Highway to Hell: India's Risk of Over-financialization

India is witnessing a significant shift in how individuals allocate their savings. A trend of moving away from traditional savings mechanisms like?Fixed Deposits (FDs)?and other conservative instruments towards?equity markets?and?mutual funds?has raised several economic questions. India’s Chief Economic Advisor?Anant Nageswaran's?recent statements reflect growing concerns about this trend and its broader implications for India's economy.

This shift, though indicative of deepening financial markets, poses risks such as?over-reliance on capital markets, potential?credit crunches for banks, and a?disconnect between financial market performance and real economic growth. This brief unpacks the economic implications of such trends, possible policy interventions, and lessons from developed economies that have undergone similar shifts.

1. The Phenomenon: Shift Towards Stock Markets

India's stock market has grown significantly, with its?market capitalization exceeding 140% of GDP, meaning the size of the equity markets is substantially larger than the real economy. Several factors have contributed to this:

• Low Returns on Traditional Savings: FD rates have fallen consistently over the last decade, making stock market investments more attractive.
• Democratization of Market Access: The rise of apps like?Zerodha?and?Upstox?has made it easier for retail investors to enter the stock market. As of 2023, there are over?15 crore demat accounts?in India.
• High Returns in the Short Term: Equity markets have provided significant returns, leading to a surge in participation by retail investors. This is reflected in the growth of?mutual fund SIPs (Systematic Investment Plans).

This shift is supported by the narrative of?wealth creation?through capital markets, often seen as a faster and more lucrative path to financial growth compared to the historically low returns from fixed-income investments like FDs.

2. Concerns with Over-financialization and the Disconnect with the Real Economy

A. Financialization Risk

The?financialization?of an economy refers to the growing dominance of financial markets over the real economy. When stock markets grow disproportionately compared to real economic activities like manufacturing, agriculture, and services, systemic risks emerge.

Nageswaran warns of?"financialization risks"?when capital markets grow much larger than the real economy. This disconnect is particularly visible in India's case:

• GDP Growth vs. Market Growth: India’s GDP growth in the latest quarter was?6.7%, lower than expected, while the?Sensex crossed the 82,000 mark, indicating a significant divergence between real economic performance and market valuations.
• Perception of Wealth vs. Reality: Stock market growth is often perceived as a proxy for economic well-being. However, if this growth is not accompanied by tangible expansion in?manufacturing, services, and job creation, it becomes unsustainable.

B. Rising Inequality and Unsustainable Debt

The disproportionate focus on stock markets can also lead to?wealth inequality:

• Concentration of Wealth: Stock market gains tend to benefit those who already hold substantial financial assets, widening the gap between the wealthy and lower-income groups.
• Increasing Debt Levels: As retail investors move savings into stock markets, they are also taking on more debt to maintain consumption or invest further.?India's household debt?has risen to?5.8% of GDP?from?3.8% a year earlier. This could lead to a?debt bubble, as leverage becomes unsustainable if markets correct.

3. The Banking Sector and Liquidity Risks

The shift from traditional bank deposits to equity markets and mutual funds carries significant implications for the?banking sector, particularly in terms of liquidity, lending capacity, and monetary policy transmission. Banks rely on deposits to fund lending activities, and a reduced inflow of deposits may lead to liquidity shortages.

A. Impact on Bank Liquidity and Lending

1. Erosion of Bank Deposits?Bank deposits, particularly?savings accounts and FDs, are one of the primary sources of liquidity for banks. As more retail investors shift towards stock markets,?bank deposits are stagnating or declining. According to the?RBI Annual Report 2023, bank deposit growth was?9.6% in FY 2022-23, compared to a long-term average of?11.5%, while?mutual fund AUM grew by 16.5%?during the same period.
2. Higher Borrowing Costs?As banks face a?liquidity crunch, they may increase interest rates on loans to attract deposits. This leads to a rise in?borrowing costs, which could slow investments in?critical sectors?like manufacturing, housing, and infrastructure.
3. Shadow Banking Risks?The liquidity shortfall in banks could lead to the expansion of?shadow banking, particularly?Non-Banking Financial Companies (NBFCs). NBFCs operate with?less stringent regulations, which may increase credit risks in the financial system. The?IL&FS crisis in 2018?exemplifies how aggressive lending by NBFCs can create systemic risks.

B. Role of Monetary Policy

Monetary policy transmission relies on household behavior towards?interest-sensitive savings instruments?like FDs. When savings shift to market-linked products,?rate cuts or hikes?by the RBI have less of an impact.

1. Weakening of Interest Rate TransmissionFDs?and?savings accounts?are directly affected by interest rate changes, but equity and mutual fund returns depend more on?market conditions. As a result, monetary policy becomes?less effective?in influencing household saving and spending behavior.
2. Impact of Global Capital FlowsWith more savings in?equity markets,?global interest rate changes?and?geopolitical risks?increasingly influence India's economy. For instance, in?2022, FIIs withdrew??2.17 lakh crore?from Indian equity markets as the?U.S. Federal Reserve?raised rates, which weakened the?Rupee?and increased?imported inflation.
3. Reduced Effectiveness of Credit Policy?The?credit-GDP ratio?in India remains low at?55%?(compared to?150% in China). If banks lack the liquidity to lend, businesses and households will turn to?costlier credit sources, exacerbating economic constraints.

4. Is India Heading Towards a Market Bubble?

The rapid rise in stock market valuations compared to the real economy raises concerns about a potential?market bubble. Bubbles form when?speculative behavior?drives asset prices higher than their fundamental value.

• Increased Retail Participation: Retail investors now account for?36% of market activity, often chasing?short-term gains.
• Speculative Instruments: The rise in?derivatives?and?margin trading?adds volatility and increases the risk of sudden market corrections.

5. Historical Lessons from Developed Economies

A. United States – Dot-Com Bubble and 2008 Financial Crisis

The?dot-com bubble?and?2008 financial crisis?illustrate the dangers of?speculative bubbles?and over-reliance on financial markets.

B. Japan’s Lost Decade (1990s)

Japan’s asset price bubble?in the 1980s led to a prolonged recession, showing the risks of financialization without real economic growth.

C. Europe’s Mixed Approach

Many European countries maintain a balance between?stock market growth?and?social safety nets, diversifying savings through?pension funds?and?government bonds.

6. What Should the Indian Government Do?

The government needs to address the risks posed by over-financialization with a combination of?policy interventions, real sector growth incentives, and?macroprudential oversight.

A. Policy Interventions

1. Promote Balanced Investments?The government should encourage investments in?bonds,?public debt instruments, and?infrastructure funds?to provide safer alternatives to equities.
2. Strengthen Regulation on Speculative Trading?SEBI should tighten regulations around?margin trading?and?derivatives?to minimize risks of over-leveraging.
3. Develop a Deep Bond Market?A robust?corporate bond market?will allow companies to raise long-term capital more efficiently, reducing reliance on equity markets.

B. Encourage Real Economic Growth

1. Incentivize Industrial and Employment Growth?Infrastructure development?and?green energy?investments can generate jobs and stimulate real economic growth.
2. Channel Funds into Job-Creating Sectors?Incentivized mutual funds?and?thematic bonds?could be directed towards sectors that drive long-term employment and growth.

C. Monitor Financial Stability

1. Macroprudential Oversight?The?RBI?should monitor?liquidity trends?and?household debt levels, intervening through?Open Market Operations?(OMOs) or?Long-Term Repo Operations?(LTROs).
2. Capital Adequacy and Stress Testing?Banks and NBFCs should maintain higher?capital adequacy ratios (CARs), and the RBI should conduct regular?stress tests?to assess resilience.

Conclusion:

India stands at a critical juncture between?financial market growth?and?real economic development. While capital market expansion indicates a deepening financial system, prudent policies are necessary to balance market exuberance with real economic fundamentals. By?diversifying investments, regulating speculative behavior, and focusing on sectors that create long-term growth, India can sustain its economic momentum without succumbing to the risks of?over-financialization?and potential market bubbles.