One glaring difference in the current cycle of growth in India versus that which began in 2003 is the absence of pick-up in investment outlays. The reasons are not difficult to fathom.
State-owned banks that comprise over 75% of the banking system’s outstanding loans are constrained in their ability to lend. Neither has the formation of bad assets ebbed, as is being evidenced in their latest quarterly reports nor have they been able to raise adequate capital to accelerate lending.
On the other hand, entities involved in undertaking large capital expenditures in the previous cycle are still shedding assets from previous excesses or do not find the demand environment viable enough to commit new money especially in commodity related areas. India’s investment ratio (Gross Fixed Capital Formation- GFCF as a share of GDP) soared from 23.7% in F2003 to almost 33% in F2008 but has since declined to 28.5%. Average nominal GFCF growth for the past two years has been a paltry 6% and barely positive in real terms.
Hence the question that we have often grappled with is who will lead and who will lend to the next investment cycle in India.
We recently watched the movie The Imitation Game, based on the life of famous British cryptographer Alan Turing. Turing cracks the almost-unsolvable German Enigma machine’s code based on a chance conversation that makes him realise that a few letters in the coded messages always correspond to the words “Heil Hitler”.
Sometimes, solutions to most vexing problems are born out of a totally unconnected happenstance. Towards the end of 2014, crude oil prices started declining materially. From $115 per barrel in the middle of June, they are at around $55 per barrel now. The salutary effect of this on India’s external deficit as well as inflation dynamics is quite well known. What this has also done is created headroom within the fiscal mathematics for additional spending.
This fact seems to be underappreciated due to tightness thus far in F2015 as almost the entire budgeted fiscal deficit has been used up with three months to go in the financial year. Moreover, popular perception is that if fiscal targets as laid out in the Fiscal Responsibility and Budget Management Act (FRBM) are to be met, there would be limited elbow-room for fiscal spending.
However a combination of lower net subsidies from fuel and fertilizers along with rationalisation of some welfare schemes could create a meaningful space for additional expenditure, even while remaining within the FRBM limits. The two heads that contribute to this are expectedly, higher excise collection from recently hiked excise duties on petrol and diesel and lower subsidy burden from fuel and fertilizers. Both put together, in our opinion create fiscal maneuverability to the tune of about 0.9% of GDP. For these calculations, we assume oil at $75 per barrel and importantly, stay within the fiscal deficit of 3.6% of GDP as originally envisaged for F2016.
It is natural that whenever there is a windfall gain, claimants who profess to be the most deserving start crawling out of the woodwork. The government would be hard pressed to allocate the gains between competing demands of corporates and / or individuals for lower taxes, sops for various sections of the economy or even higher subsidies and welfare spending.
However, given the hamstrung capital investment cycle the most prudent way to allocate this windfall would be towards fixed capital formation, primarily in the infrastructure space. It is interesting to note that public spending as a share of GDP has remained in the 14-15% range for last few years. However, the share of capital expenditure within that has shrunk from 2.4% in F2008 to 1.6% in F2014.
Data from HSBC shows that within our peer set of Asian economies this is one of the lowest. In other words, over the past few years, the skew of government expenditure has moved towards revenue spending with lesser amounts being allocated for capacity creation or augmentation. This has been part of the reason for chronic, high inflation that the economy had to withstand in the past few years. It is time to correct this mismatch.
While the current government has stated its desire to rein in some of the welfare and subsidy spend, there is need to reallocate that money towards capital expenditure that can be implemented quickly and will have a high multiplier on growth and job creation. Even if the mix is re-adjusted to the average of last decade, it could make additional 0.4% of GDP available for capital spending. Coupled with the gains from lower subsidy and higher excise, it could lead to a meaningful push worth about 1.3% of GDP in a single year.
To be sure, this is not a Keynesian policy recommendation of people being paid to dig holes and then fill them up. This is more about judiciously using the windfall, re-orienting the budget spends and kick-starting a part of economy that is tied up in a gridlock.
Skeptics worry that a fiscal push of this kind may be inflationary in the near term and reverse the gains that Reserve Bank of India has achieved in quelling inflation, causing the hopes of a monetary easing cycle to be still born. However, we think downward pressure on prices from slowing global demand would counter-act the near term inflationary pressures, if any. If all the pieces of the jigsaw were to fall into place, we could have that rare confluence of pro-growth fiscal and monetary policy for some time to come.
This article has been contributed by Amay Hattangadi and Swanand Kelkar of Morgan Stanley Investment Management.
