First published: Tuesday, 17 April 2007

One economic variable that eludes popular attention but is arguably the most important indicator of an economy's long-term health is the savings rate. 

A nation's savings rate or investment rate - the two are usually closely aligned - is the fraction of the nation's total income that is saved or invested.

In India, amid all the news of the dogged rise of the nation's foreign currency reserves, the obduracy of inflation, and the waxing and waning of the Sensex (not to mention Shilpa Shetty's moods), what has gone unnoticed is the phenomenal rise of the savings and investment rates. 

These now stand at 32% and 34%, respectively.

Through the 1970s and 1980s observers around the world marvelled at the surging growth of the East Asian nations and the fact that each one of them saved more than 30% of their national income. 

Since virtually no other nation saved and invested at such high rates, a 30-plus savings rate was considered an exclusively East Asian phenomenon.

Economic theory had long taught us that savings and growth are closely connected. But it is not easy to deliberately raise a nation's savings rate. 

Up to the late 1960s India's savings rate remained below 15%. It rose to just over 20% by the late 1970s and thereafter remained between 20% and 24% up until two or three years ago. 

The savings sprint over the last three years, which puts India in the East Asian category, is, at the same time, the most unexpected and most important change that has occurred in the economy in recent times. 

Unknown cause

It gives reason to believe that the high growth of over 8% per annum of the national income is sustainable.

What caused this change? For the rise that occurred between 1969 and 1979 it is reasonable to hazard that the cause was the founding of the Unit Trust of India in 1964 and the sharp rise in the number of bank branches following the nationalisation of banks in 1969.

At that time there were around 9,000 branches in India; this rose to over 38,000 by 1981. Ordinary folks, who previously had no place to keep their savings, came out in large numbers to save in units, banks and post offices.

The savings rate rise of the last three years is too recent for us to be sure of the cause. 

But some insight can be gleaned from the break-up of the total savings. 

Over the last few years, household savings have undergone some changes in composition - people are putting more of their money in financial assets than physical assets. 

But aggregate household savings have increased upwards only at a glacial pace. 

Interesting things have however happened to the state sector. By the late 1990s the public sector had become a net "dis-saver". 

Trustworthy nations

That is, it consumed more than it earned. But it managed to put its house in order by 2003, and now has a small positive savings rate of 2% of the national income.

The real gain, however, has come from the corporate sector, which has doubled its savings rate, from just under 4% in 2001 to over 8% in 2005. Hence, the improvement in aggregate savings in India is probably caused by a combination of better fiscal management and bullishness in the corporate sector. 

Unlike stock market indicators or the rate of inflation, the savings rate does not fluctuate too much. Hence, barring some calamitous change, our savings rate should not drop below 30% for some years to come.

But I have another reason for being optimistic. What economists do not realise is that a large part of a nation's economic performance depends on social and cultural factors. Francis Fukuyama had argued that more trustworthy nations tend to do better in the long run.

This stands to reason. One cannot rely on the courts to enforce every contract and every promise. So when we want to offer a business deal or a trade pact, we look for people who are known to be honest and trustworthy. 

East Asians are reputed for their trustworthiness; it is not surprising that investment flows into East Asia.

From the point of view of an individual, honesty is partly an in-built trait, but it is also in some measure a matter of choice. If we are interested only in the short run, we would not hesitate to ditch a business partner in order to make a quick buck. 

On the other hand, as our horizon becomes longer, we are more willing to forego short-term gains for the sake of long-run reputation. In other words, it is worthwhile for us to make "investments" in our reputation.

Some of the same factors that make us invest and save more, make us want to be more dependable and trustworthy. 

I cannot provide statistical evidence for this, but my hunch is that in India both these processes have been set in motion and the high growth that we are witnessing now is an outcome of increases in both these economic and social investments.

 Dr. Kaushik Basu, Professor of Economics and Carl Marks Professor of International Studies at Cornell University

This article first appeared on the BBC News Column published in Tuesday, 17 April 2007.