The last time a finance minister presented a budget in the backdrop of a less than 5% gross domestic product (GDP) growth was way back in 2002. The drop in growth from above 9% to about 5% in just four quarters shows the severity of the slowdown and only cyclical factors are unlikely to explain this decline. A collapse in investment activity started this slowdown and a recovery in investment is a must to push the economy back into a higher growth trajectory. In fact, a revival in investment activity is not only required for growth but also to bring down inflation in a sustained fashion by creating capacity and clearing supply-side bottlenecks. This is why it is important to understand what the finance minister can do in the budget to get investment back on track.
But before we discuss that, let us look into the genesis of this investment collapse. Four factors could have been responsible for this. The Reserve Bank of India (RBI) had to increase interest rates to control inflation and this is often cited as a factor which forced companies to put the brakes on their capex. However, I would not like to over-emphasise the importance of this factor. The second factor could be uncertainty and lack of urgency in policy and procedural clearances delaying investment projects in critical infrastructure sectors. In particular power and metals/minings sectors account for almost two-third of private corporate capex and these sectors have borne the brunt of policy paralysis.
Shrinking export markets could have slowed down investment in export-oriented sectors and hence slower global growth could be the third factor behind worsening of the investment climate. Last but not the least, difficulties in project execution delayed cash flows from projects and put the balance sheets of companies under stress. For BSE 500 companies, the average debt to equity ratio stood at a 10-year high for the first quarter of 2012 and has only moderated marginally after that. The stress in corporate balance sheets also affected the financial system and fresh flow of credit for investment also was hampered.
The RBI has started moderate easing of monetary policy, the government has shown its intention to reduce project execution delays through the newly-appointed Cabinet Committee on Investment and export growth has turned positive after eight months on the back of some stabilisation in the global economy. These are all positive developments for an investment recovery and the budget should make every effort to sustain this momentum.
There could be three different types of measures in the budget to support investment. The first set of measures could be to improve the flow of funds towards investment. The gross savings to GDP ratio has dropped to 30.8% from a peak of 36.8%, dragging down the gross fixed capital formation to GDP ratio to only 30.6% (from a high of 33%) and opening up a large current account gap. Household financial savings to GDP ratio (8%) at a 20-year low is a particular cause of worry. The budget should offer proper incentives to channel household savings back into financial assets. Reintroduction of tax concessions for individuals investing in infrastructure bonds is a possibility along with some disincentives for investing in non-financial assets.
Traditionally, lowering the fiscal deficit is also recommended to increase national savings and channel funds to the private sector. The government seems to be committed to following a path of fiscal consolidation. Meeting the fiscal deficit target of 5.3% for the financial year 2013 looks plausible and a further reduction to 4.8% for financial year 2014 is on the cards. However, this objective is achieved primarily through reducing fiscal spending. In India there is significant complementarity between public and private investment - if government spends on building infrastructure then private sector investment follows suit. So, the axe should not fall on capital spend in the budget. In fact, the proportion of capital spend at only 11.9% of total expenditure for financial year 2012 is already very low and needs to be pushed up. Also, cash-rich public sector units could be nudged to invest more. This could kick-start an investment revival through its forward and backward linkages with other industries.
Improving sentiment would be the second way of encouraging investment. Low capacity utilisation, high leverage and economic/political uncertainty have pegged back corporate investment while portfolio investments have continued on the hope of more reforms. It is important to attract portfolio inflows also because only a buoyant equity market will provide the opportunity to companies to raise equity and restructure their balance sheets. In his recent roadshows, the finance minister has tried to impress upon foreign investors his intent of fiscal consolidation and keeping the economy open to foreign inflows. This will not only strike a chord with investors but also with the rating agencies. If the finance minister is able to deliver on these promises, then the risk of a rating downgrade will come down substantially and augur well for foreign inflows. Recent relaxation of rules for portfolio investment in corporate debt would also be a positive.
The third set of measures could be sector specific. In the last budget most of the announcements for the infrastructure sector centred on providing better financing facilities, particularly through external commercial borrowings. However, the impact of these policies was limited because sector specific regulatory issues could not be sorted out in most cases (power, roads, etc,). This year, given the fiscal constraints it will be difficult for the finance minister to announce a big package for infrastructure. Stable tax rates and some clarity on infrastructure related policies is the best that one can hope for.
If all the supportive policies are in place and confidence improves, then we can hope to see some recovery in investment in late 2013 or 2014. A good budget is important but we have to be patient as well.
Samiran Chakraborty is regional head, research, South Asia, Global Research, Standard Chartered Bank
The views expressed by the author are personal