It’s well-known that India’s stock markets are at the mercy of foreign fund inflows. But is the growth of the Indian economy, too, dependent on them? To answer that question, let’s consider what happened during the last boom of 2003-08.
The Indian economy grew at an unprecedented pace in those years. Gross domestic product (GDP) growth averaged 8.88%, with the three years, 2005-08, showing growth rates of over 9% a year. What was the root of the high growth during the period?
The first change that occurred after 2002-03 was a sharp increase in capital expenditure. The increase in gross domestic fixed capital formation—or to put it simply, capex—suddenly jumped from 6.8% in 2002-03 to 13.6% in 2003-04. It remained high during the next four years before slumping to 3.5% in 2008-09 and remaining in single digits ever since. This means that for growth to come back, firms must start investing in fixed capital, or capex. That is what provided the boost to growth during the last boom and it’s what will lead to a turnaround this time, too.
But the investment needs to be financed by higher savings. That is exactly what happened during the boom years. Where did the increase in savings come from? Total household savings in 2007-08, the final year of the boom, was 24.4% of GDP (both at current prices). That’s not very different from the 23.1% of GDP it was during 1999-2000. Moreover, if we consider only the financial savings of households, the improvement was from 11.6% of GDP in 1999-2000 to 12.7% in 2007-08. In short, it wasn’t households that contributed the most to the rise in savings over the period.
The big improvements came from the private corporate and the public sectors. For instance, over the same period, the savings of the private corporate sector went up from 4.9% of GDP to 10.2%. And public sector savings improved from minus 0.9% of GDP to 5.4%, on the back of a big improvement in tax revenues. In short, it was the rise in corporate and government savings, rather than any dramatic change in household savings, that provided the fuel for the increase in investment.
What led to this rise in corporate savings? Take a look at the earnings per share (EPS) of the companies that make up the benchmark Sensex index on BSE. Their EPS increased from Rs 272 in FY03 to Rs 348 in FY04. By FY08, the EPS of the Sensex companies had increased to Rs 833, a more than three-fold growth in five years. Small wonder then, with their profits increasing so much, the companies saved more. High growth for firms also led to more taxes for the government, which helped improve its finances and bring down the fiscal deficit. The combined fiscal deficits of the state and central governments dropped from 9.57% of GDP in 2002-03 to 4.09% in 2007-08. The lower government borrowing, in turn, kept interest rates low, allowing investment to proceed unhindered.
But there was another, far more potent reason that led to a significant lowering of the cost of capital. During 2003-08, foreign funds flooded the Indian equity market, driving stock prices up. Foreign portfolio investment went up sharply from 2003-04, as the West recovered from the dotcom bust and very low interest rates there led to money rushing into risk assets like emerging markets. The high portfolio inflows and high stock prices, in turn, led to a huge boom in the primary market. The animal spirits of businessmen were unleashed. Companies wasted no time in taking advantage of the flood of capital to issue stocks at higher valuations, driving down their cost of equity. The deluge of foreign money led to an appreciation of the rupee and the central bank’s efforts to contain it led them buying dollars and selling rupees, adding to liquidity. Under these circumstances, why wouldn’t firms expand and invest?
As a matter of fact, something very similar had occurred, on a smaller scale, in the mid-1990s. At that time, too, a big increase in portfolio inflows led to a flood of initial public offers, which, in turn, led to an enormous amount of investment, quite a lot of which later became non-performing assets in the books of banks. In 1995-96, for instance, the growth in gross fixed capital formation was a high 19.6%. The upshot was that EPS of the Sensex companies rose from Rs 81 in 1992-93 to Rs 250 in 1995-96, a compounded annual growth rate of 45%. That led, for the economy as a whole, to GDP growth during 1995-96 and 1996-97 being a high 7.3% and 8%, respectively.
Could the high growth be the reason for foreign fund inflows? My bet is it’s probably the other way around. A benign risk-on global economic and monetary environment leads to portfolio flows to risky assets such as emerging markets, which lowers the cost of capital and boosts investment in emerging economies, thereby boosting growth rates, which in turn leads to higher consumption and earnings and attracts even more inflows, completing the virtuous circle.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org
Also Read | Manas Chakravarty’s earlier columns