A costly experiment that failed to deliver: Mint 25th December 2019

Demonetization was probably the biggest disruption brought about in the last decade which was based on erroneous assumptions and implemented in a rather unstructured manner, leading to the economy coming to a virtual standstill with the small and medium-sized enterprises (SME) segment and farming community being affected the most. Yet looking back now, everyone seems to be a winner. Systems have been streamlined to leave audit trails. People have become savvy and have turned digital. Currency in circulation continues to rule and cash is as important as ever. However, the collateral damage has been in the SME sector which is still struggling and employment has taken a big hit. And the Reserve Bank of India (RBI) surplus came down by over 50% meaning thereby less transfers to the government.

The assumption of cash being used to hoard black money has not been proved. Terror financing could have been an issue but the reduction in such incidents is more due to the credit of our security agencies which have controlled the same. Counterfeit currency has never been proved by RBI data. So clearly the initial thoughts were not right. Along the way the emphasis was put on digitization, though it is illogical for one to go in for demonetization to force people to digitize. Normally incentives are provided to move transactions into the digital world.

The implementation of the move was not neat as the banks did not have regular supplies of currency, nor was it known that the ATMs were not compatible with the new notes. The quantum of circulars that were issued by RBI in the period of two months or so was just too high and gave the impression that there was no concrete plan in place to implement the same as rules were fine-tuned depending on the responses of the public. Quite clearly the banking system was not prepared for this process and while the surprise element was required to catch the wrong doers (terror, black money, counterfeit) the inconvenience caused to over a billion people was unnecessary. The incongruity of the exercise was that while it was argued that black money resided in high-value currency of ₹500 and ₹1,000, they were replaced with ₹500 and ₹2,000 notes! It should have been in only lower denomination notes in case the argument had any serious merit.

The post Diwali phase of 2016 was important because it was a year with normal monsoon after successive years of sub-normal rainfall and it was widely expected that the festival-cum-harvest season would reignite demand. Not only did this not happen but also with employment in the SME sector being affected and payments to these units being impacted, the economy has gone through a serious downturn which is still in progress.

The subsequent measures that have been announced for the SMEs are good, but the damage done was deeper and it would take time before they are able to recoup and restore normalcy in operations. In fact, banks are reluctant to lend to them given the higher probability of delinquency in their loans.

Therefore, the question to be asked is whether or not such a measure should ever be attempted again. The answer is a definite no. It has been a costly experiment that has disrupted economic activity. The reverberations can still be heard and do not sound good.

Collections hit by slow consumption growth: Free Press Journal 20th Dec 2019

It may be recollected that when the GST was introduced, it was widely argued that it would lead to a decline in prices, increase collections and enhance GDP growth. Those more audacious came up with numbers of 1.5-3% increase in GDP. It was largely a theoretical exercise as the subject is complex and effect quite nebulous as these rates had to work their way through. With around two years of the new tax regime being in force, the question asked is whether or not it has worked. The issue being raised today is whether rates should be increased as there is a fear that revenue collections have been affected due to lower rates.

When the GST was introduced it was mentioned that the government was open to changes both in terms of rates and structures. Therefore, there has been fine tuning of rates in the downward direction over the last two years depending on the feedback received from industry. Systems have been made easier for SMEs so that payments became easier, as did refunds. Therefore the focus has been more on ensuring that the GST system was streamlined with the practical side. This was a pragmatic approach taken by the government as prima facie it was not possible to conjecture the way things would actually go.

The present slabs are 0, 5, 12, 18 and 28%. As a measure to move closer to a system with fewer slabs, this may be reduced to two or three to begin with. The 5% and 12% slabs can be integrated into either 10 or 12%. In case of the higher range the 18 and 28% could move to 28%. This seems to be a possibility now given that it looks like that the present momentum in the economy and the rationalised structure will not yield the kind of revenue required for maintaining the revenue targets.

The other contentious issue is in compensation for the states as it was to be in force for five years. Presently the delays have impacted the functioning of states with discretionary expenditure bearing the brunt as states have tended to defer or cut back on such expenditures with revenue flows not being buoyant. Therefore, clarity on these flows is required for sure.

The major problem for the government has been the tax collections on this score. The rule of thumb was that Rs 1 lakh crore per month had to be the collections from GST including all the three components. The states were also to be compensated for any loss of revenue which was reckoned at 14% per annum based on 2015-16 numbers. Intuitively it can be seen that for this model to work the taxable base had to increase which is that GDP growth has to be of a high magnitude in nominal terms. But the problem today has been that consumption growth (GST is a consumption based tax as against excise being on production) has slowed down leading to lower collections. This is the major challenge when tax rates are fixed with commitments to the states in the form of compensation. A double whammy is served to the centre when intrinsic growth is of a lower order. The fact that GDP growth in real terms for this year has been scaled down from above 7% to now just about 5% means that revenue collections are bound to get affected.

States are in a better position, which means that their compensation is a given quantum and the onus falls on the centre which will have a challenge to meet its fiscal targets. The expectation is that the GST council may selectively increase the rates. There are two problems here. The first is that when the rates were lowered, the benefit had to be passed to the consumer which has not always happened resulting in several companies being hauled up for profiteering. Second, if rates are increased and is passed on to the consumer, which will definitely be the case, it can actually lead to even lower growth in consumption which can come in the way of future GDP growth.

An accompanying problem is inflation. Presently, inflation is more due to supply issues on the food side and hence the so called core inflation is low. In fact manufactured goods inflation is negative going by the WPI which has helped to keep headline number low. An increase in GST rates will lead to higher growth in prices that can be a worry if the CPI number is higher wrung around 5%. This is a factor that the GST Council has to keep in mind.

The GST in India has not quite had the desired effect with the tendency being fairly volatile revenue and states not getting their compensation on time. As economic conditions have been downbeat overall consumption is also quite stagnant. Change of rates is required but has to be done in a measured way or else there would be more volatility in the markets. This was always going to be a challenge for us given the plethora of rates across the country. Integrating production and consumption taxes under an umbrella was always going to require a lot of dexterity as the interlinkages vary across commodity groups. We may still have a long way to go for the exact impact to be assessed more meaningfully.

It is going to take quite long to reach $5-trillion economy target: Interview with ET Now 18th December 2019 t

2021 will be an important year from the point of view that as the economy recovers, very gradually will the financial system be up to it in terms of assisting this kind of growth, says Madan Sabnavis, Chief Economist, CARE Ratings. Excerpts from an interview with ETNOW.

Are you taken a little aback by the kind of dire forecast that we have had for January? IMF Chief Economist Geeta Gopinath is saying that there is a possibility of a significant downward revision, that growth concerns remain and fiscal slippage risk continues to be high.This was quite expected because during the course of the year, almost all agencies including the Reserve Bank of India have lowered their forecast for growth in India. We should remember that we all started off with the budget which spoke of GDP growth at over 7%. That came down to 6% and now we are really talking of a growth around 5%. So, it is not really surprising that IMF is also going to downgrade the growth forecast

In fact, I am surprised they are doing it in January and not in December itself. But probably, they have their own processes when they review the economy. For this particular financial year, it does not look likely that there could be a significant recovery. Most of the upward movement in the growth rate in the third or fourth quarter is going to be caused more by the statistical influences rather than real growth being seen in terms of higher consumption or any kind of revival in demand. So this was something expected, not really surprising and I tend to think that it will move towards the 5% mark from 6.1% which they had earlier.

She has talked about how we may see continued slow growth for a while given the fact that the financial system continues to be fraught with risks and the process to fix NPAs is not fast enough. Also, rate transmission remains slow. Would you call this catch up commentary or is this a signal for what is to come in 2020?

It is a signal because what we have seen about the financial crisis is that it started off as a PSB issue, spread to the private banks and then to the NBFCs and now to the cooperative banks. The picture we are getting is that the financial sector is not out of the woods and there are still problems in terms of the NPAs. -- recognition of NPAs, capital issues for the public sector banks and so on. In this situation, the signal given by IMF is quite real because we are saying that currently we do not have too much demand for funds. I do not think that it is a major issue in terms of funding for corporate India.
But let us look at the situation when the economy gradually recovers and there is a demand for funds especially for investment. Is the financial system really geared for it? As of today, the answer is probably we are not really sure about it. We need to wait till March to see what the NPA numbers of the banking system are. We need to see how the NBFCs have gotten through the crisis.

We are already seeing the CP market being affected on account of the NBFCs being crowded out from here. Once we get the financials piece in the puzzle in place, only then can one talk of acceleration in growth.

2021 will be an important year from the point of view that as the economy recovers, very gradually will the financial system be up to it in terms of assisting this kind of growth.

The $5-trillion economy target is in place. According to the IMF chief, we will need 8-9% growth to achieve that by 2025?
Absolutely. This $5 trillion is something which we should keep out of our minds because it is going to be quite a long time before we reach this particular mark. When we are talking in terms of how do we get to this particular number, we need to have nominal growth in GDP reaching around 13-14% consistently for a period of five years.
Currently, we are talking of inflation in the region of 4%, we are talking of growth in the region of 5%. So, our nominal GDP growth is less than 10%. It is going to take at least six to seven years to reach it. Again, I would say what IMF has pointed out is quite right. We need 8-9% growth in real GDP, which we cannot see happening in 2021 or even 2021-22. It is going to be a bit of a stiff climb towards that particular target of $5 trillion.
She also expressed her concerns over the slow pass through of rate cuts that has been seen in India. How would you react to that?
I would have a slightly different view because I think when the RBI lowers the repo rates, that is a kind of a signalling rate and the way in which banks react, should be their prerogative. They have to look at their assets and liabilities, they have to see what are their costs and in terms of their incomes.

More important is the risk perception. That is how you bring about a change in the actual lending rates. It is going to be a mismatch between what the government and the RBI want to do in terms of signalling lower interest rates and how the banks are going to react, because today we are talking of a credit environment which is still definitely more on the risky side. Banks will be a bit cautious because the NPA hangover has been quite severe.

We are also talking in terms of the SMEs which seem to be the next burning point in terms of NPAs. The banks are being cautious in terms of the transmission. We are also seeing that deposits, financial savings are being affected. It is going to be a delicate balance between the two. Banks should not be hurried to bring about this kind of transmission change.

Economic slowdown: A long road to recovery: Financial express 16th Dec 2019

There evidently are no quick solutions here, and it can be said that most alternatives have already been explored by the government with limited success

Can anything really be done about the economy? Practically speaking, if it were so easy for a government to turn around an economy, there would be prosperity all around. All kinds of suggestions have been put up by the wise counsels and every option explored. Yet, it does not look like there is an imminent solution. The fact that there is little official acceptance that the slowdown is deep and hard to reverse, is important because as long as we believe that things are only transient, the deterioration will be fast. Using the argument that we are the fastest-growing economy sounds good for the pulpit, but does not really provide solace. The problem is three years old, starting with demonetisation, and the policy of ignoring the consequences has led to the present state.

What can the government do? The government, to its credit, has done virtually everything that can be done to revive the economy short of announcing doubling of the fiscal deficit. The motherhood statement often made that more reforms are required is open-ended and not specific. The government has addressed issues pertaining to the auto and real estate sectors besides enabling flow of credit to the SMEs. Its expenditure on projects is on schedule. Policies relating to recapitalisation of banks, merger of PSBs, disinvestment, labour laws, addressing the NBFC crisis, etc, have all been put in place.

RBI has, on its part, taken decisive steps in lowering the interest rates and opened the door to a regime of lower interest rates. Yet, there has been limited progress made by banks as the credit-risk factor lingers, and they are reluctant to lend. They have been goaded to lend to SMEs which may not be wise because it can build an adverse portfolio of NPAs. While retail loans are the flavour, it should be realised that if the slowdown continues, there is a good chance of delinquencies increasing as all home loans are taken with the assumption that the salaries are paid on time, and the bonuses and variable pay come in. Any pause here can have serious consequences for the system.

The economy is in the classic state of liquidity trap which was highlighted by Keynes during the time of the Depression, when lowering of interest rates ceases to affect demand for funds. This has happened in Japan and the euro region too, where interest rates have lost their relevance. The rudimentary theory of demand, supply and prices does not work as the underlying assumption of ceteris paribus no longer holds in the present context. Credit risk perception is high and banks do not want to lend money to all and sundry given the NPA overhang.

With both fiscal and monetary policy at the end of the road, there is little that can be done in the short run. Increasing the spending of the government by say Rs. 2 lakh crore is an option which looks unlikely, as it sends wrong signals to the market. Therefore, the ball is back in the court of the private sector.

The private sector would rather not get into infrastructure given the challenges of finance. Usually, these projects would not have a good rating to be able to command funds from the debt market. Further, with several large companies waiting for the IBC to resolve the debt issue, possible investors may prefer to purchase them in the market rather than start afresh. Add to this the fact that consumption has slowed down and it means that there is surplus capacity in most industries which has made further investment non-viable right now.

Therefore, the path to recovery is going to be a slow one. Three ingredients are required which have to fall in place and will do so only over a period of time. First, the financial sector has to get out of the labyrinth. It started with the AQR affecting the PSBs and later the private banks. Subsequently, the NBFC crisis has dealt a blow to infra finance, real estate and SMEs, thus choking the financial system. This piece has to be set right, and the news of possibly more hidden NPAs on bank’s books could prolong the recovery process. It has literally been a case of survival of the fittest in the financial world. This is within the control of the government, and RBI has to be expedited.

Second, the rural economy still holds the clue to the recovery process and in a way is a necessary condition, though not a sufficient one. It is critical as it is independent of what happens in the industrial world, and hence, the optimal output and price are the key determinants to demand recovery. Any disruption, as has been the case with the vegetables and pulses crops this year, would upset the applecart as there are inflationary implications that make monetary policy even more difficult to conduct. Clearly, everything is not within the control of any entity, and, here, the states hold the key. The focus has to be on making farming more attractive and should be run as commercial ventures rather than a sector to be sympathised with through loan waivers and cash transfers. Policy has to aim at increasing productivity of land and providing end-to-end solution till the marketing stage. State farming has to be seriously considered.

Third, job creation is necessary to generate sustainable income that will generate demand. Employment unfortunately gets linked with growth and normally follows the latter and cannot be created unilaterally. Unless there are more households with spending capacity, consumption won’t increase. As corporates cannot employ persons and keep them on the bench (given that they have already lost pricing power in the last three years), the emphasis must be more on gig workers who are able to generate income by working on a contractual basis as consultants. In the medium term, the education system should bring in courses that suit the needs of the day—specific engineering requirements or handling of back-office jobs, so that the human race does not head towards the standard courses of medicine, engineering and management. Demand will grow for such skill-sets, and short-term courses of 3-6 months which address these requirements will be appropriate.

Evidently, there are no quick solutions here, and it can be said that most alternatives have already been explored by the government with limited success. Removing administrative bottlenecks is a must; and retaining processes merely because there are legacy issues in various government organisations has brought impediments for entrepreneurship. This environment of doing business at the micro-level has to improve, and the federal structure involving multiple clearances and permissions needs to be done away with (just like what the GST has done) to smoothen the process. Getting in marginal improvements to break the World Bank Doing Business Code does not work except for getting in newspaper headlines. There has to be a deeper commitment.

The Economists’ Hour | Book pointing to the damage inflicted by economists: Financial express 15th Dec 2019

Economists also had their way with corporate policies and the author highlights the anti-trust legislation which was used in the USA to curb monopolistic power. Companies like General Electric, IBM, and Microsoft have all been under the scanner.

The Economists’ Hour is quite a fascinating book by Binyamin Appelbaum that traces the major influences of well-known economists on policy making. Economists have traditionally not been regarded highly for policy making and often lawyers were given precedence. They were valued for their ability to think but not quite for being able to do practical things. It was probably the Depression and its aftermath which gave them practical importance and since the Second World War, they have had their ‘hour’.

While being concentrated in the US geography as well as political history following the World War up to contemporary times, the author explains how economists like Milton Friedman, Arthur Laffer, and George Stigler, etc, wielded considerable power over policy making. Such was their influence that they were able to have considerable impact in countries like the UK, which is not surprising, but also China, Chile and Taiwan, where economists with such leanings were imported to formulate policy. In fact, these countries had used the services of economists, including Friedman, to formulate their approach for economic development and hence a lot of economic liberalisation could be attributed to their theories. Alexander Cairncross was welcomed in China while Margaret Thatcher had no use of his work in Britain.

The common thread in their prescriptions was that markets should determine everything, as the government everywhere was the problem. Therefore, from the period 1969 to 2008, which is almost four decades, US policy in particular was directed at deregulation, which was looked as a panacea for all economic ailments. Keynes and his economics dominated post-Depression years. In 1964, under President Johnson, Walter Heller got in the three major government programmes that are now followed in several countries in different forms — medicare and medicaid health, issuance of food stamps and subsidies. Heller agreed active management was not good but intervention was required for sure. Under President Nixon, too, it was Keynes that prevailed with high levels of spending that led to inflation. It was then that the wheels turned and the new breed of economic values got ingrained.

Friedman steered policy making, and his brand of monetarism, which came to be called ‘fresh water school’ as against ‘salt water school’ covering Harvard, Princeton, and Columbia, etc, where the existing order was espoused. The basic premise is that the market does better than what several bureaucrats sitting together can do and the underlying theme was ‘in markets we do trust’.

Interestingly, two specific arguments which flowed from market economics of Friedman which affected American society were in areas of conscription and rent. He looked at conscription as a tax on humanity which did not pay well and was analogous to the dictates of the Pharaohs of ancient Egypt who used slaves to build their pyramids. With constant lobbying he had these rules annulled and the youth joined the military out of patriotism and were supported by market-based pay. Similarly, rent controls were used as an argument for preserving equality but led to housing shortage as the rich did not buy property to rent out because of these controls. Removing them helped in reviving the housing market. He was supported by economists like Frederich Hayek, who attacked any action that would potentially lead to socialism.

President Jimmy Carter got in Paul Volcker as head of the Federal Reserve and reversed the spending principle and blamed excess profligacy, while Ronald Reagan blamed government spending. Volcker, on his part, blamed the unions for higher wages and inflation. He, therefore, continued to increase interest rates which choked growth. When President Reagan ruled, Arthur Laffer had his hour with the supply side phenomenon, which became very popular as tax cuts and expenditure increases became Reganomics, and across the Atlantic, UK under Thatcher followed the same principles. Laffer used taxes as tool, but got support from Friedman as it meant less government intervention through lower taxation, which is what the market wanted.

Economists also had their way with corporate policies and the author highlights the anti-trust legislation which was used in the USA to curb monopolistic power. Companies like General Electric, IBM, and Microsoft have all been under the scanner. The focus was always on ensuring that consumers get goods and services at the lowest prices. Here economist George Stigler had his hour as he worked against such laws and propagated antitrust laws to control government intervention. The premise was that that the government should not try to fix anything that is not broken. By doing so the system was justifying unions and regulation which led to sub-optimal states. The same was extended to utilities by Alfred Kahn, which ended up with significant deregulation.

While this is the good part of the story, Appelbaum, towards the end, highlights that such policy transformation during the economists’ hour has led to funnelling of the benefits to a small plutocratic minority. This goes back to the theory of Piketty, which is now gaining acceptance across the world as the economic structure has gotten skewed in favour of the capitalist. The financial crisis was the result of unbridled use of markets as a solution for everything. The market is not right if it is controlled by the elite, which has been the case in most countries.

The Economists’ Hour is very well researched and shifts across countries and time periods to blend the views of liberal economists with the prevalent regimes, with a little bit about the background of the protagonists. This should provide inspiration for economists who want to make a difference to look for new areas that need attention. There is hope to stay relevant.

What needs to be done to fix shadow banking: Financial Express Dec 10 2019

A pointer can be that RBI should consider integrating these societies into the banking system.

Every crisis in the financial sector brings to the fore the segment that has stirred the pot. When the NPA issue went out of hand, public sector banks (PSBs) held centre stage and levels of above 20% caused shock and umbrage. Later, private sector banks cleaned up their books and their NPAs came to the fore. Subsequently, the non-banking financial company (NBFC) crisis came to light, and after being lauded for their amazing contribution to financing India Inc, especially post-demonetisation, the flaws of asset and liability management (ALM) mismatches made them the fall guy. More recently, the PMC Bank exposé has brought to light the inherent conflict of interest in the model of urban cooperative banks (UCBs) and raised a different kind of storm. Against this background of sequential contagion across financial groups, how should one look at the financial system?

While banks have been closely monitored by RBI, the so-called shadow banking segment, i.e. NBFCs, were only partly regulated, and for all practical purposes were independent in operations. Hence, when they did put in their applications for a banking licence, the first thought that came to mind was that they would be subject to RBI regulations and norms like priority sector lending, CRR and SLR. Now with the PMC problem, attention has turned to the cooperative banking sector.

The financial system is, hence, quite large and goes beyond banks. To get an idea of the overall size of the institutionalised lending market, one can look at some numbers. As of March 2018, commercial banks had an asset size of Rs 152 lakh crore. NBFCs had a size of `21.76 lakh crore—i.e. 14% of banks’ balance sheet. Housing finance companies (HFCs) came in next, at Rs 11.6 lakh crore—around 8% of banks’ size. The overall cooperative banking system as of March 2017 was Rs 16 lakh crore (11% size) and can be called the ‘covered shadow banking system’ that has been in existence for long and yet has never quite been studied in detail. Hence, the non-banking segment is around one-third the size of the banking system or has a share of around 25% in the financial system (excluding All India Financial Institutions, or AIFIs, which comprise regulatory bodies like NABARD, NHB, SIDBI and EXIM Bank, and have a size of Rs 7 lakh crore).

The accompanying table provides some interesting information on this ecosystem. Data for all institutions except cooperative banks (excluding UCBs) is for March 2018, while it is March 2017 for the latter. This helps one grasp the magnitude of the financial system, which should ideally be integrated through regulation.

The interesting thing here is that the cooperative banking system comprises over 98,000 banks/societies; the number is really large. Intuitively one can see that regulating such units is a major challenge given the limited bandwidth of the regulator. The combined NPA ratio for them is 12.8%, which is very high, with the primary agricultural credit societies (PACS) in particular being horrendous at 26.6%. While the recovery rate is fairly high (75%) for them, the fact that these loans do not get paid on time does raise a question of evergreening that may be taking place. In fact, recovery rates for state cooperative banks (SCBs) and district central cooperative banks (DCCBs) are higher, though NPA ratios lower. The universe of UCBs is also wide, with there being around 1,500 such banks where the NPA ratio is 7.1%. Thus, there is a need to take a closer look at the models being used by PACS. Also following from the fiasco at PMC, there is a broader issue of supervision and inspection that is required, as this space is quite opaque with little known on how business is conducted.

For state cooperative agriculture and rural development banks (SCARDB) and primary cooperative agriculture and rural development banks (PCARDB) that offer long-term loans to farmers, recovery rates are 44-50%, while NPA ratios are high, too, at 23-33%. This is not a good picture even though the size of loans is not very high to cause any kind of systemic risk to the system. But for sure it is necessary to review the entire cooperative banking system that has an important role to play as it deals with the overall objective of financial inclusion since it covers largely the rural population and SMEs (when it comes to UCBs). By their sheer number, they are difficult to regulate as even maintenance of accounts does not tend to be formal as one steps down to the PACS level.

A pointer can be that RBI should consider integrating these societies into the banking system. The move towards getting in payments and small banks was to foster financial inclusion. Given that the ‘covered shadow banking system’ is large at Rs 16 lakh crore—a level that new banks will take years to achieve—integrating them with the formal system makes sense. Surprisingly, all the various committees on banking that have focused on reforms in commercial banking have not quite touched on this parallel formal institutionalised system, which occupies a very important place in the flow of credit especially to the rural and SME segments.

NBFCs and HFCs have a crucial role to play in the structure of finance as they have niche customers. HFCs have added a new dimension to housing finance and enabled the achievement of the objective of successive governments to provide access to households for buying homes.

At a broader level, RBI should ideally be regulating all these entities as a single regulator makes sense for better coordination. This also ensures that the scope for regulatory arbitrage reduces. From the point of meeting the objective of financial inclusion, quite clearly the ‘covered shadow banking system’ has a very important role to play. While nudging commercial banks to do their bit is okay in the short run, ideally the rural responsibility has to be shifted to the cooperative system, which, admittedly, has to be strengthened substantially. At present, the focus has been on creating a new category of banks, like small and payments banks, and merging PSBs. As part of this transformation, the integration of cooperative banks and NBFCs should proceed in parallel and the expertise created with the regulator.

Where households can save their money: Business Line 10th Dec 2019

Recent trends show a decent return in low-risk instruments. However, inflation has diminished the actual income on savings

The present environment, which is characterised by declining interest rates, stagnant economic growth, declining profitability of companies and high valuation of stocks, can leave the household confused when it comes to deploying money into savings. The pace of job creation has slowed, as has the rate of growth in incomes.

Obtaining high returns on savings is the goal of every household, and it goes with commensurate risk that may have to be considered. In this context, how have different avenues of savings fared?

The exercise undertaken here looks at the last five years and calculates the average returns over this period (see Table), where annual returns are summed and averaged instead of considering a CAGR, which ignores the returns in the interim period and looks at the two end points.

Hence, it is assumed that one holds on to the instrument for a year, and then moves out of the market and enters again at the new price, which can be an interest rate or value of index or price of product.

 

The Table thus gives the average returns on various savings options for the period 2014-15 to 2018-19. Alongside is also provided the standard deviation for the five set series which denotes volatility, meaning thereby that variation could be to this extent in any particular year.

This is important as it indicates that there can be an upside or downside, depending on the environment.

Long-term gains

The Table is quite interesting as it presents a fairly wide range of returns on various instruments of savings, from a -0.8 per cent for gold to 12.2 per cent for the stock market. This can be confusing for a household, as it is a hard choice to make. Stock markets give high returns over a five-year period, but if the savings horizon is less than this time horizon, there is both an upside and downside risk of 13.1 per cent deviation.

The RBI’s All India House Price Index is a theoretical option, as it tells how this market has fared. It cannot be strictly compared as rarely does anyone buy and sell houses every year. They are assets that would be held normally for a longer period of time, when they could yield high results.

But still, if a house becomes an annual investment, the downside is high with a high standard deviation. Therefore, it can be said that these two avenues would be medium- to long-term investments where there can be high gains made.

Avoidable avenues

Foreign currency and gold have been poor instruments of savings, and while the former is more theoretical as people rarely do trade in it (though derivatives are popular), the latter is normally held for the longer tenure and probably rarely sold. However, if gold was held for earning an income, the return would have been negative.

Also, in the case of forex, there are several factors which are at play — with RBI intervention being most common, either directly through purchase and sale of currency or indirectly through PSBs which can go against the market movements. Therefore, for individuals, to take a position in the futures market — which gets the gains of forex movements without actually dealing with the currency — is not a good avenue as it is necessary to understand the dynamics, which are closer to treasury desks than households.

Even in the case of gold, the movements have been quite volatile and returns have averaged negative in the last five years. It is only in FY20 that there has been a recovery in prices.

Therefore, while gold is held traditionally by households, the purpose is never to get annual returns, but rather to add to wealth or appreciation over a very long period of time, if at all one wants to liquidate the same. In fact, even within families who exchange gold during certain occasions like weddings, the transaction is decided in terms of quantity and rarely value.

Noteworthy returns

The choice then leans toward instruments with low risk (low standard deviation) and reasonable return, and here, the results are quite noteworthy. G-Secs and bank deposits had similar returns, with the latter surprisingly displaying higher volatility.

This is because banks have tended to revise the rates more often than the market re-priced the G-Secs. Also, while G-Sec yields have both increased and decreased based on market conditions, bank deposit rates have moved down continuously.

Small savings gave an inferior return relative to these instruments. This actually debunks the theory of bankers always arguing that they cannot lower their interest rates as small savings give higher returns. The one-year term deposit is less rewarding than a bank deposit. Normally, one compares bank deposit returns with those on PPF, which are superior due to the tax benefit. But the PPF also has a lock-in period with a limit on the amount of deposits that can be made in a year.

The surprise element is the AAA-rated bond in the market which gives a higher return of 8.3 per cent but also carries higher risk. The risk arises as these bonds not only reign at a spread above G-Secs, but tend to fluctuate more due to the risk factor. Hence they have ranged between 7.30-8.71 per cent.

Now, inflation for this period has averaged 4.8 per cent, which has to be subtracted from the above absolute returns to get the real return — ranging from 2.1 per cent to 3.3 per cent for deposits/debt and much higher, at above 7 per cent, for equity. For fixed-income earners, cumulative inflation is what matters, because an average inflation rate of 4.8 per cent for five years means cumulative inflation of 24 per cent, which actually erodes the value of the real principal that is being saved.

Quite clearly, when the effective income earned on savings gets impacted, the spending power too diminishes and affects aggregate consumption. This also presents a glum picture for deployment of funds, and it is no wonder that non-financial savings in the country have been declining over time.