India’s Investment Slowdown: The Role of Confidence and Uncertainty1
Standard macro-financial variables do not fully explain the recent sharp investment deceleration in India. Using a new measure of economic policy uncertainty, the results suggest that heightened uncertainty and deteriorating business confidence have played an important role in India’s recent investment slowdown.
1. The marked accelaration in economic growth experienced in the years preceding the global financial crisis (GFC) was tied to a surge in investment activity. Gross fixed investments as a share of GDP rose from an average of about 24 percent during 1996/97–2003/04 to a peak of nearly 34 percent in 2008Q2. Also, economic growth in non-agricultural sectors of the economy picked up from an average of about 6¾ percent during 1996/97-2003/04 to nearly 10½ percent during 2004/05-2007/08.
Gross Fixed Capital Formation, Real
Source: Haver Analytics.
2. However, the growth and investment outlook changed dramatically with the arrival of the GFC, but especially so during 2011/12-2012/13. The investment-to-GDP ratio declined to about 32 percent in 2009/10–2010/11, and then fell further to about 30 percent in 2011/12. Moderation in investment activity was accompanied by a gradual decline in the value of newly-announced investment projects, from an average of 10 percent of GDP in 2006/07 to just 1 percent in 2012/13. Furthermore, the share of stalled and shelved investments jumped to over 2½ percent of GDP in mid-2011, after moderating slightly following a spike in early-2009. As the share of stalled projects remains elevated, and the pipeline of new projects is exceptionally thin, concerns about India’s growth outlook remain.
Investment Projects Announcements 1/
Sources: CAPEX Database; CEIC; and IMF staff calculations.
1/ Value of new projects minus value of shelved projects.
3. Several supply-side constraints and confidence factors have been cited as plausible causes of India’s weaker growth and investment. Among them, rising policy uncertainty and subdued business confidence, delayed project approvals and implementation, and supply bottlenecks are prominent (see IMF 2013). Higher real interest rates have played only a minor role in the current investment slowdown (RBI, 2013; IMF 2013). In addition, Tokuoka (2012) finds that high and volatile inflation and heightened global uncertainty may have contributed significantly to the slowdown in corporate investment. While monetary easing since the GFC supported corporate investment, the monetary tightening since early 2010 may have hurt corporate investment only marginally. Looking at the determinants of the decline in corporate investment since the GFC in India, Tokuoka (2012) finds that structural factors, in particular, the business environment, have played an important role in explaining corporate investment activity.
4. Standard macro-financial variables do not explain India’s recent investment slump. Staff analysis suggests that standard macrofinancial variables (interest rates, external demand, relative prices, global financial market volatility) do not appear to fully explain the recent slump in domestic investment in India. These variables are able to explain only about half of the total investment slowdown witnessed during 2010/11–2012/13, while systematically over-predicting investment in the past two years. This suggests that other factors, such as supply bottlenecks and potentially policy uncertainty, are at play.
Components of Policy Uncertainty Index
Sources: Baker and others (2013); and IMF staff calculations.
5. Measuring economic policy uncertainty, which appears to be an important contributor to the investment slump, is difficult. The index developed by Baker, Bloom, and Davis (2013) is an important advancement in measuring policy uncertainty. It has two underlying components: the dispersion of individual-level forecasts regarding consumer prices and central government budget balances as a proxy for uncertainty, and the quantification of newspaper coverage of policy-related economic uncertainty.
6. India’s policy uncertainty has remained high. The index rose sharply from the second-half of 2011, and while a series of structural reforms as well as monetary policy easing since the second half of 2012 has alleviated uncertainty somewhat, its level has remained particularly high over the last ten quarters. Moreover, the current level of uncertainty exceeds its post-Lehman highs, suggesting that uncertainty is primarily driven by India’s domestic policy challenges, and not by global uncertainty such as related to changes in expectations about QE tapering.
Overall Business Confidence and Economic Policy Uncertainty
Sources: Baker and others (2013); NCAER; and IMF staff calculations.
Economic Policy Uncertainty and New Investment Projects
Sources: Baker and others (2013); CEMI; and IMF staff calculations.
7. Heightened economic policy uncertainty and deteriorating business confidence have played a key role in the recent investment slowdown. It can take some time for the aggregate investment data to uncover the adjustments in investment activity in response to the changes in outlook or its uncertainty, as projects that are well underway may still continue to show up in aggregate investment. Therefore, to provide a more in-depth analysis of investment activity, the focus is on explaining changes in aggregate investment flows, as indicated by the data on volumes of announced new and shelved investment projects. Staff analysis suggests that heightened policy uncertainty has had a particularly pronounced link with the decline in new investments, and in an increasing share of investments that were postponed or cancelled. After controlling for these factors, financing costs do not appear to be a critical factor in explaining a decline in new investments (Tables 1 and 2).
|Dependent Variable: New investment projects (Projects costs as percent of GDP)|
|Real interest rate||1.816 ***||0.802|
|% per annum||(0.365)||(0.560)|
|Economic Policy Uncertainty||−0.063 ***|
|Number of observations||40||40|
|R2, d.f. adjusted||0.389||0.043|
|Dependent Variable: Shelved investment projects (Projects costs as percent of GDP)|
|Real interest rate||0.071||0.160 ***|
|% per annum||(0.049)||(0.051)|
|Business confidence||−0.012 ***||−0.016 ***|
|Economic Policy Uncertainty||0.005 ***|
|Number of observations||40||40|
|R2, d.f. adjusted||0.626||0.515|
8. Continued progress on structural reforms and resolving supply-side bottlenecks remains critical to shore up confidence and revitalize investments and economic growth. The current investment slowdown is primarily driven by weak business confidence and policy uncertainty, which to some extent may reflect factors not explicitly captured in the regression analysis—for example, persistent supply bottlenecks. In the short term, lowering nominal interest rates may provide some relief in terms of reduced interest burden, especially to corporates with high leverage. However, in the medium term, lower rates with little slack in the economy would stoke inflation further and exacerbate inflation trends across sectors, hurting investment. In addition, simply lowering nominal rates without tackling deep structural issues is unlikely to attract new investment.
AnandR. and V.Tulin2014 “Disentangling India’s Investment Slowdown” IMF Working Paper (forthcoming).
BakerS.R.N.Bloom and S.J.Davis2013 “Measuring Economic Policy Uncertainty” Chicago Booth Research Paper No. 13-02.
International Monetary Fund2013India: 2013 Article IV Consultation IMF Country Report No. 13/37 (Washington: International Monetary Fund).
Reserve Bank of India2013 “Real Interest Rate Impact on Investment and Growth—What the Empirical Evidence for India Suggests” August.
TokuokaK.2012 “Does the Business Environment Affect Corporate Investment in India?” IMF Working Paper 12/70 (Washington: International Monetary Fund).
Prepared by Rahul Anand and Volodymyr Tulin.