External Deficits and the Decline in Domestic Saving: A Hurdle for the Financing of India’s Development

Rising current account deficits in India imply external financing needs that now raise important challenges. In this paper we study the causes of this deterioration and observe that external shocks have played a significant role, especially the rise in commodity prices. Domestically, the counterpart of external imbalances has been a fall in savings, related to negative real interest rates and the lack of structural reforms to address inflation and budget deficits. Meanwhile, external deficits have been increasingly funded by debt capital inflows, in particular short-term flows, which imply that India’s external vulnerability is increasing. Foreign investors are now more and more reluctant to invest in emerging markets and European banks are decreasing their exposure in regions like Asia where their activity involves US dollar funding needs. The link between growth and savings suggests the current deceleration in economic activity is related to the fall of domestic savings and the tighter external financial constraint. Fostering savings is thus fundamental for India to achieve its growth potential and we suggest policy options to achieve this objective.