In choosing what reforms to pursue and where to spend political capital, it is crucial to first identify what the binding constraint to higher growth is. In that vein, jumpstarting the private investment cycle is key. Much of the investment we’ve seen since the pandemic has been public investment. Encouragingly, gross fixed capital formation has increased from 31.5 per cent of GDP to 33.5 per cent of GDP in recent years but more than half of that has come from public investment, Central and state, and the rest has come from real estate. Public investment can do the heavy lifting for another year or two but given fiscal and public debt constraints, it will need to be pared back. And private capex will have to take its place.
The question then is, why hasn’t corporate investment picked up more strongly? Balance sheets are very strong, corporate debt is down, profits have been healthy. So why hasn’t corporate capex picked up more?
My sense is that corporates need more demand visibility before investing with more conviction. Where is that demand challenge showing up? Neither has there been capacity utilization for manufacturing, which has been range-bound at the 74-75 percent levels, nor has soft core inflation been taken care of, suggesting firms don’t have much pricing power. There has been nominal sales growth which, even though it has ticked up, remains in single digits. These are telltale signs that corporates need more demand visibility to invest. This is exacerbated by what’s happening globally. China is sitting on massive excess capacity and is exporting this excess capacity to the rest of the world. For instance, India’s bilateral trade deficit with China remains elevated at 2.4 percent of GDP. This simply increases the demand visibility imperative for corporates to invest.
If we want the corporate investment to pick up, in an environment in which the public sector eventually has to retreat, that demand will have to come from private consumption and from exports. Over the last 10 years, the government has been working with success on the supply side — from bank balance sheets to bankruptcy and infrastructure. Now the focus should be to structurally boost demand, in the form of consumption and exports, because that will trigger a private capex cycle and then you get into a virtuous cycle.
On what it takes to boost private consumption and the role of labor
Over the last five years, consumption growth has averaged about 4 and a 1/2 percent, and it’s important to increase that. Over any length of time, consumption tracks income growth and so boosting consumption in the medium term will inevitably come down to boosting the quantity and quality of jobs.
One way to analyze the task ahead is to decompose GDP into capital, labor and total factor productivity (TFP). India’s working age population has risen rapidly in recent decades and yet the contribution of labor to GDP over the last 25 years has been much below that, which is implied by the growth of the working age population. That means labor has been punching below its weight for the last two decades. So this has been a long-standing challenge. This is also reflected in the rising capital intensity in the economy from about 2005. If you look at manufacturing in the ASI (Annual Survey of Industries) data, capital-labor ratios have been consistently rising. Similarly, if one looks at our export basket over the last 20 years, the share of labor-intensive exports has reduced and the share of capital-intensive exports has increased.
So for me, that’s the more fundamental challenge that policymakers face. How can policy redress the capital-labor balance? How can we make labor a more attractive factor of production. To answer those, we first need to answer why has Indian capital shunned labor? How much [of this] has to do with education, skilling, and human capital? How much of this is friction that firms face in hiring and firing? How much of this is the incentives provided to capital versus labor? For me, that’s the heart of the issue. Structurally boosting consumption means making growth more labor intensive which means making labor a more attractive factor of production.
On structurally boosting demand through exports
While we have discussed private consumption, I can’t emphasize the role of exports enough. There have been only 13 economies since the Second World War that have grown at seven percent or more for 25 years. One thing they all had in common: strong exports growth. They exploited the demand that the global economy offered. In other words, no economy has grown rapidly for a sustained period without strong exports growth.
That’s why India’s aspiration should be to grow at seven percent or more for the next 25 years. And we must harness the export opportunity. Admittedly, this is a much tougher global environment. We are seeing much more deglobalisation. We are seeing economic Balkanisation. We’re seeing aggressive use of industrial policy by the US to try and reshore manufacturing to itself. This is a pretty hostile environment for emerging markets to grow their exports in. But there’s also a lot of opportunity.
China has pivoted to new-age, capital intensive manufacturing exports — solar panels, electric vehicles and the like. In so doing, it has vacated space in labor-intensive, lower-skill manufacturing, such as textiles, leather, apparel, gems and jewelery and plastics. We should be filling that space. Meanwhile, on the services side, India is becoming a global leader and we need to consolidate that advantage. There are, therefore, still opportunities of labor-intensive exports. That’s the key.
When I talk about structurally boosting demand, I mean two things: first, making labor a more attractive factor of production, which will boost employment and consumption, and second, maintaining an export mindset to increase our global competitiveness, to make exports a sustained source of demand. The latter will involve the entire ecosystem, from special economic zones (SEZs) to import tariffs and the exchange rate.
On the role of monetary policy in this environment
We must recognize there are limits to cyclical policy instruments. Monetary policy played a very important role in guiding us through the pandemic. But now the time has come to ensure inflation remains low and stable. This will both ensure macro-economic stability and boost household purchasing power, especially at the bottom of the pyramid.
The good news from the Central bank’s perspective is that core inflation has been coming off steadily. But food inflation has averaged eight percent over the last year. It matters because it’s 46 percent of the basket and shapes inflation expectations. Thankfully, the monsoon is expected to be healthy this year and that should help, although it’s off to a patchy start.
But the RBI needs to have more conviction that food inflation is coming down so that headline inflation can stay close to four percent more sustainably. Then I think some space for monetary easing may open up. But the key to boosting demand more structurally, through reforms, is not having to rely excessively on monetary and fiscal policy, which are more cyclical tools.
Finally, even as we focus on employment, consumption and exports, India must take solace from the huge leap we have made over the last 10 years on institutionalizing macroeconomic stability — from building a chest of foreign exchange reserves, to implementing an inflation targeting regime, to boosting tax revenues with Combined Tax/GDP likely surpassing 18 percent for the first time last fiscal year. In a world ridden with shocks, this provides India with much-needed armor to stay secure.