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Is Indian economy capable of attracting foreign investment?

By M Suresh Babu
April 26, 2015 10:15 IST
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The Indian economy at present needs to achieve these twin objectives; any divergence between them would nullify the positive gains realised from the other, says Suresh Babu.

The electoral mandate for the present government is mainly to revive growth in a tepid economy.

The government's approach so far has been in terms of incremental changes in policy reforms with some 'path dependence' and only the occasional departure.

The expectation from policy, however, including from the last Union Budget, was a radical departure - the sort signalled by the replacement of the Planning Commission with the NITI Aayog.

The government itself built an aura of ushering in big reform with the sporadic unveiling of 'emblematic' changes.

The prevailing economic situation being favourable - lower oil prices, a slowdown in inflation and nascent recovery in growth - seemed to provide an ideal platform.

Perhaps the single biggest challenge of economy policy for the government over the Budget session is to outline an approach to increase the rate of investment in the economy.

All strands of economic theory emphasise the role of investments in accelerating growth and employment generation.

The Indian economy at present needs to achieve these twin objectives; any divergence between them would nullify the positive gains realised from the other.

Since 2000-01 the economy has shown the tendency of being unable to absorb all domestic savings as investments.

This is evident from the fact that in only two years - 2001-02 and 2008-09 - have investments, in terms of gross fixed capital formation, been higher than savings as a percentage of GDP.

While savings as a percentage of GDP increased from 23.7 per cent to 30.6 per cent between 2000-01 and 2013-14, the rate of increase has not been impressive in recent years.

In fact after reaching a peak of 36.8 per cent in 2007-08, it has consistently declined over time - and the last fiscal year showed a huge decline, despite the new series of GDP estimates.

This is due to a decline in household savings, while corporate savings have touched a recent high of 10.9 per cent of GDP in 2013-14. For the period 2000-01 to 2013-14, gross fixed capital formation increased from 22.7 per cent to 29.7 per cent of GDP, still below 30 per cent.

This is because fixed capital formation in the private sector declined in the last year after peaking in 2011-12.

So, we have a situation where private sector savings have increased but fixed capital formation has declined.

Why is this happening? The Budget and associated economic policy were expected to provide a vision to tackle this trend of sluggish private investment.

But as it turns out the vision has been clouded by some illusions.

The vision of the government's economic policy as revealed over this session of Parliament is the explicit recognition of the need for enhancing physical investments to accelerate growth.

This is nothing new.

Growth models from Solow's to the new growth theory of Romer and Lucas have identified investment as the key driver of growth.

The only difference has been that one set of models emphasises physical capital formation, while the other includes human capital formation also. We have been focusing on the former; altering the trajectory of human capital formation assumed secondary importance.

The government has set out a grand vision of higher physical investment through infrastructure and basic social amenities.

This is evident from a range of measures announced, from power projects to housing for the poor.

There are two underlying assumptions in this vision.

First, there is a necessity for institutions that will enable the market mechanism to work efficiently - such as the Mudra Bank and the debt management office; second, maintaining a high level of public investment will "crowd in" private investment.

While both assumptions are not unreasonable, this approach is nevertheless unlikely to have an impact on private investment in the coming year.

First, actual private investment in manufacturing has always fallen short of what has been proposed, ever since the economic reforms of 1991.

An examination of proposed investments, their actual implementation, and employment generation between August 1991 and March 2014 - in other words, for the near quarter-century of liberalisation - shows that actual investment is well short of that promised. DIPP data shows that there were about 94,000 investment proposals, through IEMs and Direct Industrial Licences.

These proposed an investment of more than Rs 102 lakh crore (Rs 102 trillion), and were supposed to generate 23 million jobs.

However on the implementation front only Rs 5.1 lakh crore (Rs 5.1 trillion) has been actually invested and just two million jobs created.

This is less than five per cent of the proposed investment and 8.9 per cent of the promised jobs.

The investment-to-employment creation ratio looks abysmally low.

Given that the Rs 5 lakh crore (Rs 5 trillion) actually invested has created a little over two million jobs, in terms of capital-labour ratio this amounts to four jobs per crore of investment! Further, there exist wide interstate differences in this. Every crore invested in Jammu and Kashmir creates about 12 jobs, but in Gujarat has created only two jobs.

Hence, relying on 'Make in India' to bolster private investments and growth is too ambitious.

Second, as rightly noted in the Economic Survey, "an unambiguous fact emerging from the data is that the debt to equity for Indian non-financial corporates has been rising at a fairly alarming rate over time, and is significantly higher when viewed against other comparator countries". There is a problem here.

Private investment may continue to be bogged down by excess debt in the balance sheets of Indian companies; cash flows will be used to reduce this debt rather than to fund new projects.

In this situation can the private sector be expected to rise to the occasion? Certainly not.

The government's vision is clear: get institutions right and harness investment.

But the illusion is that the private corporate sector will respond to its call.

In fact, the evidence shows that the private sector has been evading the call, citing "unfavourable market conditions" and clamouring for more fiscal concessions.


Suresh Babu teaches economics at IIT Madras

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