India needs to urgently address its investment problem

Things are looking bleak for the Indian economy. GDP growth in the latest quarter was a subdued 5.8 per cent, unemployment levels are at record highs, the fiscal deficit numbers projected in the Budget are suspect and presumed to be larger, export growth hit a 41-month low in June this year, and growth in the eight core sectors of the economy remained sluggish at 0.2 per cent. On the demand side, passenger vehicle sales, tractor sales, two-wheeler sales, and domestic air traffic growth have all been declining for around six months. FMCG sales are slowing down as well. Further, the trade war and the prospect of a global growth slowdown should be giving our economic policymakers sleepless nights.

One of the core issues which lie at the heart of many of these problems has to do with India’s dwindling investment rate. In just under a decade, India’s Gross Capital Formation (investment rate) has fallen about 9 percentage points from a high of 40 per cent of GDP in 2010-11 to about 31 per cent in 2017-18. The situation has become worse in the preceding few months where announcements of new projects have drastically declined. According to CMIE database, Indian companies announced new projects worth ₹43,400 crore in the June 2019 quarter for both private sector and public sector combined. This translates to about 81 per cent lower than what was announced in the March quarter and a stunning 87 per cent lower than the same period a year ago. The real worrying trend here is that private investment has slowed down even more sharply than public investment. In fact, in the last few years, it was public sector investment that was propping up the economy. This reveals the dwindling confidence in the economy by private investors. The government has been trying to cover up the shortfall by the private sector, but that is not sustainable in the long run. This slowdown is broad-based and cuts across all major sectors in the economy, except construction and real estate.

In further bad news, the magnitude of the stalling rate of projects (percentage of projects that have been abandoned after initiation) is unprecedented. It reached an all-time high of 26.1 per cent in the June quarter. Capacity utilisation of private firms is at an all-time low of below 70 per cent.

There are multiple reasons for the decline in investments – supply chain problems, Land acquisition problems, lack of environmental and other clearances, lack of promoter interests, tough labour laws and other regulatory burdens among others. However, the biggest reason remains lack of funds, as a CMIE survey reports.

The main source of funds, bank credit, has not been very reliable in the recent few years. Credit offtake by key sectors in the economy has been declining. Non-food credit growth has halved to 4.5 per cent in April 2016-17, from 8.4 per cent over the period April 2015-16. It has slightly picked up since then in 2019. Worryingly, advances to the manufacturing sector witnessed a deceleration (-1.4 per cent) in 2016-17 compared to the previous year. In short, banks are unwilling to lend, and the monetary policy transmission mechanism is not working in India.

The main reason for declining credit growth is the twin-balance sheet problem – the situation where both banks and private firms have stressed balance sheets. Nearly 17 per cent of the entire bank loans in India are stressed, a significant share of which may not be repaid, which explains the reluctance of banks to lend. Nearly 40 per cent of debt is owned by overleveraged corporates who are unable to make interest payments. Finally, due to the rebounding of the US economy and raising of the US policy rate, FDI and FII inflows into India have started decelerating as well.

Complicating matters further is the high fiscal deficit of the union government. In the latest budget speech, the first of the Modi government’s second term, the Finance Minister Nirmala Sitharaman announced that the fiscal deficit for the year 2018-19 was 3.39 per cent, though most analysts concur that the number is much higher (around 4.1 per cent), if we account for off-budget financing. In the previous year, the CAG reported that recalculating the fiscal deficit with off budget borrowing would increase the number from the reported 3.46 per cent to 5.8 per cent.

The problem with such large government borrowing is that it does not leave any room for private borrowing and investment. Of the three sectors of the economy – government, business, and households – it is only the last that has a positive savings rate. The household sector financial savings is about 7 per cent of GDP, the combined fiscal deficit of the states and union government is well above that figure. PSU borrowings require about 1.5 per cent of GDP in addition to government’s borrowings. This leaves no room for private sector borrowing, which explains the lack of funds and low investment rates.

It is in this light that the overseas sovereign bonds must be viewed. The Union government wants to borrow about $10 billion from issuing bonds in overseas capital markets, in order to free up borrowing space for domestic industry. However, that is laden with problems of currency volatility and might seriously endanger India’s public finances.

What needs to be done?

Quite obviously, the complexity and the magnitude of the problem implies that there are no easy quick fix solutions. There are a number of things that the government must undertake on parallel fronts.

On top of the priority list should be solving the Non-Performing Assets problem. There are numerous recommendations for solving this problem, from bank recapitalisation to creation of a holding company. However, those are only temporary fixes and cannot guarantee that the same problem will not rear its ugly head again. In the medium term, the solution is to professionalise the management of the public sector banks (PSBs) and finally, in the long-run, there’s no getting around the privatisation of PSBs.

The bankruptcy and insolvency code was a move in the right direction to restructure corporate debt. However, it could be made more effective by making it robust, decentralised, less costly, inclusive and speedy. One of the first steps in this is to open more National Company Law Tribunals where the banks initiate bankruptcy proceedings.

Finally, there is a pressing need to give life to India’s corporate bond market. In successive budgets, various finance ministers have paid lip service to this, but nothing has come out of it. The size of the corporate bond market in India is just 16 per cent of GDP, compared to 46 per cent in Malaysia and 73 per cent in South Korea. A well-functioning and liquid bond market can help long term financing of infrastructure and other projects and reduce the stress on the banking sector. Presently, most of the long term financing of firms’ projects is done through the banks, which leads to an asset-liability mismatch.

Currently, the bond market in India is dominated by government bonds (92 per cent), which is crowding out corporate bonds. Further, India’s secondary market for corporate bonds is nearly non-existent. This significantly increases the risks for investors, as it complicates the exit from the asset. A bond market will also ensure market discipline on corporates, which bank lending has failed to achieve.

Currently, the corporate bond market is dominated by the safest bonds (AAA issuers) and the issuances by the slightly more risky A-rated entities are a measly 2 per cent. This is due to strict investment regulations that permits only AA or higher rated bonds as safe investment. SEBI should encourage issuance and investment in A category paper by domestic investors and foreign hedge funds.

The Indian economy is staring at the prospect of a long period of unimpressive economic growth. If we don’t fix some of these fundamental structural issues, India could witness an entire generation subject to middling incomes, joblessness, and bleak prospects. It’s the economy, stupid! It always has been.

(Anupam Manur is an Assistant Professor at the Takshashila Institution, an independent and non-partisan think tank and school of public policy)

(The views expressed above are the author’s own. They do not necessarily reflect the views of DH)