India's World-Beating Growth Hides Troubling Investment Trend

India has bounced back strongly from the pandemic and stands poised to claim the mantle of fastest-growing economy in 2021 and probably 2022 as well. The government's latest projections are for a 9.2 per cent expansion in the fiscal year that ends in March. Forecasts from the International Monetary Fund have growth dipping to 8.5 per cent the following year, but even at that slower pace, India is expected to outshine all major economies.

While the headline numbers are impressive, they conceal a troubling trend. Gross fixed capital formation, a measure that encompasses investment in physical assets from plants and equipment to bridges and roads, amounts to less than one-third of gross domestic product, according to World Bank data. In China, it's more than 40 per cent. Reserve Bank of India Governor Shaktikanta Das remarked in early December that private investment “is still lagging,” which could jeopardize the improvement in aggregate demand.

There's a broad consensus among economists that India needs to boost that number to ensure a sustainable recovery. The government is winding down its pandemic stimulus, motivated in part by the risk of having India's sovereign debt rating downgraded to junk. And while the central bank kept interest rates low even as inflation ticked higher in 2021, economists surveyed by Bloomberg are predicting 60 basis points of hikes in this calendar year.

Pent-up demand from households that were forced to retrench during two waves of Covid-19 infections will help underpin growth, but it will fade as the year wears on. “The two drivers that were there in the pre-Covid period—private consumption and government spending—will not be growing at the same pace,” says Nikhil Gupta, chief economist at Motilal Oswal Financial Services Ltd. “So the only possible driver is private investment, which has yet to show strong pickup.”

Investment had been trending down for about a decade going into the pandemic, despite efforts by Prime Minister Narendra Modi's government to revive it, including Make in India, a program launched in 2014 to encourage companies to set up factories. Yet for many would-be investors, labor and land rights issues that hamper such projects overwhelmed the incentives.

An initiative unveiled in 2019 that earmarked $1.9 billion for infrastructure projects via public-private partnerships was also supposed to goose investment. Then the pandemic struck.

Undeterred, the government rolled out a new program in 2020 that offers cash payments to companies meeting production targets in industries such as electronics, pharmaceuticals, and auto components. If companies needed any further incentive, India's Reserve Bank cut the benchmark interest rate to a record low of 4 per cent at the start of the pandemic, where it still remains.

So why are businesses reluctant to invest? Among the possible explanations is that demand remains fragile across many sectors, plus uncertainty about the impact of a new wave of infections.

Yuvika Singhal, an economist with QuantEco Research in New Delhi, calls it a chicken-and-egg situation: “From a macroeconomic standpoint, only when the consumption recovery looks durable are we likely to see the investment cycle turn decisively,” she says.

There are signs the pandemic may have given rise to a two-speed economy. While formal employment is picking up, rural India's vast informal economy continues to struggle, with demand still high for government assistance and jobs available through an employment guarantee program. If about two-thirds of the population doesn't have the means to purchase items such as biscuits, shampoos, and two-wheelers, many companies could remain reluctant to invest.

“Sustainability will remain the key challenge,” says Kunal Kundu, an economist with Société Générale GSC Pvt. “While the most pronounced K-shaped recoveries ever and the concomitant rising inequality helped drive consumption in certain segments, aggregate demand is likely to remain muted—especially in comparison to the level seen two years ago.”