By Laura Papi, Assistant Director in the Asia and Pacific Department of the International Monetary Fund, heading the South Asia division, and Kiichi Tokuoka*
India's investment, the main driver of economic growth in the mid-2000s when the country was growing in excess of 9 percent a year, has been sluggish for the past five years. Private consumption is growing at a rate comparable to pre-crisis levels, but investment has not regained its strength.
The culprit is corporate investment: its share in GDP has fallen to about 10 percent-4 percentage points lower than that in 2007/08. This is a serious concern as India needs more supply capacity.
Reserve Bank of India (RBI) Governor Subbarao recently said that India's "non-inflationary rate of growth is about 7 percent," down from 8.5 percent before the global financial crisis, suggesting that supply constraints - for example in power, coal, and land - have become increasingly binding.
Many reasons have been put forward to explain the investment malaise. Some analysts focus on the spillover effects of weak and uncertain global growth and point to the fact that Indian companies are increasingly factoring in global supply and demand when making investment decisions.
Others have blamed the RBI for raising interest rates (though they were recently lowered). But weaker investment has also been attributed to a host of other factors: slower project approvals and clearances; shortages in power and coal; governance issues; inflation; policy uncertainty; and limited progress with reforms. The list is long.
Confluence of factors
Of course, as usual in economics, it's not just one factor, but a confluence of causes. Admittedly, this is not a very satisfactory answer, so to shed some light on this issue, we have analyzed the data in a recent IMF Working Paper.
What does our study show? First, a bird's eye view. Investment data from the national accounts indicate that in explaining the decline in corporate investment between 2006/07 and 2010/11, inflation and its volatility contributed five times more than global economic conditions.
Meanwhile, lower domestic growth had a small impact. Real interest rates actually helped investment as they were lower in 2010/11 than in 2006/07. So from our analysis, we can conclude that domestic factors, but not real interest rates, were the main cause of the slowdown.
Another interesting finding is that macro variables alone cannot fully explain the weakness in investment in recent quarters: this suggests that other causes, such as structural factors that affect the business environment, were also at play.
To try to get a handle on the missing culprits, we zoomed in and looked at firm-level data for over 1,000 companies across 12 cities. We found that their capital expenditure depends on their profitability, leverage, and liquidity. This is a fairly standard result; the finding that cash holdings matter indicates that there is room to improve access to credit.
However, corporates' liquidity position has not deteriorated substantially over the past few years and financial sector reforms-for example, interest rates have been fully liberalized, measures have been taken to help develop the corporate bond market and fund infrastructure-have advanced. Instead, what has worsened appreciably has been corporate profitability, which has not returned to levels recorded before the global financial crisis.
We thus searched for factors that might explain corporate profitability. We found that profitability is affected by business costs: things like the cost of starting a business, registering property, enforcing contracts, and the cost of exporting-the latter pointing to infrastructure being important to boost corporate profitability and investment.
Creating a better business climate
It is well appreciated that India has substantial room for improving the business environment. The World Economic Forum ranked India in 56th place in terms of its global competitiveness index in 2011 down from 49th place in 2009, reflecting weakening institutions (for example, transparency of government decision making) and relatively slow pace of infrastructure development.
Equally, the authorities are keenly aware of this. In his budget speech, Finance Minister Pranab Mukherjee, stated "The domestic investment environment has suffered on multiple counts in the past year."
"Right now," the Deputy Chairman of the Planning Commission, Montek Singh Ahluwalia, recently stated, "we should focus on reviving the investment climate".
Difficult to change
But how can India reduce business costs? This seems a hard nut to crack.
Fortunately, India has a model of its own as large variations in the business environment exist across the country. For example, the costs of registering property and exporting vary substantially across cities: for registering property (in percent of property value), the best city has a cost which is a fifth of the most expensive city.
This means that poorly performing cities and states could gain significantly by emulating their neighbors. We have estimated that reducing the average of each cost of doing business to the lowest among Indian cities could boost aggregate corporate investment by as much as 10 percent. This would be no small feat as just the direct demand impact could yield up to 1.5 percent of GDP, without counting the positive spillover effects on the rest of the economy.
In short, India can learn from itself.
* Kiichi Tokuoka is an Economist in the IMF's Asia and Pacific Department.