India’s investment cycle is going nowhere

Yesterday’s Financial Times carried an interesting data chart comparing the proportion of gross capital formation to GDP. China, unsurprisingly, was top of the chart with ~45% capital formation to GDP ratio. India came next as a standalone country, a proportion of over 30%. While the focus of the data commentary was on the fact that UK lags behind the European average (though, both the UK and Europe have sub-20% proportions) and emerging economies were a reference point only; the question on how far India can the still maintain robust capital formation to GDP ratio is an important one for India watchers.

In Q1, 2011-12 (the start period of the new national accounts data series for India) GCF/GDP ratio stood at 40.3%, and by Q3, 2016-17 (the latest data point available), the ratio has declined to 32.4% i.e a decline of almost 8 percentage points. While part of this decline can be explained in terms of faster growth in consumption expenditure, which grew by a particularly strong 11.4% as per the latest data, that is hardly the only explanation. Capital formation shrunk in 8 of the 19 quarters for which data is available, indicating that the slack in India’s investment cycle is for real.

Further, the decline is unlikely to abate anytime soon. There could be a few quarters of recovery, such as the latest one, during which capital formation grew by a small 2.4%, turning around the decline seen in the three quarters preceding it. But these are unlikely to make a significant dent to the steady decline in the proportion of capital formation in GDP. This is for two reasons, one, on average consumption expenditure has been growing faster, which gives it a lead. Second, underlying trends don’t indicate an investment recovery.

The first of these underlying trends is that in capacity utilisation. As per the RBI’s quarterly Order Books, Inventory and Capacity Utilisation Survey (OBICUS) for manufacturing companies, continued to showed a consecutive decline in capacity utilization (CU) for the third consecutive quarter in Q3, FY17. It declined marginally to 72.7%, from the 73.1% levels seen during the previous quarter. Even though there was a mild improvement from the corresponding quarter of the previous year, when capacity utilisation was reported at 72.2%, the improvement is too little to make any dent on the need for capacity enhancement or investments in the near future.

The second underlying trend that provides further proof of the fact that the investment cycle is unlikely to go anywhere fast is the trend in industrial production. Related to capacity utilization is the sluggishness in industrial production numbers. The manufacturing IIP index has shown a commensurate decline over the past quarters along with CU. The latest value stands at 184.8, also showing a decline for the third consecutive quarter and down from 198.9 during Q4, FY16. The latest industrial production numbers show a decline of 1.2% in February 2017.

Third, industrial credit, has been a big drag on overall credit. Accounting for over 35% of total credit, credit to industry has been shrinking and as per the latest number (February 2017), is down by 5% from the previous year. Since credit is often used for capacity creation or other forms of expansion in business, this is not a good sign for the investment cycle. Other sectors – like agriculture and services are faring better on the credit front, with positive loan offtake compared to the previous year, but these too are at sub-10% levels. The biggest boost to credit growth is from the personal loans segment, majority of which are unlikely to go in to investments. The only exception to this is the strength in housing loans demand, but these form a small part of overall credit in the system and are unlikely give a significant boost to the overall GCF/GDP ratio.

If the government steps in with a major investment drive, the dismal outlook for the investment cycle could change. But in so far as it is tied in with the maintenance of a fiscal deficit-GDP target, capital spending is unlikely to increase significantly more than budgeted. Even with an improvement in the capital spending to total expenditure proportions for the 2017-18 budget, the absolute amount remains limited.

There are of course, some trends that suggest the possibility of the first signs of a turnaround. In terms of optics, just the fact that investments have been declining in the recent quarters suggests that there is a base effect for a turnaround in the cycle. But barring this, there are some real reasons for small hope in a pickup in the investment cycle. For instance, business confidence remains high on future economic conditions. And if businesses won’t borrow or create capacity when their confidence is high, when will they?

The second is the improvement in demand conditions itself. A pickup in consumption expenditure and demand, will necessarily result in a pickup in production going forward. Even non-oil imports into India have started showing signs of pickup in recent months, indicating that a demand turnaround is for real. However, given the still fresh burns from the continued slack in demand after creation of capacities, Indian business is unlikely to rush into investments until its assured that the demand comeback is strong and sustainable. Until then, the investment cycle is unlikely to go anywhere.