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ExplainSpeaking: Should the Union Budget depend on an investments-led economic recovery?

While it appears that there are all the preconditions of a sustained uptick in investments in the Indian economy, there are many reasons why it may not happen 

Written by Udit Misra , Edited by Explained Desk | New Delhi |
Updated: January 25, 2022 7:28:19 am
With the Indian Budget round the corner, what matters the most is the government's overall strategy for sustaining India’s growth story. (Photo: AP)

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Dear Readers,

In just about a week, India’s central government will unveil the Union Budget for the next financial year (2022-23). Like most years, this year too — and perhaps more so given the high rates of inflation for the past two years — your first few queries might be: Will the Budget bring down prices? Will your dream car or house be cheaper? Or will it be cheaper to run it because taxes on petrol and diesel have been reduced? Will you get an income tax cut? Will the Finance Minister raise the exemption limits of taxable income, thus bringing down your tax liability? Or, will you get a job or a better-paying one?

Of course, these are legitimate concerns. But at a time when the Indian economy, which was already fast losing its growth momentum in the three years leading up to the pandemic, is hoping to consolidate its recovery, what matters the most is the government’s overall strategy for sustaining India’s growth story.

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To be sure, adopting a wrong or at least a sub-optimal economic strategy could adversely affect India’s growth trajectory over the coming decade. That, in turn, might well reflect in fewer jobs, lower productivity and higher prices over time.

The phase from the announcement of demonetisation in November 2016 until the start of the Covid pandemic was a case in point. India’s overall GDP growth rate decelerated from around 8% in 2016-17 to just 4% in 2019-20. Be it manufacturing or real estate or constructions — sectors which were supposed to create millions of new jobs — all saw an alarming fall in total employment, thus paving the way for the unemployed to rush back to a starkly unremunerative agriculture sector in 2021.

Overall, India’s employment rate has plummeted. Historic unemployment and faltering growth not only exacerbated inequalities of income and wealth but also led to an increase in the absolute number of poor people in India — an unprecedented and embarrassing reversal in poverty alleviation.

In the years leading up to Covid-led technical recession, there was much disagreement about the government’s approach.

For one, the government appeared unwilling to accept that there was steady deceleration. Two, to the extent that it was undeniable that there was a slowdown, the government diagnosis was that it was a supply-side problem, and not a slowdown in demand. As such, it was natural for it to unleash a reform — a sharp and historic cut for corporate income tax rates — aimed at boosting the supply in the economy.

But since the slowdown was due to reduced demand, the corporates simply pocketed the windfall from not having to pay as much taxes, and either improved their profits or retired their existing debts, instead of raising investments in the economy (and thus creating new jobs and greater prosperity).

With Covid-induced lockdowns on the one hand and reduced earnings on the other, the demand problem got further accentuated. It was again argued that the government should have spent more both directly and via fresh investments to boost aggregate demand.

However, the results of the second-quarter GDP data provided a striking data point: Of the three main engines of growth — private consumption demand, the government’s consumption demand, and new investments in the economy — it was investments that single-handedly pulled the GDP above the pre-Covid levels even as consumption demand stayed below the 2019-20 levels and government expenditure was the lowest in the past five years. In contrast, more investments were made in Q2 of FY22 than in any Q2 over the last five years.

An aside on what qualifies as investments.

For those who do not know what all comes under investments, here’s a quick clarification: The investments in question are technically called Gross Fixed Capital Formation (or GFCF). They comprise two main components.

Construction: All “new” constructions and major alterations and repairs of buildings, highways, streets, bridges, culverts, railroad beds, railroads, subways, airports, parking areas, dams, drainages, wells and other irrigation sources, water and power projects, communication systems such as telephone and telegraph lines, land reclamations, bunding and other land improvements, planting and cultivating new orchards etc.

Machinery and equipment: All types of non-electrical and electrical machinery like agricultural machinery, power generating machinery, manufacturing, transport equipment, furniture and furnishings. Also included are increments in livestock in respect of breeding stock, drought animals, dairy cattle and other animals raised for wool clippings.

This is not a complete list but should give a good sense of what we mean when we say “investments” here.

An overwhelming percentage of all such investments are made in the private sector — either by corporations or households — and only about 20% to 25% by the government or government-owned entities. That is why GFCF is a good marker of private investment demand in the economy.

One final clarification on investments that some readers have asked for. The broader variable to track capital formation in an economy is Gross Capital Formation (GCF). It includes two more types of investments apart from GFCF. There are “valuables” (they include expenditures made towards acquiring things like gold, precious gems, paintings etc.) and “change in stocks” (or CIS and it includes materials and supplies, work-in-progress and finished products and goods in the possession of producers and dealers”. All three types of expenditures — GFCF, Valuables and CIS — are added in GDP calculations.

Getting back to the analysis. Based on this recent spike in investments, the government believes — according to the Ministry of Finance’s Monthly Economic Review (for November) — the “recovery suggests kick-starting of the investment cycle, supported by surging vaccination coverage and efficient economic management activating the macro and micro drivers of growth”.

To be sure, if the government believes the investments will sustain from here on, it should tailor the Union Budget quite differently from a scenario where it allows for the possibility that the investment may not sustain.

This assumption — that India’s economic recovery is strong enough to kickstart a sustainable investment cycle, which, in turn, propels future growth — could well be the biggest strategy call by the forthcoming Union Budget.

The chart shows the corporate debt-equity ratio.

On the face of it, there was no dearth of reasons why the investment cycle will not sustain. As a recent research note by analysts at Nomura observes: “At face value, a number of preconditions appear to be in place. The government has announced various reforms, including the national infrastructure pipeline (NIP), the production linked incentive scheme, lower corporate taxes and privatisation. Corporates have deleveraged their balance sheet during the pandemic. The corporate debt-equity ratio has fallen broadly across industries from 0.79 in FY19 and 0.82 in FY20 to 0.63 in FY21 (see Figure 113)”

Nomura analysts further point out that “with no real capex [short for capital expenditure] for over a decade, supply capacity may be necessary in some industries”. Moreover, another reform — the creation of a bad bank — “may also help resolve the supply of credit issue”.

And yet, Nomura’s analysts adopt a “cautious” stance and instead explain why “a virtuous capex cycle appears unlikely”.

The chart shows the phases of capex of projects funded.

1. For one, the NIP targets spending of Rs 111 trillion (or lakh crore) between FY20-FY25, but Nomura estimates that “given the state of readiness and financing” only two-thirds of this amount would be spent. “The plan has the Centre contributing a 40% share, which means an annual central capex outlay of around Rs 9-10 trillion (~3.8% of GDP), which is 60% higher than the pace of spending over the last three years. Another 40% will need to come from state governments, where the paucity of revenues has often led to compromise in capital spending to meet fiscal targets. Lastly, the private sector will need to contribute 21% of the Rs 111 trillion target.” However, Nomura points out that “the current phases of existing projects sanctioned by banks and financial institutions do not look particularly encouraging (see Figure 114)”.

The chart shows new investment in projects.

2. It further points to the graph of total new projects. “There are around Rs 1,075 billion (0.5% of GDP) of ongoing projects into FY22, lower than in FY21 (0.8% of GDP). Unless new investment picks up significantly, which is not yet the case (Figure 115), the project pipeline looks weak.”

3. It also underscores the poor macroeconomic environment. It states that despite a negative output gap, inflation remains above 5%, unlike the low inflation/high global growth environment of the early 2000s. As such, it expects the current ultra-low interest rate environment to reverse.

4. Here is another key point: “The demand recovery has also not been broad-based, with consumption demand from lower income households weak, and capacity utilisation rate still muted at below 70%.” In other words, while the supply-side conditions may be more favourable, the demand-side conditions are not, “which suggests a durable capex upcycle is not yet on the cards”.

Nomura is not the only one doubting India’s investment upswing sustaining for long. Another research firm, Oxford Economics, too highlighted India’s “long-term investment challenge”. A recent note prepared by Priyanka Kishore makes the point that there are limits to government-led recovery in investments.

The chart shows the Centre’s infrastructure push.

“To date, public spending has driven the investment pickup, underscoring the government’s strong infrastructure push (see Figure 3). The FY22 budget (April 2021-March 2022) has earmarked Rs 5.5 trillion for capital expenditure, a 26% increase over the previous year, and proposes to raise its share in GDP to the highest level in over a decade. While this has catalysed investment in the short term, fiscal constraints and credit rating concerns limit the scope for public capex to continue bolstering overall investment trends forever,” she writes.

India’s manufacturing capacity utilisation

Like Nomura, Oxford Economics, too, is sceptical about the projected spending under the NIP fully materialising. It, too, points to the capacity utilisation levels in manufacturing (see Figure 6) being well below 80% even before the pandemic. In this context, it quotes the RBI’s Annual Report for 2019-20, to reiterate that the 2019 corporate tax cut was “utilised in debt servicing and in building up of cash balances and other current assets, rather than in restarting the capex cycle”.

As a result, while Oxford Economics expects a gradual rise in the private investment rate, they see it settling well below its 2012 peak in 2030.

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