OPINION | Economic Survey flags sticky CAD as cause of high interest rates but underrates the best solution

The Economic Survey unpacks the factors that influence the level of interest rates

The current state of private investment and signals about its likely trajectory make up an important strand of the Survey. In this context, it identifies the cost of capital as an important influence on the level and growth of private investment.

Over a 30-year period (1995 to 2025), the weighted average interest rate in India averaged 7.61%. It was much higher than Switzerland’s 1.04% but far lower than that of another emerging market, Indonesia, where the rate was 14.1%.

Link between CAD and interest rates

The Survey unpacks the factors that influence the level of interest rates and concludes that the most important structural explanation for India’s relatively high cost of capital is linked to the overall savings position. This, in turn, has its roots in a persistent current account deficit (CAD). Consequently, there’s a risk premium which is priced into interest rates as well as equity returns.

The point here is that India’s persistent CAD is undermining industrial competitiveness and acting as a drag on investment. Find a way to get rid of this deficit on the external front and an important drag on investment goes away.

Services come to the rescue

India doesn’t do too badly when it comes to CAD, particularly when seen in a global context. At a little over 1% of GDP, India’s current CAD level puts it in the same category as Australia or UK.

The primary reason for it is that the services exports have been the foundation on which the Balance of Payments has coped with multiple shocks over the last six years.

In FY25, services exports hit a record of $387.5 billion and the trade surplus in this segment was $188.8 billion.  It is this surplus which offset about two-third of the merchandise trade deficit. Take away services exports from the equation, the situation would have been precarious.

Yet, services exports are treated with a lens that may have been relevant in another era but is inconsistent with evidence across the world.

According to Survey, services are not a substitute for a goods-based export ecosystem that underpins resilient currency and external stability.

Why? Services exports do not compel broad upgrades in state capacity, argues the Survey.

What global evidence teaches us

Even within India, the pressure on state governments, Karnataka being the prime example, to upgrade their ability to cope with urban demands suggests otherwise.

That said, there’s a more important reason why the Survey and, by extension, the general policy approach underestimates the importance of what services can do for the Indian economy.

The World Bank in 2021 took a look at the changing nature of global development in a report titled ‘At Your Service? The Promise of Services-Led Development’.

Amongst its key findings were that the line of demarcation between services and manufacturing was increasingly hazy. A classic example of manufacturing prowess such as the automobile industry is no longer free of services inputs.

For example, the World Bank report said that software-related services contributed 40% of the value of a 2010 GM Chevy Volt model. If anything, the contribution of the services industry in automobiles will only represent a much larger value in future.

Even in the case of China, the global manufacturing powerhouse, data tells us a counterintuitive story. The number of jobs and wages supported by the export of business services exceeds that of manufactured goods in China. That is the case in India too.

One legitimate complaint about services is that is not a monolith. A lot of services in India are characterized by limited value addition and low wages. Even that is not a good enough for policy making to underestimate the contribution of services.

Data from the World Bank report shows that labour productivity in informal services has been consistently higher than agriculture since 1990.

None of these facts support a case for ignoring manufacturing when it comes to policy and resource allocation. But these facts do make a case that India’s’ on to a good thing when it comes to services. Therefore, it’s unwise to underrate its potential and, thereby, pay inadequate attention to what makes it work.

That’s precisely what the debate about Bengaluru’s urban woe is.