Talking Point. Improving investment sentiment is key

Five quarters of declining GDP have put economy watchers in a tizzy. While demonetisation and GST are obvious villains by proximity, a more dispassionate analysis will show that little has changed structurally.

First, the data growth in GDP at an average 7 per cent in the last five years was powered largely by personal consumption, which contributes over 55 per cent. Gross fixed capital formation contributes around 35 per cent but has been growing more slowly around 5 per cent, which has been the real issue.

The other two engines, government consumption and net exports, have fluctuated, alternately boosting or dampening growth. Government spending (about 11 per cent of GDP) boosts growth, but in a one-off manner.

Net exports have traditionally been negative and growth-depressing, but declining deficits (imports falling faster than exports) have the opposite effect; thus the steep decline in trade deficits since 2013-14 added points to GDP growth during last three years, somewhat compensating for low capital formation.

This favourable situation was brought about by ultra-low oil prices and a general decline in demand. But with both world trade and oil prices now picking up, trade deficit during Q1 2017 shot up due to a spike in imports (13 per cent) and low growth in exports (1 per cent).

To be sure, manufacturing growth also fell to a low of 1.2 per cent during Q1 2017 — all of which pulled growth down to 5.6 per cent, which has set off alarm bells. Whether demonetisation and GST were behind manufacturing’s poor show could be debated, but if this were so, one could also expect it to revive when these effects fade away. The million dollar question is, will it revive or will the slack in investment continue?

A point to note here is that the manufacturing sector’s contribution to GDP has been steadily declining over the years, with services, finance and the social sectors being the principal drivers now. But manufacturing is the primary generator of jobs and falling investment will therefore also mean fewer jobs.

As much as the problems are well known, so are the solutions. The usual suspects — high interest rates, strong rupee and falling bank credit — would all point to the RBI for action, while the other option with Government, namely pump-priming, seems unlikely at the moment, given the risks.

The connect between the Bank rate and credit offtake has been fuzzy at best — the repo rate went down from 8 per cent in 2014 to 6 per cent currently, while the weighted average lending rate of banks fell from 12 per cent to 9.7 per cent; yet, growth in bank credit to industry actually fell from 13 per cent in 2014 to 2.7 per cent in 2016 and to a negative 1.9 per cent in 2017. Besides, as earlier RBI governors have pointed out, rate transmission is weak because it is the risk premium component of lending rate that remains high due to large NPAs.

Clearly, factors such as declining demand, excess capacities created during boom times and the profitability of speculation (preference for the short term over the long term) have dampened sentiment. Falling tariffs are another major issue in at least two crucial sectors, power and telecom. Telecom firms and power plants are struggling to remain viable while lenders struggle to maintain asset quality.

In such a scenario, one can hardly expect fresh investments in these sectors. The only large-scale investment proposals would be with Government in railways and core sectors, which do not depend on commercial bank credit.

As for exports, while it is true that weak world trade was a factor, rupee appreciation (due to strong inward flows) definitely hurt it more. The RBI has an even more difficult task in managing the value of the rupee and liquidity and inflation at the same time. Lower interest rates could work if they dampen portfolio inflows and halt rupee appreciation, but then the external front has always been at the mercy of global policies and events. Likewise, revival of bank lending to industry would be a long shot, given the lack of risk appetite on the part of both lenders and borrowers. Banks are wary of fresh project lending and prefer to play safe, deploying deposits in government securities or in consumer credit.

While undoubtedly bank credit is now being substituted by bond and equity markets, as SEBI data indicates, it has been the financial sector that has been raising the bulk (over 50 per cent) of the money while industry and infrastructure seem reluctant to tap the markets in a large way. In the short term, ramping up Government spending may work, but in the long term, it would be a host of fiscal, regulatory and monetary reforms that improve investment sentiment that will be needed.

The writer is an independent consultant

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