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As pent-up demand runs its course, growth could begin to slow around the second half of the year. That’s when it is hoped investment will step in. After a decade-long decline, many believe the time is ripe for a revival. Corporations have shed large amounts of debt in their balance sheets, liquidity is ample, and interest rates are low.

But there have been false starts in the past. How likely is an investment revival this time?

Our trusted investment model shows that four variables explain the trends in investment rather well. These are: World growth, a corporate indebtedness metric, a policy uncertainty index, and excess growth returns (i.e. future growth expectations over and above real interest rates).

Each of these had pushed investment lower in the last decade. Now, two of the four—world growth and the health of corporate balance sheets—have become supportive of a revival.

But two other drivers, which also tend to be tightly correlated in volatile times, are not as robust. Policy uncertainty levels have risen in the pandemic period, and the index is running about 40% higher than during India’s golden period of investment (2003-07). This is not surprising, given back-to-back uncertainties triggered by the pandemic waves, chip and container shortages, commodity price volatility and rising global inflation.

True, excess growth returns have shot up from their pandemic lows. But there is uncertainty about future trends, and a fear of a moderation once pent-up demand runs its course.

Which of the drivers will dominate? Will the improvement in world growth and corporate balance sheets outpace the rise in policy uncertainty and moderating growth returns?

We employ some additional techniques (i.e. a rolling coefficients analysis) and find that in the recent period when the health of balance sheets improved, the importance of it in driving the investment cycle has fallen. This, we believe, implies that strong balance sheets may be necessary for investment revival but not sufficient.

And indeed, around the same time, the importance of excess growth returns has risen sharply.

Unless policy uncertainty falls and the prospects of excess growth returns rise, the investment cycle uptick may not be strong footed.

What’s holding back future growth prospects?

A couple of factors. One, rising inequality at both the firm and individual levels. Large firms have become larger at the cost of smaller firms. Informal-sector firms have been disrupted. The impact of this may show up over time in the form of lower demand and growth. Two, sluggish capacity utilization. The Reserve Bank of India’s (RBI’s) index on this been in decline since 2012, and fell further in the pandemic period. It used to be above the 75-mark in the golden period of investment, and is now about 15% lower. A rise back up is becoming increasingly important for ushering in new investment. But some recent developments make us a bit worried.

As observed, 2021 was a year of rising goods demand. The jury was out on whether it was pent-up demand or it will rise further. If it is just pent-up demand, it can only go so far and perhaps not be enough to raise capacity utilization to levels that incentivize new investment.

After rising rapidly, goods production has indeed plateaued at about pre-pandemic levels. There is hope that services demand does better, but both goods and services demand are driven by the same underlying drivers (such as incomes).

There is a sense that the government’s Production Linked Incentive (PLI) scheme will provide a push to manufacturing and investment by enabling Indian firms to cater to global demand. And while the scheme has been successful in encouraging the mobile handsets industry, continued success for the 10-odd new sectors it has been extended to may need more work. The PLI scheme is small-sized (supportive of 1.2% of investments per year), and a continuous rise in import tariffs is raising input costs and making exports uncompetitive.

The central government’s capital expenditure has risen, but needs to rise more and for longer in order to have a meaningful impact.

So, is the outlook all bleak? We think not. At a time of heightened exogenous shocks, government policy can be a huge source of stability and predictability, which are important prerequisites for an investment revival.

And it can start with the Union budget to be announced on 1 February.

Last year’s budget had a lot of positives: Transparent accounts (e.g. repaying the dues owed to the Food Corporation of India), credible budget estimates (e.g. tilting towards conservative tax revenue estimates), high-quality spending (e.g. the push for capex), gradual fiscal consolidation (e.g. efforts to lower the deficit gradually), and tax stability (e.g. no major tax changes). Sticking to these principles can go a long way. Our estimates suggest that it is possible to achieve all of these simultaneously.

How about reforms?

The continuity and predictability theme can be extended to policy reforms as well. The government is already pursuing some important reforms related to fiscal policy (e.g. its asset monetization scheme), tax policy (e.g. improving the GST regime), the financial sector (e.g. improving the Insolvency and Bankruptcy Code), and manufacturing (e.g. the PLI scheme). Implementing these properly is a better strategy than announcing new reforms.

And the central bank faces an urgent task, too— namely, inflation control. The “durable recovery" that RBI desires may only come about if price predictability makes investors confident about investing.

If the budget and subsequent reforms are based on the principles of predictability and stability, investment revival would have a chance.

Pranjul Bhandari is chief India economist at HSBC

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