Monday, January 16, 2017

The missing investment recovery in India

An examination of the credit-to-GDP gap data released by the BIS reveals an interesting picture. The data captures the difference between the actual credit-to-GDP ratio and its long-term trend of borrowings from all domestic and foreign sources to the private non-financial sector.
The BIS uses credit-to-GDP gap to assess systemic risks from excessive credit flows, having found this a useful early warning indicator. In particular, it has found that a credit gap in excess of ten percentage points was found to be associated with a two-third likelihood of a serious banking crisis within the next three years. Accordingly, as per the Basel III regulations, the counter-cyclical capital buffers for the banks should be raised as soon as the country's credit-to-GDP gap exceeds two percentage points. Three observations.

1. China is flashing red big time. Since late 2008, when the country triggered off its stimulus package, the credit to private non-financial sector has rocketed. Since late 2011, it has risen nearly five-fold to touch 30% of GDP. No country even comes close in terms of the scale of such excess credit build up.

2. India presents the other side of the spectrum, a stark contrast with China in terms of private sector investment activity. Its credit-to-GDP gap has been in continuous decline since the crisis, and is now in the negative territory and the lowest among all major emerging economies. In fact, from this and other data (the IIP has been on declining trend), it becomes clear that the private sector investment cycle did not recover after the crisis. Growth has largely been driven by public investment and consumption. 

3. The weakness in investment activity is surprising given that the balance sheet problems constrain only the infrastructure sector firms and certain large corporate groups. Aggregate corporate indebtedness, as measured by the private non-financial debt service ratio (ratio of debt repayments to income), has been very stable and under well below danger levels. 
Consider this. Two of the three growth drivers, business and households, have stable balance sheets. The government's Make in India campaign has doubtless done its part in stoking the animal spirits. But investment activity, even in consumer durables and other cyclicals, and intention to invest remains muted. 

There can be three explanations. One, businesses do not feel that the excess capacity built up during the boom years of 2003-08 have not been wrung out. There is some evidence to this effect in the RBI's OBICUS survey. Two, businesses do not find the prospects of growth in demand promising enough. Three, there is some other constraint holding back investment activity.

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