The economy is on the mend. Or is it?

Fresh investments are constrained by tepid demand; the Pay Commission's award may not provide a stimulus

Tempting as it may be, it is premature to view the acceleration in headline GDP numbers as proof that the economy is on a surer footing now. While GDP growth has accelerated to 7.4 per cent in the second quarter of the current financial year, up from 7 per cent in the previous quarter, the principal drivers of growth continue to be weak.

On the investment side, gross fixed capital formation grew to a five quarter high of 6.8 per cent in the second quarter on the back of a 41 per cent expansion in the central government's capital expenditure over the previous year. Government capital expenditure stands at 59 per cent of the budget estimate for FY16 in April-October. By contrast, spending in the same period last year was only 48 per cent of the full-year target.

While the frontloading of government capital expenditure may have pushed up investment growth, a broad-based revival in investment remains elusive.

In fact, in the first half of the current fiscal, gross fixed capital formation as a percentage of GDP was marginally lower at 29.9 per cent compared to 30.3 per cent in the same period of the previous financial year. Data from Department of Industrial Policy and Promotion shows that actual implementation of projects filed through the Industrial Entrepreneurs Memorandum route was a mere Rs 37,915 crore in the current year (January-August) as against Rs 64,276 crore in the same period of the previous year. Further, proposed investments in the current year (January-August) have fallen to Rs 36,423 crore from Rs 332,441 crore the previous year .

Economists contend that the task of reviving the private investment cycle is proving harder than anticipated, thanks to the combination of low capacity utilisation, high leverage and weak asset quality of the banks.

  In such a scenario, there is a strong case for greater reliance on public investment to revive the investment cycle. "Post 2002, the revival in growth was largely driven by public investment, especially in roads," says Pronab Sen, chairman, National Statistical Commission.

While the Narendra Modi government has pushed for greater public spending, especially on roads, Sen says this push has not materialised to the extent it was hoped as debt-laden firms are unable to launch fresh projects on a large scale. Sen therefore proposes that "rather than tendering out the entire project, the government could contract out packages, perhaps 50 km each, to players".

The problem is that the government's commitment to fiscal conservatism and higher expenditure on salaries on account of the Pay Commission may lead to less capital expenditure next year. As such it will be difficult to maintain investment growth next year if the private sector doesn't step up its investments.

But, it is difficult to see a broad-based revival in private sector investments as demand continues to be tepid. Private final consumption expenditure, the locomotive of growth, is losing steam: it's growth fell to 6.8 per cent in the second quarter from 7.4 per cent in the first quarter. This growth was driven largely by urban demand with anaemic rural demand weighing down overall growth.

An immediate pickup in rural demand is unlikely, given that two consecutive weak monsoons, lower increases in crop support prices and moderating rural wage growth have taken a toll on rural demand. "Early trends in Rabi crop suggest that the sluggishness in rural demand is likely to persist," says ICRA in a research note.

Urban demand, meanwhile, seems to be gaining momentum. Data from the index of industrial production (IIP) shows that consumer durables and motor vehicles & trailers have grown by 7.6 per cent and 7.9 per cent respectively in the first half of the current financial year. The transition to a low inflation and low interest rate regime could spur demand further in the coming quarters.

Household demand could get an additional push with the government accepting the recommendation of the 7th Pay Commission. Though, the stimulus is unlikely to be of the same magnitude as last time because of two reasons.

One, unlike last time, this time a delay in the implementation of the recommendations of the Pay Commission seems unlikely. This means there won't be any significant arrears being paid out.

And two, "in 2006, most government employees were on pensions. But now roughly a third of them are on National Pension Scheme. Thus it is possible that a significant portion of the Pay Commission proceeds will be saved," says Sen.

Of the roughly Rs 1 lakh crore increase in salaries, 25-30 per cent will go back to the government by way of taxes. Thus, actual money in the hands of government employees will be to the tune of roughly Rs 70,000 crore, says Madan Sabnavis, CARE chief economist.

Of this, Sabnavis expects Rs 20-30,000 crore to be saved. This means that the incremental consumption boost is likely to be much smaller, probably Rs 40-50,000 crore. Economists are guardedly optimistic in the growth projections. Citi projects GDP to grow at 7.5 per cent in FY16 and marginally higher at 7.8 per cent in FY17.

On a side note, while lower commodity prices have helped lower input costs, the flip side is that WPI deflation makes it all the more difficult for the government to meet its fiscal deficit target. In the Budget for 2015-15, Finance Minister Arun Jaitley had projected nominal GDP to grow at 11.5 per cent. But with nominal GDP growth in the first half of the current financial year down to 7.4 per cent from 13.5 per cent the previous year, it is quite likely that nominal GDP growth for the entire fiscal year will be significantly lower than budget projections. This suggests that meeting the fiscal deficit target of 3.9 per cent in 2015-16 will be a challenge.