Editorial: Capex concerns

Investment spending has been a very significant contributor to India’s recent growth performance. The share of investment in gross domestic product (GDP) has risen steadily over the past few years, reaching a peak of about 38 per cent last year. As the recently released advance estimates for the first quarter of the current year indicate, even as the GDP growth rate has slowed appreciably, investment remains at around 35 per cent of GDP. From a macroeconomic perspective, the value of investment spending is two-fold. In the short term, it helps increase demand for goods and services. Over a longer period, it enhances the productive capacity of the economy, thus laying the foundations for sustained growth. The fact that investment has remained relatively buoyant in the face of slowing growth and high inflation says something about the confidence of producers as far as long-term business prospects are concerned.

 

However, this does not mean that companies, however confident they may be about the future, can afford to ignore the present. The current environment, particularly the high interest rate regime that it has engendered, is unquestionably hostile to investment activity. More expensive funds combined with uncertain short-term prospects can cause businesses to scale down and defer ambitious capacity expansion plans. That this is already significant is indicated by a recent study by the Reserve Bank of India (RBI), which was reported in this newspaper on Monday. The study suggests that capex by the corporate sector will drop by about 30 per cent in the current year compared to 2007-08. This is a striking change from four successive years of growth rates of over 40 per cent (in nominal terms). High interest rates, high prices of oil and other inputs and uncertain market conditions are all reasons cited for this anticipated decline. The fact that companies are going to invest less this year should not come as a surprise. Even in the most conducive of circumstances, investment spending is prone to cycles because of its lumpiness. Producers build capacity in excess of demand because it is cost-effective to do so and then wait for a while for demand to catch up before the next wave begins. What is of concern in the current scenario is how sharp the swing appears to be, going by the results of the RBI study. With this order of magnitude, the investment downturn could have a significant impact on the growth rate.

Of course, this decline will be offset by the steady increase in investment in infrastructure sectors that is less sensitive to short-term prospects than is capacity expansion in the manufacturing sector. Nevertheless, policy makers need to keep a close eye on this indicator as they decide their next steps in the fight against inflation. This study suggests that the downside risks to growth from high interest rates may be more significant than was indicated by the first quarter GDP numbers. In that case, the trade-off between growth and inflation is more severe than is currently perceived and the costs of being excessively cautious about inflation can be rather high. The dangers of over-cautiousness by central banks from a global perspective were recently highlighted by UNCTAD’s Trade and Development Report for 2008. Keeping interest rates too high for too long will do more harm than good by slowing growth more than is necessary to control inflation, particularly much-valued investment spending.