Slow growth, sticky inflation and hopes of economic reforms driving a recovery?these are the issues that nowadays dominate any discussion about the Indian economy. While low growth and high inflation are symptoms of economic challenges, a sustained cure cannot be found without diagnosing the root causes. To put it differently, the effectiveness of the suggested remedies would also depend crucially on whether the problems are correctly diagnosed or not.
India?s GDP growth plunged sharply to 5.5% in Q1-FY13 (year ending March 2013), from 9.2% in Q4-FY11. As near-term growth deteriorates, a question often asked is whether potential long-term economic growth has also been affected. Can India ever achieve 8%-plus growth rates again? Estimating potential growth is a hazardous task for rapidly transforming economies like India because of a paucity of quality data and the rapidly changing relationships between different economic variables. However, a careful examination of data trends suggests that declining productivity and falling investment rate have been the main culprits, dragging down India?s potential growth from FY08 onwards.
Slowing down of the capex cycle is a common explanation of the growth challenges. The average investment rate (ratio of gross domestic capital formation, ?GDCF?, to GDP) fell to around 34% in FY12 from 38% in FY08 and is likely to fall further. The trend is more worrying for gross fixed capital formation (GFCF) where the GFCF-to-GDP ratio fell to around 29% from 33% over the same period. The gross domestic savings also fell at a fast clip, widening the savings-investment gap and leading to a current account deficit of 4.2% of GDP in FY12. Not only is investment falling, our ability to finance investment from domestic resources has also been strained.
Falling public sector savings or rising fiscal deficit has surely been a reason behind the declining investment rate. But we worry more about the private corporate capital expenditure. According to RBI data on corporate investment, the aggregate investment intentions in private-sector projects (only projects larger than R100 million were considered) funded by banks and other financial institutions declined 46% between FY11 and FY12. Capital expenditure on new projects approved in FY12 totalled only R746 billion, a drop of 32% from the previous year. Indian corporates also seem to have been inspired by the mantra of ?small is beautiful??the share of large projects (R50 billion and above) dropped to 33% in FY12 from 48% in FY11.
A similar trend is observed on an industry-wide basis. In FY11, 75% of corporate capital expenditure was split between infrastructure (54.8%, with power accounting for 46.9%) and metals (20.4%). This share dropped to 63% in FY12, as regulatory and financing issues have plagued these sectors. On the other hand, consumer-oriented sectors? share of capital spend increased: textiles (7% in FY12 from 2.9% in FY11), transport (5.7% from 1.4%) and entertainment (1.2% from 0.7%) are some such examples.
The FY13 outlook remains challenging. If there are no deferments of capex plans, then existing projects? capex will likely be R2.07 trillion in FY13. Although capex on new projects has been declining for three years now, FY13 will be the first year when capex on existing projects is likely to fall. In this case, capex on new projects will have to be R1.43 trillion in FY13 to match the overall FY12 capex spend of R3.5 trillion. This will require a 91% increase in capital spending on new projects in FY13 compared with FY12, an impossible target to achieve. Therefore, overall corporate capex is likely to decline in FY13 too.
Tracking the productivity numbers is not so easy. The incremental capital output ratio (ICOR) measures how much output (GDP) is produced with every unit of additional capital. This is a simple measure of productivity where falling ICOR indicates higher productivity. In the boom years of FY04-FY08, ICOR averaged 4.3. This, along with close to a 36% investment rate, generated around 9% GDP growth during those years. In fact, barring a few abnormal years, for most of our post-independence history, ICOR has hovered between 4 and 5. However, in FY12, ICOR increased to around 5.9; and, with a falling investment rate, it is becoming difficult to achieve even 6% GDP growth. Rising ICOR is a clear indication that capital is not being used efficiently. One of the reasons could be projects stuck at different levels of approval or because of lack of critical inputs.
We are also worried that the total factor productivity (TFP) index for manufacturing fell drastically between FY08 and FY10. We estimate the TFP as the residual in the manufacturing growth process which is not explained by movements in the two inputs?labour and capital. In a sense, TFP should capture all the external and internal factors affecting production in a firm, other than the basic raw materials. For the TFP calculation we use data from the Annual Survey of Industries (ASI) that provides estimates of employment and capital stock which are not otherwise available. Unfortunately, it comes with a two-year lag and the latest ASI data is for FY10. The TFP index increased substantially between FY02 and FY08 and, in our view, was one of the major contributors to the phenomenal GDP growth in this period. This rise in TFP was partly due to the reform measures undertaken in the preceding years. In particular, financial-sector reforms, opening up of the economy to trade and capital flows, and higher penetration of telecom and information technology helped achieve higher productivity.
It is difficult to pin-point what has caused the TFP decline. Most likely, it is because of a combination of several factors. These may include infrastructure and more generally supply-side bottlenecks, execution delays, regulatory challenges, difficulties in raising finance and slowing global economy. We fear that potential GDP growth might have fallen to 6-6.5% rather than the 7.5% that RBI referred to in its latest annual report. The rather puzzling issue of persistent inflation even while growth is slowing down can partly be explained by falling potential growth. The output gap is probably not wide enough to reduce pricing power.
When evaluating economic reforms, we should ask ourselves whether they are ticking the check-boxes of improving productivity and increasing investment rate or not. Clearly, FDI in retail should be a productivity booster because of its potential to overhaul the supply chain. Similarly, the loss-restructuring plan for state electricity boards can improve the power situation (productivity improvement) and release funds from the financial system for more productive investment. Steps taken to reduce the fiscal deficit should also increase the investment rate over time but the near-term impact might be limited. Other recent policy announcements might not have a direct impact on productivity and investment but they are trying to revive investor sentiment and attempt an asset-market-led economic recovery. We think that more important reforms would be the setting up of the National Investment Board to fast-track project approvals, streamlining the land acquisition process by passing the relevant bill, and implementing the uniform GST. The productivity impact of these measures is going to push the potential growth higher, sending us back into a virtuous cycle.
The author is regional head of research, South Asia, Standard Chartered Bank
