The fall in private investment

The decline in private investment as a percentage of GDP is not as huge as it may appear at first glance

There has been a huge fall in private investment in India from 27.5 per cent of gross domestic product (GDP) in 2007-08 to about 20 per cent in 2020-21. Why?

To set the stage, consider some simple economics first. If investment is more than savings, then the interest rate tends to rise. And, if investment is less than savings, interest rate tends to fall, unless it hits the zero or near-zero lower bound. But that has not been the case in India. So, the standard analysis applies here.

Coming to the main analysis now, the GDP growth rate was near 8 per cent for several years, roughly from 2003 to 2010. Some of this was part of a boom in the world economy; it was also due to domestic policies during that period and during the previous years. GDP growth moved up significantly above “the trend”. It is plausible that the domestic savings rate went up for many people due to the uncertainty that the very high growth rate of GDP was indeed sustainable. Though there had been a long-term upward trend in the aggregate savings rate anyway, it rose quickly from 24 per cent in 2000 to 34 per cent in seven years!

Though the savings rate was high in the boom period, the absolute amount of consumption demand was rising impressively. The export demand was also rising. So, there was a need for more capacity to produce. Consequently, the rate of investment rose at a time when the domestic savings rate also rose, and foreign capital inflows, too, were high. Given that both savings and investment were high, there was not much effect on interest rates. And, of course, GDP growth was high.

Eventually, the tide turned; this was somewhat in line with what happened in many countries. By 2012, the growth rate of GDP was “just” a little over 5 per cent in India. An expansionary macroeconomic policy was used but after a point it did not work. In fact, inflation went up. And, the rate of private investment was falling. Why? There was less need to add to capacity, given the economic slowdown and given, what started looking like, excess capacity. Also, several businesses tended to be highly leveraged due to the large investments made previously; it was difficult to raise more funds.

Apparently, the weak growth of GDP was aggravated to some extent due to a specific recession in the real estate industry from about 2012 to 2020. Also, the non-performing assets (NPAs) in banks were being recognised implicitly at first and explicitly later; the NPAs were affecting the growth of bank credit to “new” businesses.

It is all so far a story of a somewhat long economic cycle that included a boom and a slowdown. The rest is history, the more familiar history. Demonetisation in 2016 and the introduction of goods and services tax in 2018, though likely beneficial economically in the long run, aggravated the economic slowdown in the short run. An expansionary monetary policy was used in 2019, but the main effect was on the inflation rate which went up from about 4 per cent to more than 6 per cent. Soon after, though unrelated, GDP growth rate fell to minus 7 per cent. This was due to Covid-19 and the severe lockdown that followed.

In the entire phase of the economic slowdown, the growth rate of GDP was obviously below “the trend”. Now it is natural that the opposite of what had happened during the boom years would happen. In those boom years, as seen earlier, the savings rate and the investment rate had moved up. During the slowdown, the savings rate and the investment rate would come down. And, again since both savings and investment had changed, there was no major effect on interest rates. And, the fall in the savings rate was not just due to a slowdown; there was disruption and distress for many who, in fact, needed to dissave.

We have seen so far that the growth rate of GDP affects savings and investment. But the story does not end there. Savings and investment, in turn, affect the GDP growth rate. The relationship runs both ways. This is why when there is a boom, it tends to be big and when there is a slowdown it is not small.

To conclude, the very high GDP growth over the period 2003-08 was not the new normal. It was part of a cycle that included a boom and a slowdown, and then the slowdown continued further. Relatedly, the fall in the rate of private investment is partly cyclical. But yes, even the remaining part is a big fall.

The writer is visiting professor, Ashoka University. gurbachan.arti@gmail.com. Nikhil Vuyyuru  contributed to the column