Another year has passed and there are still no signs of a revival in private investment. It was never meant to be easy. After all, India is in the midst of what resembles a “credit-less recovery”. GDP growth has bottomed out, but several big banks are grappling with huge stocks of non-performing loans (NPLs). Credit growth, in both real and nominal terms, is well below the long-term average, recovering more slowly than during previous slowdowns (see chart). The big question is can investment rise convincingly when the funder-in-chief, the country’s banking system, is still limping.
Once considered rare, credit-less recoveries are actually quite common. An IMF paper analysing 223 case studies from around the world found that one of every five recoveries are credit-less and they have special characteristics, which are surprisingly consistent across countries. First, output growth is about a third lower than during normal recoveries, and this has been the case for India this time around. Second, the financially-dependent investment sector makes a disproportionately lower contribution to growth. Lower investment has been a stand out characteristic in India, while consumption has fared relatively better. In fact a substantial portion of bank credit
is funding consumer loans rather than investment. In short, going by global experience, India’s low-credit investment recovery was never meant to be rapid.
What’s the way out? Amid all this uncertainty, the words of Saint Francis of Assisi seem particularly insightful: “Start by doing what’s necessary; then do what’s possible; and suddenly you are doing the impossible.” His message from 800 years ago is still relevant today.
India tried the “necessary” in 2015. Taking a break from the path of fiscal consolidation, the government attempted some counter-cyclical fiscal policy and did a good job. Savings from the oil subsidy bill were deftly channelled towards investment and, hey presto, government capex rose 31% yoy. Sadly, this was not sufficient to “crowd in” the private sector. While some previously stalled investment projects showed signs of life and parts of the transport sector received additional government funds, overall, the results were lacklustre.
The government realised that a crucial piece was still missing. Even if the private sector was interested, greater incentives were required. A new public private partnership (PPP) model was needed to allay private sector concerns about shouldering excess risks, while at the same time making sure there were no free lunches on offer. This is work in progress and, hopefully, PPPs will be the talk of 2016.
All this is encouraging but can new PPP contracts alone lift the investment cycle? This time around, it is not just a funding problem. The system is also plagued by insufficient demand. There is excess capacity and slack across several sectors, as made clear by output gap estimates and RBI’s capacity utilisation survey. But, how long do we need to wait for this overcapacity to shrink?
Luckily, there is another development brewing on the horizon, what St Francis referred to as the “possible”. The stars seem to be aligning for a meaningful lift in consumption demand, which could in turn eventually encourage investment. The Seventh Pay Commission has recommended a hefty 24% wage hike for government employees.
The last time this happened, in FY09-10, a 30% “windfall” in wages stoked demand for big-ticket items like cars and houses. But back then urban private sector wage growth was low (remember the fallout from the global financial crisis?) and a shocking rise in inflation had eroded real purchasing power. Overall consumption growth was not just unbalanced and inflationary, but also weaker than before.
This time, recovering private sector wages and real gains from low inflation are also likely to provide additional support to government wage hikes. We find that consumption that is driven by real wage growth across the whole labour force, rather than a windfall for a select few, tends to drive demand for all goods and services (not just the expensive ones). As such, this time, the spurt in demand could be more balanced and sustainable, as shown in the accompanying chart. Over time, this should shrink overcapacity and provide incentives for greenfield investment.
Admittedly, these building blocks are complex. But this could well be India’s ‘best case’ scenario for ushering in private investment.
The problem is that this scenario is fraught with risks, primarily fiscal ones. If the government cuts back on capex to fund wage hikes, it could block the “necessary” channel needed to crowd in the private sector, the point where our conversation began. Ultimately, the ability of the government to finance the competing demands of capex and higher salaries may hinge on whether it can generate fresh fiscal funds over the next few years.
The roadmap looks something like this: 2015 marked the start of higher government capex. Consumption starts to rise in 2016, helping shrink overcapacity; new PPP contracts are unveiled and government capex continues like in the prior year. This could set the stage for the long-awaited arrival of private sector investment in 2017 and beyond. RBI’s efforts to deal with NPAs, continued monetary transmission and low commodity prices could also help the process.
The bad news is that the rise in private investment—even with the necessary and the possible playing their part—is not going to happen immediately. The good news is that there are some drivers out there that could make the seemingly impossible, possible—eventually.
Pranjul Bhandari, Chief India Economist, HSBC