The investment climate change

FACTORING in the experiences of the past decade-and-a-half of reforms, despite claims to the contrary by some economists, there are telltale signs that all is not well with the economy.

The rapidly-rising forex reserves, low credit-deposit ratio, the failure of the economy to absorb even the domestic capital and the falling gross capital formation in the private corporate sector are all signals of a larger disquiet within the economy the lack of investment confidence.

Consider these facts. For the past four years, the gross capital formation (GCF) in the economy has been lower than the savings. For instance, the GCF for 2003-04 was 26.3 per cent of GDP, whereas the savings rate was an impressive 28.1 per cent of GDP. This represents an excess of savings over investments to the extent of 1.8 per cent of GDP. This implies that India has not been able to absorb even the domestic savings fully and convert the fiscal savings into physical investment.

Such a surplus of domestic savings mocks at the need to import capital through the FDI route. Simply put, we are justified in importing capital only when we face a shortage, not otherwise.

The burgeoning forex reserves, created by increased exports of goods and services as well as remittances from abroad, represents a problem, albeit of a different kind. This build-up does not reflect the transmutation of an unhealthy to a healthy economy; rather it is the story of the malnourished becoming obese.

The build up of current account surplus underlines the distressing fact that India is unable to absorb even the savings in its current account and runs the risk of exporting precious capital. This has serious implications for the economy. Theoretically speaking, at India's current stage of development, it needs to run a current account deficit and not surplus. In effect, by running surpluses for years, it is actually exporting precious capital.

The net investment of the banks in government securities aggregates 43 per cent of their total deposits. This is 18 per cent more than the stipulated 25 per cent investment to be maintained by banks in government securities technically called the Statutory Liquidity Ratio, or SLR. In real terms, this means that approximately Rs 3.6 lakh crore is invested in treasury bonds by banks over and above the statutory limit. Despite the fact that such investments in the government bonds bring about lower rate of returns, such positioning is indeed bizarre. This has the effect of depriving the economy of the much-needed credit. Interestingly, the bank credit-to-GDP ratio in India is at a low 33 per cent of GDP when it is over 136 per cent in China. Access to credit is a very important determinant of growth in an economy. Unfortunately, we are yet to focus on this crucial issue.

There has been a steep fall in the gross capital formation (GCF) in the private corporate sector, from over 9 per cent of GDP in 1996-97 to less than 5 per cent of GDP in 2003-04. This reflects the ground reality as there has been no significant accretion to the existing capacities, especially in the manufacturing sector in the past few years.

Banks for consumer loans?
Thus, the systematic erosion in investment confidence is reflected in the functioning of the banks. Financial institutions formed for financing "industrial and investment activities" have virtually repositioned themselves as "global banks". Consequently, instead of spurring industrial activity, they are marketing credit cards and consumer loans for computers, houses and vehicles.

Such repositioning and the manner of sustaining credit flows within the economy was captured by a cartoon in which the child asks his mother what the EMI is for the toy she bought him. If this a telling reflection on the spread of consumer loan culture, it also highlights the current business focus of banks — that on consumer loans. The reasons for the shift in the focus of banks are not far to seek. For over a decade, we have been resorting to fiscal orthodoxy in our anxiety to benchmark ourselves with global standards. For instance, the non-performing assets (NPA) levels of the financial institutions aggregate to approximately less than 4 per cent of their advances. This is akin to putting a teenager on a strict diet.

Though such NPA levels compare well with certain developed countries, we are squeamish about the `high' level of NPAs. What is ignored is that a developing country could well `afford' to have a slightly expansionist credit programme and, hence, run the risk of a higher rate of NPAs. In fact, common-sense demands that it should.

While on every parameter, India seems compelled to compare itself with China, it is interesting to note that latter's NPA levels are never compared with the former's. While there is no confirmed data available from China on this, experts have repeatedly pointed out that the NPA level in China is as high as 45-60 per cent of its advances.

China's growth, in effect, has come about by ignoring the orthodox economic prescriptions, not by following them.

Fiscal orthodoxy takes its toll
This strict adherence to the NPA norms has virtually choked credit flows into the economy. Consequently, banks find it more convenient to invest in government securities than to engage in traditional lending operations. This is simply because such investment is deemed to be beyond any risk and, hence, is not subject to any provisioning norms.

While this approach to investment has reduced the NPA levels of banks, it has come at tremendous cost to the economy. Surely, we need to strike a better balance between fiscal orthodoxy and growth. Sadly, we seem to have forsaken the latter for the former.

Apart from the stringent NPA norms, other factors too inhibit the free flow of credit to the economy. The former Finance Minister, Mr Jaswant Singh, after presenting the Budget for 2003, commented that the three Cs CBI, CVC and C&AG are preventing higher credit flows into the economy.

Bank officers fearing visits from investigating officers in case a loan goes bad, have over the years begun citing frivolous reasons for rejecting credit proposals.

While one is not arguing for the Government and its investigative machinery to go slow on wilful defaulters, at the same time, we need to ponder whether, under the current scheme of things, we are missing the wood for the trees.

Surely, we need to strike a balance with a more liberal credit environment, better investment climate (including stable tax laws) while coming down heavily on those who have violated the law of the land.

The reference to the extent of fiscal orthodoxy practised in India and its debilitating impact are merely illustrations to highlight the gloomy investment climate.

The state of infrastructure and the convoluted tax laws are other issues that are often quoted by analysts in this connection. The Chinese approach to the issue of investments is a study in contrast.

As per a recent AT Kearney report, China outscored India in a superior tax regime (58 per cent favoured China compared to 42 per cent favouring India), economic stability (61 per cent for China and 39 per cent for India) and government initiatives (66 per cent China to 34 per cent India). All these are crucial determinants of a superior investment climate.

Thus, China, by maintaining a better investment climate, has encouraged higher domestic investments and, thereby, ensured that its domestic capital is absorbed within the economy. This has been achieved through liberal funding of its investment requirements, mainly by domestic banks.

Faced with a capital shortage, FDI flows into China have been a natural sequel. This has ensured that China has not invited FDI on desperate terms, but as a logical extension of its economic policies. Thus, China has been successful in attracting FDI while we are lagging.

Investment is a function of confidence and foreign capital is always a sequel to domestic capital. Successive governments have not paid attention to improving the investment climate in India.

Without strengthening the economic fundamentals, successive governments in India have been fixated on the idea of inviting FDI to meet the country's investment deficit. Such an approach to woo foreign capital has been counterproductive and meaningless, especially when domestic savings have not been fully absorbed.

It is to be understood that the role of a modern government is to improve the investment climate and not to distinguish between domestic or foreign capital. Else, there will be neither domestic nor foreign investment in India.

Published at: http://www.thehindubusinessline.com/2005/06/10/stories/2005061001170900.htm