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One glaring difference in the current cycle of growth in India versus the one that began in 2003 is the absence of pickup in investment outlays. The reasons are not difficult to fathom. Government-owned banks, responsible for over 75% of the banking system’s outstanding loans, are constrained in their ability to lend. Neither has the formation of bad assets ebbed, as is being evidenced in their latest quarterly reports, nor have they been able to raise adequate capital to accelerate lending. In contrast, entities involved in undertaking large capital expenditures in the previous cycle are still shedding assets from previous excesses or do not find the demand environment sufficiently viable to commit new money, especially in commodity-related areas. India’s investment ratio (Gross Fixed Capital Formation, or GFCF, as a share of Gross Domestic Product, or GDP) soared from 23.7% in FY2003 to almost 33% in FY2008 but has since declined to 28.5%. Average nominal GFCF growth for the past two years has been a paltry 6% and barely positive in real terms. Hence the question that we have often grappled with is: who will lead and who will lend in India’s next investment cycle.

We recently watched the movie The Imitation Game, based on the life of famous British cryptographer Alan Turing. Turing cracks the almost-unsolvable German Enigma machine’s code based on a chance conversation that makes him realize that a few letters in the coded messages always correspond to the words “Heil Hitler". Sometimes solutions to the most vexing problems are born out of a totally unconnected happenstance. Towards the end of 2014, crude oil prices started declining materially. From $115 per barrel in the middle of June, they are at $55 per barrel now. The salutary effect of this on India’s external deficit as well as inflation dynamics is quite well known. What this has also done is create headroom within the fiscal mathematics for additional spending. This fact seems to be underappreciated as, thus far in FY2015, almost the entire budgeted fiscal deficit has been used up with three months to go in the financial year. Moreover, the popular perception is that if targets laid out in the Fiscal Responsibility and Budget Management Act (FRBM) are to be met, there will be limited fiscal elbow-room. However, a combination of lower net subsidies from fuel and fertilizers along with rationalization of some welfare schemes could create meaningful space for additional expenditure, even while remaining within the FRBM limits. The two heads that contribute to this are, expectedly, higher excise collection from the recently increased excise duties on petrol and diesel and the lower subsidy burden from fuel and fertilizers. Both put together, in our opinion, create fiscal manoeuvrability to the tune of about 0.9% of GDP. For these calculations, we assume oil at $75 per barrel and importantly, stay within the fiscal deficit of 3.6% of GDP as originally envisaged for FY2016.

It is natural that whenever there is a windfall gain, claimants who profess to be the most deserving start crawling out of the woodwork. The government will be hard pressed to allocate the gains between competing demands of private sector firms and/or individuals for lower taxes, sops for various sections of the economy or even higher subsidies and welfare spending. However, given the hamstrung capital investment cycle the most prudent way to allocate this windfall will be towards fixed capital formation, primarily for infrastructure. It is interesting to note that public spending as a share of GDP has remained in the 14-15% range for the last few years. However, as the accompanying graph shows, the share of capital expenditure within that expenditure has shrunk from 2.4% in FY2008 to 1.6% in FY2014. Data from HSBC shows that within our peer set of Asian economies this is one of the lowest. In other words, over the past few years, the skew of government expenditure has moved towards revenue spending with lower amounts being allocated for capacity creation or augmentation.

This has been part of the reason for chronically high inflation that the economy had to withstand in the past few years. It is time to correct this mismatch. While the present government has stated its desire to rein in some of the welfare and subsidy spending, there is need to reallocate that money for capital expenditure that can be implemented quickly and will have a high multiplier on growth and job creation. Even if the mix is re-adjusted to the average of the last decade, it could make an additional 0.4% of GDP available for capital spending. Coupled with the gains from lower subsidy and higher excise, it could lead to a push of about 1.3% of GDP in a single year.

To be sure, this is not a Keynesian policy recommendation of people being paid to dig holes and then fill them up. This is more about judiciously using the windfall, re-orienting budget spending and kickstarting a part of economy that is tied up in a gridlock. Sceptics worry that a fiscal push of this kind may be inflationary in the near term and reverse the gains that the Reserve Bank of India has achieved in quelling inflation, causing the hopes of a monetary easing cycle to be still-born. However, we think downward pressure on prices from slowing global demand would counteract the near-term inflationary pressures, if any. If all the pieces of the jigsaw were to fall into place, we could have that rare confluence of pro-growth fiscal and monetary policy for some time to come.

Swanand Kelkar and Amay Hattangadi are portfolio managers with Morgan Stanley Investment Management. These are their personal views.

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