Investment boost needed to break India’s vicious cycle

April 9, 2013

(Any opinions expressed here are those of the author and not necessarily of Reuters)

The current account balance reported last month hammered in the fact that India is spending more than it saves. While it had been stubbornly in the red for all but a couple of years in the last two decades, reaching a record deficit in both absolute terms and in relation to the gross domestic product was sobering.

In practical terms, a current account deficit even at its current level is not bad in itself. However, it does imply that foreigners must be willing to finance the gap. And if the fund flows dry up, it could create economic imbalances including a weakening currency.

For the most part, these fund flows come in the form of either portfolio investments that can be moved freely, like in the stock market or direct investments that are more long term. While foreign direct investment is still flowing and has allowed the rupee to stabilize since the start of the year, a deeper look into its composition raises some concern.

Reliance on the less sticky portion of portfolio investments has increased. In this context, last year’s reforms that opened up certain industries are of help, but they are but one aspect of luring international capital. Making the domestic economy more attractive and its growth potential more promising is a more important incentive to foreign investors compared to the mere permission to invest.

The heavy lifting needs to be done in domestic investment. It is said that India is a consumption-driven economy. While this may be true, it misses the point of causality. It is investment that creates productive capacity and jobs and ultimately the income that enables consumption, and not the other way around. It is therefore no coincidence that India’s economic slowdown was led by investment, followed later by consumption. Clearly, investment growth has to pick up first for the economy to turn up sustainably.

The question is whether this will be possible with a government whose hands are politically tied, especially after the DMK party walked out of the ruling coalition. The answer is yes, up to a certain point. For one, smaller measures outside the political radar do contribute. One example is the environment ministry’s changed approach to giving clearance to projects that may not involve large tracts of forest land but only strips of land for roads that lead to a mine — not exactly headline-grabbing, but progress nonetheless.

The more disciplined national budget is positive as well, as long as the cuts focus on consumption rather than investment, which it did. The hiking of rail fares and diesel prices can also create room for investments.

Another aspect that is conducive to investment is partially independent of the government – taming inflation, a key driver for profit margins. One good thing is that unlike its Asian peers, inflation in India is still coming off, so profit margins, which have been improving for the last six months, should expand further in the coming quarters. With the potential profit recovery, companies will have more room to invest.

Interestingly, the latest GDP data showed a break from a trend that was overlooked. For the first time in 15 months, investment outpaced consumption and overall GDP growth. For investors, the key message is that while GDP growth may languish for some time yet, early signs of a new investment cycle suggest companies exposed to investment should be favoured.

To be sure, a stronger government could speed up India’s economic recovery, but one should not discount that the healing is taking shape in profit margins in combination with smaller administrative measures. If this can be sustained, it will be much easier to convince foreigners of the benefits of investing in India, and thus help the country to start breaking the vicious cycle it is in.

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