this imbalance has corrected, but physical assets continue to dominate the savings mix. The marginal increase in financial savings has also been concentrated in shares and debentures, insurance and retirement funds rather than bank deposits," the report says. (See chart below)

According to the research note, India's savings rate is caught in a cyclical rather than structural slowdown. It says, "Unlike much of Asia where rising incomes have been accompanied by a fall in savings, India’s per capita gross domestic product (GDP) is still amongst the lowest in the region. Despite this level of incomes, savings have been falling (See chart below).

"We reckon this is more a function of low incomes, tough economic conditions, falling real returns and high inflation, rather than structural impediments of a rising dependency ratio or a fall in working age population," DBS Bank says.

The report endorses demographics as one of India's key strengths. It says, "While Japan, China and many Western countries grapple with ageing populations, India’s dependency ratio is declining. The working age group (15-64 years) makes up close to two-thirds of the overall population. Growth in the working age population will exceed overall population growth for at least two more decades, pointing to a sustained fall in the dependency ratio. Although structural tailwinds are in place, the savings rate continues to stagnate, pointing to cyclical hurdles."

In the near-term, DBS says, Indian authorities need to continue encouraging households’ to shift from physical savings to financial avenues. "This is important not only to meet investment spending needs, but also ensure efficient savings for growth and limit external imbalances," it added.

On policy, the report says, further significant rate cuts are thereby unlikely in the interest of maintaining positive real and nominal deposit rates. IT says, "We look for 25 basis points (bps) cut in December, before rates plateau, contingent on sharp disinflation to or below 5% and dovish monetary policy committee."

"Further out, concerted efforts to lift incomes and job creation are crucial structural tailwinds to lift the savings rate. Work is in progress on this front, under the government’s ‘Make in India’ initiative, skills development, ensuring education access and improving the ease of doing business. Until the domestic private sector is able to pick the baton, we expect public sector and foreign direct investments to drive the initial part of the capex cycle," the report from DBS concluded.