Two engines of the economy need to fire

The recovery in investments will continue in fiscal 2019, led by government efforts to build roads and houses. Capacity utilization, which is a pre-condition to revival in private sector investments, should also keep improving. Additionally, the crowding-in impact of public investments is expected to kick in later. Yet a broad-based and decisive pick-up in the investment cycle will take time. The share of gross fixed capital formation—fresh investments in the form of plant and machinery, dwellings and other buildings—in India’s gross domestic product (GDP), which is also called the investment rate, averaged 31% in fiscals 2015-2018, compared with 33.6% in fiscals 2010-2014. It touched a decadal low of 30.3% in fiscal 2016.

The uptick in fixed investment growth (14.4%) in the fourth quarter of fiscal 2018, as shown by the recent Central Statistical Office (CSO) release, should be taken with a pinch of salt as the CSO numbers have a tendency to undergo revisions. For example, fixed investment growth in all the three quarters of last fiscal was revised downwards. As a result, growth in fixed investments last fiscal year was 7.6% compared with 10.1% in fiscal 2017.

Why have investments been slow to pick up?

Data suggests weakness on two fronts as the reason for the decline in investments: one, the sticky share of private corporate sector investments in GDP; and two, a secular decline in household investments. CSO data shows private non-financial corporate investments have remained subdued, barring some improvement in fiscal 2017. Data from the Reserve Bank of India (RBI) paints a similar picture. It suggests capital expenditure by the private sector declined for the sixth straight year in fiscal 2017. However, it is important to note that the coverage of the RBI data is limited to institutional financing and does not include projects below ₹ 10 crore. Projects with private ownership below 51%, or undertaken by trusts, Central and state governments, and educational institutions are also excluded.

A broad-based pick-up in private corporate investments was elusive for three reasons: First is the capacity overhang. Data from the RBI suggests overall capacity utilization declined to 74% at the end of December 2017 from 81% at the end of March 2011. CRISIL Research analysis corroborates this trend. Capacity utilization in some large industrial sectors, such as thermal power, two-wheelers, tractors, cars, cement and steel, remains below the peak, though we expect improvement in fiscal 2019.

Second is the focus of corporates on improving their capital structure: High leverage has also been haunting the corporate sector and has been a deterrent for fresh investments in the economy. Companies are, therefore, focused on improving capital structure than investments. Consequently, debt/equity and interest coverage ratios have improved, not so much investments.

Third was that the transitory shocks from demonetization and implementation glitches in the roll out of the goods and services tax (GST) added to the uncertainty, which further delayed investment decisions.

The household sector was the biggest contributor to investments in fiscal 2012 (share of about 45%), but its share has declined consistently since then and was about 31% in fiscal 2017. Purchase of houses is generally the largest part (more than three-fourths) of household investments, so a slowdown on that score becomes a key reason for the decline. Construction output data corroborates this, showing construction of dwellings/houses has slowed in three of the past four fiscals. Government investments improved from 3.7% of the GDP in fiscal 2015 to 4.2% as of fiscal 2017. But the government does not have the fiscal muscle to offset the sluggishness in household and private corporate investments, which pulled down the overall investment ratio.

What about productivity of investment?

After a significant decline between fiscals 2012 and 2014, productivity of investments, as measured by incremental capital output ratio (ICOR), has shown some improvement in the last four years.

Between fiscals 2015 and 2018, ICOR averaged 4.3 compared with 5.5 between 2012 and 2014—a period of growth slowdown and policy paralysis. Lower the ICOR, higher is the productivity of capital because ICOR measures the capital required to produce an additional unit of output. The recent ICOR, however, is still higher than the 3.4 achieved during the high-growth (over 9%) years of fiscals 2005 to 2008.

The way ahead

A broad-based pick-up in investments is unlikely this fiscal as capacity overhang persists and corporates continue to focus on reviving their capital structure. Pre-election year uncertainty, too, discourages private sector investments. The election season is generally marked by uncertainties over regime-change and policy. Large investment commitments, especially by the private corporate sector are, therefore, unlikely. That said, this fiscal is expected to see a mild improvement in investments, given the government’s sharp focus on affordable housing, rural infrastructure and roads.

Beyond the current fiscal year, we are more optimistic on a broad-based pick-up in investments. The government has initiated a number of steps to ease the business environment: big moves such as the GST and Insolvency and Bankruptcy Code (IBC), and others, such as introducing online single-window model for providing clearances and filing compliances, fast-tracking foreign investments, surpassing the Foreign Investment Promotion Board, have helped. Some of these, however, remain a work in progress.

So, both investment and its productivity should pick up as the deleveraging phase gets over, crowding-in benefits of public investment kick in and efficiency-enhancing reforms start bearing fruit. That will lead to faster economic growth.

Dharmakirti Joshi and Adhish Varma are, respectively, chief economist and economist at CRISIL.

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