India’s investment deficiency hides a blessing

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There’s one accusation that casts a perennial shadow over Indian business. Notwithstanding all the conferences, seminars, exhortations and programmes by the government, Indian business just isn’t investing. The latest numbersfrom Centre for Monitoring Indian Economy (CMIE) add more grist to this mill. In the December 2017 quarter, fresh investments in India plunged to a 13-year low with the value of new projects declining to more than half of what they were in the year-ago period. The last time project announcements reached such a low was in 2004.

These numbers are not new. According to World Bank development indicators, gross fixed capital formation (as a percentage of GDP) in India was 27.12% in 2016, having fallen steadily every year since 2011 when it topped 34%. Critics compare that with 42.86% figure for China and worry that the investment cycle in India is unlikely to witness a turnaround anytime soon.

It is true there is a lag between capital investment and growth. A factory needs to be set up for production to begin, jobs to start paying workers who can then go out and spend, thus boosting consumption growth. Most capital investment tends to be cyclical as we saw during the global recessions of 1991 and 2008 which witnessed a steep decline in gross fixed capital formation. That’s because when output falls, companies start cutting back production in anticipation of lower profits.

But for a minute, if we take a step back and look at the evolution of the data rather than the snapshot view it gives of the economy, the worries may well be exaggerated. Indeed, given that the earlier cycle reflected a distortion of the economy through huge levels of mal-investments, the current correction may well be worthwhile. The mis-investment in real estate is a perfect example of this. Against the prudential norm of 4-6% of GDP, investment in real estate flared to 16% in the years immediately preceding the financial crash. We are bearing the consequences of that excess till date.

It hardly needs repeating that capital investment is vital to India’s growth. In the absence of a large enough innovation base, it is the only way to increase labour productivity. But we have come around to believing that any investment, regardless of how productive it is, is good for the economy. That’s simply not true. During Japan’s lost decade in the 90s, economic growth rates slowed down as a result of low capital accumulation. The primary reason for the slow capital accumulation was the low rate of return on capital following its misallocation over the preceding years. The empty plants and cities in China are another example of undisciplined capital investment leading to grief.

In India, part of the reason for the investment crawl was the mega scams that came to light between 2010 and 2012 which in turn led to delays in decision-making, creating an element of uncertainty in the minds of investors.

But Indian industry cannot absolve itself merely by pointing to this. Its own inefficient capital formation that led to low corporate profits is also to blame. Over-investment in sectors like power, steel and telecom led to a high capital/output ratio and a low rate of return on capital. With low real interest rates, caution was thrown to the wind as businessmen over-invested often merely because there was debt available on tap.

What we are witnessing now may well be the capitulation candle, the end of that cycle. Already, credit growth is up (nearly 10%) as is capacity utilization. These and other trends point to the stage being set for a revival of investment.

In any case, it is far better to have a disciplined 15% gross fixed capital formation (as a percentage of GDP) economy like the US than a bubble economy like Japan or China.livemint