"India's Investment Slowdown: The High Cost of Economic Policy Uncertainty", authored by Rahul Anand and Volodymyr Tulin was released yesterday.
It finds that heightened uncertainty regarding the future course of broader economic policies and deteriorating business confidence have played a significant role in the recent investment gloom.
"The recent Indian investment slowdown has been, to a large extent, reflective of deteriorating confidence and rising policy uncertainty," it said adding that some widening of interest rates has accompanied these developments; however, only a portion of the investment slowdown can be attributed to the increase in financing costs.
"We find that heightened policy uncertainty has had a particularly pronounced link with the decline in new investments as well as with the rising value of investments that were postponed or cancelled. After controlling for these factors, financing costs do not appear to be a critical factor in explaining the decline in new investments," the paper said.
Therefore, it appears that the current Indian investment slowdown is primarily driven by weak business confidence and policy uncertainty, though factors not explicitly captured in the regression analysis, for example supply bottlenecks, are also at play, the two authors wrote.
"In the short term, lowering nominal interest rates may provide some relief in terms of a reduced interest burden, especially to corporates with high leverage," the IMF working paper recommended.
However, in the medium term, lower rates with little slack in the economy would stoke inflation further and exacerbate inflation trends across sectors, hurting investment.