April 16, 2014
Indian Economy
Irrational Expectations
By Nitin Desai
There is a certain euphoria in business circles in anticipation of a big victory for the business friendly Narendra Modi. He appears to have the backing of the corporate sector, more so from family controlled companies dependent on political for competitive positioning. But business-friendly and market-friendly are not the same thing and one senses some hesitation from professional managers, some of whom have joined AAP, who are more concerned about crony capitalism.
Foreign institutional investors share in the expectation of good times as is evident from the Rs.80000 crores they have poured into the Indian stock market in 2013-14. But that may well be because India right now is a more attractive market than many others for the investment funds earmarked for emerging economies.
Regardless of what is driving these anticipations, the reality is that an economic turnaround is going to take longer than the short horizons of market players. Their expectations of a coming boom has fuelled a 19 percent rise in the Sensex in a year when economic performance was worse than at any time in the past decade. This stock boom, which may well continue for some months after the results are announced. It may be as misleading as the fall in the stock market after the 2004 election just prior to an extraordinary period of high growth and the sharp rise after the 2009 general election which marked the beginning of a torrid time for the Indian economy.
The key to economic revival lies in a restarting the productive investment engine because the slowdown in growth has a lot to do with the sharp decline in infrastructure and corporate investments. The gross investment numbers are misleading because they include the accumulation of inventories and valuables (basically gold) which do not add to growth potential. If one looks at the numbers for Gross Fixed Capital Formation (GFCF) as a proportion of GDP at current market prices the decline is from 31.7 percent in 2009-10 to 30.4 percent in 2012-13. Within this the share of direct investment by households as a proportion of GDP has gone up 13.2 percent in 2009-10 to 14.1 percent in 2012-13 and since this goes mainly into construction, plant and machinery investment has grown even more slowly than GFCF. The trend continues as the CSO's Advance Estimates for 2013-14 show a further decline in GFCF as a proportion of GDP at current market prices to 28.5 percent.
The reduction is particularly marked in the private corporate sector whose gross investment as a proportion of GDP has declined from 10.2 percent in 2009-10 to 8.4 percent in 2012-13. Part of the reason for this is the decline in corporate savings which as a proportion of GDP fell from 8.4 percent in 2009-10 to 7.1 percent in 2012-13. The numbers for 2013-14 will be even worse.
A recent IMF study looks for explanations for this sharp decline in investment growth and the decline in new project announcements from around 10 percent of GDP the 2004-08 period to barely 1 percent of GDP now. It also argues that project delays have become worse.
A closer look at the data presented in the IMF study suggests that actually the 2004-08 period was exceptional when new project announcements rose to very high levels and project delays fell sharply. The period prior to 2004 looks very similar to the post 2009 period, though one must admit that the last two years have been exceptionally bad for.
The study attributes asserts that "heightened uncertainty regarding the future course of broader economic policies and deteriorating business confidence have played a significant role in the recent investment slowdown." It attributes only a small role to high interest rates which have been blamed by many for the slow down. It points out that real interest rates during the recent period may have been 300 basis points lower than in the 2004-08 boom. But this argument needs to be tempered since for corporate profitability what matters is the inflation in manufactured goods. The inflation in food prices does little to mitigate the burden of high nominal rates.
Will a stable NDA government led by Modi be able to change this soon enough?
The BJP appears to believe in lowering interest rates and will certainly lean hard on the RBI. But they also have to bring down inflation, which will remain a worry with a 70% chance of an El Niño event this season, and an interest cut may work against that. The other constraint is the need to maintain interest rates at a level that will keep the NRI flows, which have been booming over the past couple of years coming in. But some cosmetic reduction in interest rates will come and may help to boost confidence.
A more important argument is that a business friendly government that does not carry the baggage of scams and scandals will reduce policy uncertainties and revive confidence. But even this reason for optimism needs to be tempered with a dose of reality.
The policy uncertainties that need to be resolved involve some matters like the tax treatment of transactions by foreign investors which has roiled sentiment, pricing decisions on gas for instance and a few others that could be addressed in weeks. But much of the rest involves a long haul. Changes in the system of environmental clearances, forest rights, land acquisition will require legislative changes that will take time. Moreover many of the bottlenecks are at the State level or imposed by court orders that Centre cannot influence as readily. Investments have also been held back by supply constraints, for instance for coal and also slow demand growth, particularly for capital goods.
For all of these reasons the chances are that the initial euphoria over a business friendly government will give way to a correction in the mood in stock markets and corporate boardrooms in a matter of months after the election. The fact is that the slowdown is not due just to the paralysis in decision making but to deeper factors like the fiscal and current account deficit which will take years rather than months to correct. Does the 'vikas purush' have that much time to prove his worth?