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Arun Jaitley can’t just spend his way out of trouble

Rajrishi Singhal
By Rajrishi Singhal

The union budget, to be presented by finance minister Arun Jaitley on Feb. 01, has engaged everybody’s attention for multiple reasons. Primarily, though, it’s because this is his last full budget before the 2019 general elections and everybody anticipates a political-economy imprint. But, mainly, it will be judged for its ability to create conditions leading to asset and job creation. So far, so logical.

Investment has been falling for a while now, primarily because of private sector withdrawal.

Job creation will need large dollops of investment in fresh capacity or augmenting existing capacity—whether it’s manufacturing, services or infrastructure. Investment as a percentage of gross domestic product (GDP) has been falling for a while now, primarily because of private sector withdrawal, and the only way to move the needle is for the government to invest in large projects. This hit a roadblock because resident economic orthodoxies drew a thick red line on fiscal deficits, limiting the government’s capacity for public expenditure.

Thankfully, chief economic advisor Arvind Subramanian may have found a way around the ideological obstacles through the economic survey for 2017-18.

“Invest, and savings shall follow”

The ingredients necessary for asset and job creation—investment and its raw material, savings—have been in trouble for some time and need remedial measures. Ideally logic—and received economic wisdom—would have then said that higher savings need to be generated to catalyse investment. This is where Subramanian makes an important deviation: He says, forget savings for now and focus on increasing investment first. That will get you growth which in turn will take care of savings.

What he seems to be saying is that it’s okay for the government to breach the year’s fiscal deficit target, if government investment can crowd in private investment and spur another virtuous cycle of economic growth. The economic survey doesn’t seem to be saying this explicitly but it’s there. With regard to fiscal performance in 2017-18, the document states: “Reflecting largely fiscal developments at the centre, a pause in general government fiscal consolidation relative to 2016-17 cannot be ruled out.” While discussing the prospects for 2018-19, the survey is cautious: “…setting overly ambitious targets for consolidation—especially in a pre-election year—based on optimistic forecasts that carry a high risk of not being realised will not garner credibility…”

A decline in investment rate…also means diminished ability to absorb employable youth.

So, Subramanian seems to be bestowing investment with some kind of primacy. Investment is important because government and private sector investment into new factories, infrastructure facilities, or services will be necessary to create jobs for the armies of young, able-bodied youth joining the workforce every year.

But the investment rate, measured through gross capital formation (GCF), has been declining: from a peak of 39% of GDP in 2011-12 to 33.2% now. A decline in investment rate means a slowdown in fresh capacity being added to existing manufacturing, infrastructure, or service capacities. That also means a diminished ability to absorb employable youth.

All eyes on private sector

Private investment is a key engine that drives the overall investment rate, contributing between 65% and 75%. The government has already been spending substantial amounts in public expenditure in the hope of “crowding in” private investment. The centre’s capital expenditure has increased from 2.6% of the GDP during 2014-15 to 3% in 2016-17. According to data from the controller general of accounts, till November 2017, the government had already spent 60% of its budgeted allocation on capital expenditure.  In some sectors, such as the ministry of road transport and highways, 73% of the budgeted outlay on capital expenditure had been spent till November 2017.

Yet this has failed to catalyse private investment. The private sector’s GCF has dropped from a peak of 29.2% of the GDP during 2011-12 to 23.9% in 2015-16. Going by the first advance estimates of national income for 2017-18, GCF is unlikely to improve. While the government may have to continue focusing on capital expenditure, it has simultaneously taken action on other fronts to spur private investment: resolving the non-performing assets overhang in public sector banks’ balance sheets, recapitalising these banks, and improving the ease of doing business.

Key to accelerating private investment, though, will be stability and certainty in the policy environment. An overnight, unilateral decision to demonetise high-denomination bank notes, without first arranging for adequate replacement and replenishment, resulted in considerable hardship for both firms and households. Before the economy could re-adjust to the new reality, the government introduced the goods and services tax (GST) which, ideally welcome in normal circumstances, added to the confusion and chaos.

No escaping savings

But, much as Subramanian may want to take his foot off the savings pedal, the economy will need increased savings for investment to materialise. Perhaps not immediately but soon.

Data for India’s gross savings rate is available only till March 2016 but provides some general trends for analysis. So, here’s the bad news: India’s gross savings rate has been falling for the past few years. It reached a peak of 36.8% of GDP during 2007-08 but has steadily declined thereafter to 32.2% by 2015-16. It will be interesting to see how it behaves during 2016-17, especially since it will take into account the effects of demonetisation.

Traditionally, the household sector has contributed the bulk of savings.

On a disaggregated basis, the household sector still accounts for the largest share of savings at 19.1% of the GDP, a sharp drop from its high of 25.2% in 2009-10. Traditionally, the household sector has contributed the bulk of savings, with the private sector and the public sector bringing up the rear. The government, which forms a part of the public sector, has traditionally shown negative savings, thereby bringing down the overall rate by 1-2% of the GDP. The household sector’s savings rate, despite its decline, has one redeeming feature: Over the years, it has been slowly moving away from physical assets (such as land or bullion) towards financial assets, with the ratios decisively flipping in 2015-16.

The household sector’s savings in financial assets have been further bolstered by the after-effects of demonetisation and apprehensions over deposits being used for “bailing-in” wobbly banks. The recent rush of savings into equity markets, via mutual funds, is testimony to that phenomenon.

Disaggregated gross savings data shows that the private sector’s savings, especially in the non-financial segment, has been going up—from 8.3% of the GDP in 2011-12 to 11% in 2015-16. This means many non-financial companies in the private sector, in either manufacturing or services, are sitting on cash and waiting for the right opportunity to invest these surpluses.

Budget 2018, therefore, must incorporate a policy nudge to not only increase the overall savings rate but to also channel private non-financial corporate savings into investments.

There are many expectations from the budget which, oddly, is the most-awaited economic event in the policy calendar. Nowhere else in the world does a budget offer such mass anticipation or allure; its appeal in India, perhaps, springs from its ability to make annual changes in personal tax rates and levies on consumables. With the GST introduced from July 2017, some of the yearly variations in prices of goods will now cease.

Yet, the excitement persists because of the political action expected over the next 12-18 months. Given past tumbles and future challenges, one of budget 2018’s big themes is likely to be job creation. And, for that, it may first need to sort out how to stimulate savings and investment.

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