Onus on private investment

The focus has to be as much on keeping the risk premium in check as on controlling the levels of the risk-free rate

India has set itself a goal of doubling the GDP in five years. The Economic Survey presents a case for unleashing “animal spirits” and making private investment the key driver of this growth. It outlines the creation of a “virtuous cycle” led by private investment that will drive demand, create capacity, increase labour productivity, introduce new technology, allow creative destruction, and generate jobs.  

Private investment: The driver?

Should the focus of economic planners be on private investments? Or should investments by the government (public investments) be the driver? There can be no clear answer. Public investments could have negative or positive impacts on private investments. Huge public investments might necessitate government borrowings that push or crowd-out private borrowers from the capital markets. On the other hand, big public investments could create favourable conditions (for example, through creation of better infrastructure) that attract — or crowd-in private investments. 

Like the Economic Survey, the Union Budget 2019 too seems to lean towards letting private investment be the driver; not public investments. The Budget did not lay out big ticket public investment plans that could possibly be used as catalysts to crowd-in private investments. The share of capital spending actually came down from an already low 1.1 per cent of the GDP in the previous year to 1 per cent of the GDP. In fact the attempt seemed to be to avoid a crowding-out of private investments. In her maiden Budget speech, Finance Minister Nirmala Sitharaman announced that the government of India, for the first time ever, will be directly borrowing from the global capital markets through foreign currency denominated sovereign bonds to meet as much as 10 per cent of its total borrowing needs. 

But where is the driver?

So if private investment has to drive the economy, where is the driver? Data compiled by Centre for Monitoring Indian Economy (CMIE) showed a 34 per cent fall in the January-March quarter of 2019 as compared to the same period in the earlier year. At least as of now, the driver is missing. And why may have the driver abandoned her seat? The same CMIE data showed that in value terms an alarmingly high 25.4 per cent of private sector projects under implementation were stalled; put on hold. And why? “Lack of funds” was the most commonly cited reason.

Indian industry has been crying itself hoarse for a long while about what it perceives as a punishingly uncompetitive (high) cost of capital/funds. Emboldened by a period of benign inflation, the Reserve Bank of India (RBI) has been lowering the repo rate (currently at 5.75 per cent), almost continuously over the last five years. Moving in sympathy, the yields on the benchmark 10-year bonds have also been on the decline touching a new low of 6.33 per cent on Tuesday. But this is only a reduction in the “risk-free rate”; the rate at which the sovereign can raise funds. For a private entity, the cost of capital equals risk-free rate of return plus risk premium. If the risk premium remains constant, the reduction in the risk-free rate gets transmitted to the cost of capital. But that is a big ‘if’. 

Illustration by Binay Sinha

The risk-premium has touched 130-140 bps for top rated AAA entities; compared to historical levels of 60-70 bps (Business Standard, July 17, 2019: 10-year bond yield hits lowest level since demonetisation, closes at 6.33%). It has not remained constant; it has risen. The arithmetic of the cost of capital means that the 70 bps increase in risk premium effectively wipes off three consecutive, much debated and laboured over 25 bps reductions in the repo rate. It also tells us that even if the RBI were to lower the repo rate further and even if it were to use its might to buy government bonds and bring down risk-free rates, the cost of capital for a AAA rated entity might still end up not reducing if risk premiums were to increase even more. The arithmetic of the cost of capital also tells us that even by reducing the pressure on domestic markets by borrowing abroad the government can only lower the risk-free rate; not the risk premium. To bring the investment driver back to the seat, the focus has therefore to be as much on keeping the risk premium in check as on controlling the levels of the risk-free rate. 

Risk premium, credit crisis and ‘animal spirits’ 

Erroneously, often, excessively high risk premia are attributed to a capital crisis, to a ‘lack of funds’. However, they may actually be reflective more of a ‘credit crisis’: excessively risk-averse, tight-fisted lenders might be sitting on adequate capital but might not be willing to lend out except at high risk premium levels. The global economy struggled with similar problems after the dot-com bust of 2001 and the sub-prime credit crisis of 2007.  

Prising open the fists of excessively risk-averse lenders is easier said than done. Risk-aversion is about fear; and about trust. It is psychological, behavioural. Animal-linked metaphors come in naturally and easily, thus, when talking about risk aversion. The Economic Survey talks about letting “animal spirits” thrive. Commentators talk about “the Asian tiger”, “the Indian elephant”, “and the Chinese dragon”. 

Animals are dispirited when they are fearful; when there is uncertainty and ambiguity. Private investment needs long periods of calm on all fronts — policy, legal, economic, social and political — to be cajoled out of the cage and into the driving seat. Chapters 5 and 6 of the Survey discuss these issues. But there has to be continuous demonstration of intent. Even a single IL&FS like event will get them scurrying back into the cage. Or episodic instances of policy surprises; or social unrest; or political uncertainty. There has also to be a cultural shift; a shift away from the blame culture. Investors need to be assured that they will not be hounded and vilified if they were to fail; by definition private enterprise cannot guarantee successes alone. A voyeuristic environment in which failed investors are taunted and poked-at — like caged animals in a zoo — will only ensure that they remain in their cages. 

Will risk-aversion come down? Will thus there be easier credit and lower costs of capital? As the survey says “economies are intricately interwoven systems” and we are in a “world of butterfly effects and unintended consequences”. Policy stances are often acts of faith that require liberal doses of good luck. Let us hope that we are showered with large doses of good luck and that the driver gets out of the cage and onto the driving seat! 

The author is a Faculty Member in the Finance and Accounting Area, IIM Udaipur