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Escaping the low-investment trap
While interest rates have declined dramatically recently, private investment has remained stagnant. Why and how do we get out of this trap?
This is a somewhat technical question but can be understood with a little patience. The starting point for the answer is the powerful savings-investment identity, which says that investment in an economy equals the savings available to it.
In an open economy, there are three sources of savings: private, government and foreign. Likewise, there are two broad categories of investment: private and government. Measuring all variables as a proportion of GDP and denoting government and private investments by Ig and Ip and government, private and foreign savings by Sg, Sp and Sf, respectively, the identity can be written as Ig + Ip = Sg + Sp + Sf.
Government investment includes investment in infrastructure, health and education. Private investment refers to investment in plant, machinery and buildings by firms. Private savings consist of savings by households and firms. The former equal incomes of households not allocated to current expenditures and the latter the excess of firmsí revenues over current expenditures. Government savings equal revenues minus current expenditures and are represented by the revenue surplus.
Foreign savings are slightly more complicated to explain. They are represented by two equivalent measures: external current account deficit and external capital account surplus. A positive current account deficit means that our current exports of goods and services fail to fully pay for our imports. The gap is effectively covered by sales of our assets such as plant and machinery, equity or domestic debt instruments to foreigners. Thus, the current account deficit, which equals the capital account surplus, effectively represents foreign savings invested in our economy.
The key policy implication of the identity between the current account deficit and capital account surplus is that the government can control the current account deficit (and therefore the inflow of foreign savings) by controlling the capital account surplus. The latter is readily controlled through the accumulation of foreign exchange reserves. To the extent that the RBI purchases forex reserves, it offsets the inflow of foreign capital by outflow.
Denoting then the current account deficit as a proportion of GDP by CAD and capital account surplus as a proportion of GDP by CAPS and recognising that each equals savings from foreign sources (Sg), we can rewrite the savings-investment identity as (Ig - Sg) + (Ip - Sp) = Sf = CAD = CAPS. Viewed this way, the investment-savings identity says the combined investment-savings gap of public and private sectors must be bridged by foreign savings.
Remembering that government savings represent revenue surplus, the investment-savings gap in the government sector (Ig - Sg) represents fiscal deficit. Therefore, if fiscal deficit rises more than private savings, either the current account deficit must rise to bring additional foreign savings into the economy or private investment must decline. Unless private savings are rising fast enough, a profligate government is condemned to choosing between declining private investment or rising current account deficit: there is no free lunch.
Once these powerful implications of the savings-investment identity are understood, the current macroeconomic scene is readily explained. The RBI rightly worries about significant appreciation of the rupee lest it scuttles the competitiveness of Indian exports. As a result, it has reacted to the large inflows of dollars through foreign investment and remittances by buying foreign currencies and thus accumulating foreign exchange reserves. But this act of the RBI automatically reduces the capital account surplus and therefore the current account deficit. The inflow of foreign savings is choked off.
Recently, the current account deficit has turned into a surplus, which implies that on net we are now investing a part of our savings abroad albeit at the very low return fetched by forex reserves. Though private savings have risen, they have been partially offset by this reduction in foreign savings. What is left has been absorbed by increased fiscal deficits, leaving no room for private investment to expand.
One may ask why the government has been able to mop up the savings at interest rates that are now substantially lower and why private sector has failed to compete for them. There are two possible answers. First, the economy has been in a downturn, which has kept the investment demand sluggish. Second, in so far as non-corporate borrowers are concerned, banks do not want to lend them at interest rates comparable to those available on the government securities. Not only are these borrowers untested, the current administrative controls unduly punish bank managers for making bad loans without symmetric rewards for making good loans. As regards corporate borrowers, their investment demand is approximately limited to their retained earnings.
The question remains, however, why the investment demand of the corporate sector is so limited? In part this may be due to the downturn phase of the business cycle. But given how long the investment sluggishness has persisted this cannot be the whole story. The hard reality is that with small-scale-industries (SSI) reservation and archaic labour laws, potentially lucrative labour-intensive sectors are effectively closed to the corporate sector. The corporate sector has been moving forward steadily in areas such as pharmaceutical and auto sectors where it is not hamstrung by these restrictions nearly as much but the big potential lies in the labour-intensive sectors.
While the SSI and labour-law reforms will undoubtedly help stimulate investment demand, we cannot delude ourselves into thinking that we can escape the tyranny of the savings-investment identity. Unless private savings rise, the government must choose between cutting fiscal deficit or running larger current-account deficit if it is to let private investment rise. Without these measures, any pick up in the investment demand will be dissipated in higher interest rates.
Economic Times February 25, 2004