Who is investing now?
Indian Express, 30 May 2011
Concerns about slowing investment, both domestic and foreign, have become stronger in recent months. The sluggishness in new projects being announced seen since the global financial crisis has continued, resulting in a slowdown in the growth rate of private corporate investment. This is bad news for both growth and inflation, as growth will slow down and inflation will remain high. At the same time, real interest rates remain low, both historically and in comparison with other emerging economies.
While advanced economies were hit sharply by the crisis, India appeared to remain unaffected. The transmission of the slowdown in the world appeared to be limited to a fall in exports. Monetary policy responded rapidly to the risk of a fall in growth. Fiscal expansion was already on the cards due to NREGA, the increase in subsidies due to a rise in world oil prices, and the sixth pay commission. These fitted in as part of a fiscal stimulus. As a consequence, growth did not slow down, and the Indian economy appeared to have braved the crisis very well.
However, one thing did change after the crisis, and that trend has not reversed since. While investment appeared to be unaffected, as projects under implementation went on to be completed, new project announcements slowed down sharply. This was first expected to be temporary as bank credit became tight and bankers became unwilling to lend due to the increase in risk perception. Most people expected that this trend would soon change and animal sprits would rise. But that has not happened. CMIE Capex data shows disturbing trends in new investments. First, new investment announcements have continued to fall sharply. Data available till March 2011 shows that new investment announcements continue to be fewer quarter after quarter. In addition, there is a sudden rise in projects abandoned. So even out of projects that were announced despite the slowdown in project announcements, many more projects have been abandoned.
Investments decisions are based on expectations about the future. An investment appears profitable when the price of outputs is expected to be higher than the cost of producing them. There are many reasons that could possibly be attributed to the decline in expected profits of investment decisions in the country. While it is easy to blame the scams for the slowdown in investment projects, the slowdown has not happened suddenly. However, the policy environment, in a much larger sense, is certainly responsible for the change in sentiment about India. Private investment was the biggest driver of growth in India in the 2000s. Unlike in China, where external demand might have played a bigger role, in India it was the sharp increase in the share of private corporate investment that led to GDP growth acceleration. The fiscal expansion meant a large and expanding government borrowing programme that pre-empted private resources. Policy uncertaintly introduced by land use, resource extraction and environment policies introduced regulatory uncertainty. It started making sense to wait and watch before planning new investments.
A crucial element in the decision to invest is expectations about profits. When input costs and output prices are volatile, making predictions about profits becomes difficult. As a consequence, it is seen that highly volatile inflation reduces investment. The last 5 years, after 2005 have seen not only inflation rise, but the volatility of inflation in India nearly doubled. This has made making forecasts about the inflation rate in India increasingly difficult. As an example, we can look at the differences between the inflation forecasts by the RBI and the actual inflation at the end of each fiscal year for which RBI makes the forecast. During this period the monetary authority, with a large research team that is supposed to specialise in this field, and which has policy levers that give it the power to impact the inflation rate, has got the forecast wrong every single time by 100-200 basis points. For businessmen with neither the specific training to make inflation forecasts, nor the monetary policy tools to impact it, the task is naturally much harder.
What can policy do? Fiscal policy, more people agree now needs to be contractionary. In the long run most people would agree that monetary policy should provide the economy with a low and stable inflation rate. However, it is in the short-run when one of the elements of this strategy is to raise interest rates that industry lobbyies start arguing for keeping the cost of investment low by maintaining low interest rates. This argument normally looks at nominal interest rates, rather than real interest rates. In India too, even at the currently high levels of inflation and low real interest rates we often hear arguments in favour of keeping rates low. If RBI has to fight inflation it will have to raise real interest rates.
But raising interest rates is not going to be enough to fight inflation. Bringing inflation now may be much harder now that inflationary expectations have risen. A central bank can successfully fight inflation only when it has commitment, credibility and a proper communication strategy. If the RBI continues to fight for turf on other issues such as who will run the debt management office for the government, it will continue to communicate to the public that its commitment to fighting inflation is limited. This will make its job of providing low and stable inflation much harder. It would not be surprising if the coming year continues to witness inflation in the range of 9 to 10 percent while the RBI continues to raise interest rates. Communicating its commitment to low and stable inflation cannot be done only in monetary policy statements. It needs to be done even when the role and function of the central bank is under discussion.
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