An alternative lens to understand economic transformation

At its heart, capitalism is a financial system. Every entity in the economy, whether an individual, a household, a business, or a state institution faces monetary constraints in its operations and must constantly balance the exigencies of cash inflows and cash outflows. Thus, money flows, including the accumulation of debt and the acquisition of financial assets, are the very lifeblood of the system. Despite this fact, most of our understanding of the macroeconomy is based on the national accounts system which foregrounds current expenditure by various sectors. While highly useful, such an approach often misses or obscures underlying monetary relations. To provide a sharp example, if one is buying a second-hand property, perhaps one of the most important financial transactions in one’s life, this will not show up in the national accounts because the property has already been accounted for when it was originally built and there is no current expenditure associated with it.

C.D. Deshmukh’s vision

Given such lacunae, an alternative approach was originally suggested in 1947 by Morris Copeland, who promoted the Flow of Funds (FoF) account approach. This is an accounting system created to capture the pattern, duration and timing of money flows within the economy. Examining these flows of funds provides a simple but effective portrait of the nature of financial claims in an economy, and acts as a very useful adjunct to the national income accounts in understanding the current and likely future trajectories of an economy. Interestingly, due to the pioneering efforts of the then Finance Minister, C.D. Deshmukh, India was an early adopter of a domestic FoF framework and has always had one of the most extensive and up-to-date sets of data on money flows for developing economies. These accounts examine flows across six sectors — households, government, private corporations, banks, other financial institutions (OFIs) and the Rest of the World.

Surprisingly, despite the availability of the data, there have been very few attempts to provide a description of the monetary flows in the economy. Some of this may be because the data are calculated from balance sheet positions and may not always tally with other published accounts, some of it may be because the data is not easily collated, but neither are sufficient to explain the lack of scholarly engagement with the data. In a recent paper, we collated this data published by the Reserve Bank from 1955 to 2014 to provide a broad-brush picture of the evolution of Indian financial relations over this period. A few key findings were evident. Households in 2010 saw their net assets increase by 10% of GDP while the government increased its net liabilities by 5% of GDP.

First, almost across the entire period, the government sector is the largest net deficit sector while the household sector is the largest net creditor. Second, following the onset of liberalisation, the private corporate sector is running larger deficits as a fraction of GDP than any time in the past, although these deficits rarely exceed those of the government. Third, since the period of liberalisation there is a lot more volatility in financial positions than before it, signalling the growing complexity of monetary relations during this time. Fourth, the rest of the world has moved from being quite unimportant to becoming the second largest net surplus sector in the economy after households.

In addition, we find several striking results that are often glossed over in the general discourse on the Indian economy and that therefore bear highlighting. First, we find that the patterns of sectoral transfers have changed substantially over time. For example, the private corporate sector relies much more extensively on households and the rest of the world for their financing now than in the past where they relied on banks and OFIs.

Similarly, since 2010, banking has suddenly seen an influx of funds from the rest of the world and these funds account for a larger part of banking sources of funds than ever in the past.

Second, while the government is funded by the issuance of securities, the private corporate sector still relies more extensively on loans and advances and while this spread has reduced since the 1980s it is still large and significant.

Third, despite this India is moving from a bank-based to a market-based financial system. Between 1970 and 1990 loans and advances exceeded security issuances in all but two of the years; between 1991 and 2010, by contrast, loans and advances were smaller than security issuances in 11 of the 19 years.

Devil’s in the detail

These are only some of the results and insights that one can obtain from an examination of the data. While such a broad-brush picture necessarily omits details, using the flow of funds allows us to have significantly enriched picture of the broader economy. As Indian financial markets become more sophisticated and important, more fine-grained analyses will certainly need to be made for anyone wishing to understand the patterns and financing of India’s development. C.D. Deshmukh’s early and perspicacious development of these accounts provide a very useful starting point in this regard.

Amay Narayan is a research associate at Azim Premji University, Bengaluru; Arjun Jayadev teaches Economics at Azim Premji University