Has the investment cycle turned?
There are convincing signs that it has. The most immediate one is the momentum in cement demand, steel demand and the import of capital goods. There are also some weak signals that corporate deleveraging has begun. The interest cover ratio of manufacturing firms has been rising in recent quarters, and is currently at its highest level since the March 2012 quarter. However, much of the fresh investment seems to be concentrated in expanding existing production facilities rather than in greenfield projects. The burden of delayed projects continues to weigh on the investment cycle.
One of the best ways to assess whether companies have reason to buy new capital equipment to meet demand is by looking at the capacity utilization numbers released by the Reserve Bank of India (RBI). There is some good news here. Seasonally adjusted capacity utilization is now at a five-year high. It is also above the long-term average. Excess capacity continues to be far higher in an aggregate sense than what it was a decade ago—at the end of an unprecedented economic boom—but its steady decline in recent quarters should increase the attractiveness of new corporate investments.
There is another way of looking at the issue of capacity. Higher consumer demand is more likely to be inflationary when excess capacity shrinks, because companies cannot respond to strong demand by quickly increasing production. Some of the extra demand could also spill over into higher imports. Most economists would agree that the output gap has more or less closed, or that the Indian economy is now expanding at a rate that will have inflationary consequences. The supply side has to respond to higher consumer demand if further macroeconomic imbalances are to be avoided.
The current phase of the investment cycle has an estimated four years to go before the next downturn begins. A new study by economists at the Indian central bank provides some useful insights into the Indian investment cycle since 1950. First, the typical Indian investment cycle lasts for 12 quarters, with an acceleration of seven quarters followed by a slowdown of five quarters. Second, there have also been episodes of longer downturns, the one after 2011 being the most recent example. In fact, the magnitude of investment downturns have been significantly larger after the 1991 reforms. Third, it is important to empirically distinguish between the cyclical and structural components of investment downturns.
Take the most recent downturn that has gone on for far more than the typical five quarters. RBI economists Janak Raj, Satyananda Sahoo and Shiv Shankar noted: “While the trend component has consistently moderated from 2011-12 onwards, the cycle component has turned from 2016-17.” This means that the ongoing investment revival will not take gross domestic capital formation to the highs we saw in the previous investment boom that ended with the North Atlantic financial crisis. The structural decline in investment activity will ensure that.
The investment rate in the Indian economy is sensitive to several factors—the real interest rate, capacity utilization, availability of bank credit, global growth, the pool of domestic financial savings and the fiscal deficit. Many—though not all— of these factors are now positive for capital spending by companies. Capacity utilization has improved, non-food bank credit has recovered, the global economy is doing well, there has been a shift of household savings from physical to financial assets, and the fiscal deficit is far lower than it was five years ago.
The impediments to a stronger investment recovery are also well known. The domestic monetary policy has shifted into tightening mode relatively early in the investment recovery cycle, the global economy is showing signs of overheating, the banking mess is still deep and the fiscal situation could be deteriorating. Yet, the overall constellation of forces should support the investment uptick.
Many have used the analogy of an airplane to explain the state of the Indian economy in recent years. It has been flying on one engine—consumer spending. The other three engines of aggregate demand have been stuttering—government spending, investment spending and exports. Indian exporters missed benefiting from the recent recovery in the global economy because supply chains were disrupted during the twin shocks of demonetization and the transition to the goods and services tax (GST). The recovery in investment spending is thus good news because economic growth is less imbalanced than before.
The three RBI researchers say that the current investment recovery will peak in fiscal year 2023, with an investment rate of 33% of gross domestic product (GDP) — or around three percentage points lower than the fiscal year 2007 peak. A quick calculation based on this estimate suggests that India has lost around 75 basis points of potential growth over the past decade. Inflation will tend to pick up much earlier than before. Even as the cyclical investment recovery is to be welcomed, there needs to be policy attention on the structural shift to a lower investment rate that will eventually hurt economic growth over the medium term.
The Indian investment cycle had its longest downturn ever after 2012. There are now finally reasons to believe that a cyclical recovery is underway—though the larger structural decline in the investment rate has not yet been addressed. That will be a key policy challenge in the years ahead.