For a domestic demand driven economy like India, consumption and investment are the key components in growth dynamics. In recent years, consumer spending has been the primary driver, contributing close to 60% of total real growth on average. However, concurrent rise in import growth over this period has meant that the Indian economy did not benefit fully from this growth in domestic demand. Consequently, investment growth has been sluggish and the virtuous cycle of employment creation through higher investments supporting further consumption, has not played out. As we start into what’s hopefully the post Covid recovery phase, when private consumption has been badly bruised by income losses in the aftermath of the pandemic, investments remain critical to the economy’s resurgence story both in the near and the medium-term.
It is important to note at this point that the current downturn in the investment cycle started years before the pandemic hit and has lasted more than a decade. The ratio of gross fixed capital formation to GDP in the Indian economy climbed from 22.85% in 2000-01, reached a peak of 34.3% in 2011-12 and has been sliding down since then to hit an estimated low of 27.6% in 2020-21. And expectations of automatic bounce-backs from investment slowdowns haven’t materialised through these years. Such a long period of falling investment levels have passed under the radar, largely because the slide has been gradual, unlike say, the sharp adjustments globally, following GFC. Also, given the large fall in investment, the economy has paid relatively modest costs in terms of growth till now.
However, the deeper the slowdown, the slower and shallower the recovery. India’s investment decline has proven to be particularly difficult to reverse, despite multiple efforts by policy makers, mostly because it has been unusually large. A series of initiatives including ‘Make in India’, corporate tax rate cut to the recent extension of the PLI scheme have all fallen short of what is required to push the investment levels. At the same time, global experiences suggest that policy action can decisively improve the outlook. It is however critical to direct the policies where it helps most.
Indian economy is facing multiple structural issues inhibiting investment – fiscal challenges, falling revenues and demands for industrial products, and poor capacity utilisation. The list of required reforms is long, beyond just the cost of capital issues. But the usual prescription fails to consider what General Theory of John Maynard Keynes propagated many crises back- ‘that the basic cause of a downturn is the absence of aggregate effective demand’. In times of uncertainties, both consumers and producers prefer to hold on to money. What follows is a fall in the aggregate rate of saving and investment in the economy. He coined the term ‘animal spirits’ to refer to such investors’ confidence in taking action.
Very often investments are not an outcome of dispassionate analysis of discounted cash flows, internal rate of return and net present values. The future is uncertain and investing large sums in long term projects is a significant leap of hope. What ultimately drives the corporate sector to make investments in projects, where cash flows will accrue in the future are “the animal spirits”. In India, income uncertainty and the desire to hold on to cash has been triggered by several disruptions on the demand side in the past few years, which has hurt business confidence and fresh investments. While their justifications are a topic of another discussion, speed, timing and sequencing of these hits have created a doubt and an uncertainty that business abhors. To add, macroeconomic policy focus on low tolerance for inflation without concerns for possible impact on employment has taken a toll on incomes and spending and extended the investment famine.
This is hence a time to take some lessons from Keynes. Getting the consumption cycle flowing, creating a healthy credit flow-through and a supportive business environment could just be the elixir we need to revive ‘animal spirits’. By all means keep chiselling on the structural impediments but first of all revive the animal spirits and both employment and investment will follow.
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