Road To Growth Is Paved With Low ICOR

India’s slowing investment rate and rising incremental capital output ratio, or ICOR, have led to low economic growth.

Two recent, and epochal, events deserve our unstinted attention because they mark the end of an era and the beginning of another one. These are critical because of a common thread linking both: the investment rate of the economy.

The 12th Five-year Plan has just ended, bringing down the curtain on decades of India’s planned economic growth and development. This was the last Five-year Plan; as an alternative, the Planning Commission’s successor NITI Aayog has announced the release of a three-year “action plan”, a seven-year “strategy paper” and a 15-year “vision document”. There is one key difference between these documents and Five-year Plans: The government is free to disregard the Aayog’s recommendations.

The end of a centrally planned economic system also coincides with the formal interring of the Planning Commission, an organization central to not only India’s economic strategy but also to its federal temper through the added responsibility of allocating grants, Plan and non-Plan funds to states. The commission’s federal remit was not granted through constitutional mandate and this generated sufficient heartburn, especially among non-Congress states. However, the commission’s shuttering is also due to questions raised about the relevance of centralized planning in a globalized, market-led economy. And then there is politics. The commission was created through a government resolution which makes it easy for the Narendra Modi government to bury it.

But before the institution is shut down, it might be worthwhile to examine the 12th Plan performance, especially some of its macroeconomic targets. The 12th Plan ran between April 2012 and March 2017, with a Congress-led administration in charge till April 2014 and the Bharatiya Janata Party-led government steering the Plan thereafter. Prime Minister Modi announced his intentions of abolishing the commission and ending Five-year Plans during his first Independence Day speech in 2014 but allowed the 12th Plan to formally run till its original expiry date.

The plan had set an average gross domestic product (GDP) growth target of 8% for the 2012-17 period. This growth target was not achieved in any single year by either of the two political dispensations, despite a step jump resulting from a new series introduced by the Modi government. The closest India came was in 2015-16, with 7.9% annual growth. Otherwise, the average growth for the period works out to below 7%, way lower than the average annual growth rate of 8% achieved during the 11th Plan.

A low investment rate is among the many reasons for the under-average performance. The 12th Plan envisaged an average investment rate of 34%. However, the investment rate has been declining every year, starting with 33.4% during the first year of the Plan; the Central Statistical Office’s second advance estimates for 2016-17 show gross fixed capital formation at 26.9% of GDP, the lowest in more than a decade. What’s worse, investments have not been forthcoming from either the private sector (which has historically contributed the bulk of investment as a percentage of GDP) or the government sector which should ideally be investing when private investment dries up.

In a recent newspaper article, former Reserve Bank of India governor C. Rangarajan has also pointed to low productivity of capital, captured through incremental capital output ratio, or Icor, which measures how many additional units of capital are necessary to produce one additional unit of output. India’s slowing investment rate and rising Icor have led to low economic growth.

Discussing Icor might sound anachronistic, especially since the service sector accounts for 55% of India’s GDP where the relation between capital invested and output is still unclear. In addition, supply-side thrusts (such as increased government consumption expenditure) can lead to higher GDP growth despite a depressed investment climate, which can then send garbled messages about improved capital productivity. Ordinarily, a falling ICOR should be accompanied by palpable technological improvements and skill enhancements, leading to an all-round increase in productivity and efficiency.

Discussions on capital productivity seem to be back in fashion because high ICOR in recent times (higher than six during 2013-16) have been complemented by sluggish economic growth, over-leveraged corporate balance sheets and burgeoning bad debts in the financial sector. These factors have dragged down the economy’s growth impulses. In all discussions on efficiency and factor productivity, it is usually Indian labour that has to bear the cross. But this time the focus is squarely on capital productivity.

Obsessing with high ICOR becomes necessary when resolution of non-performing assets (NPAs) tops the public policy agenda. Most of the reasons behind high Icor in India are similar to those found elsewhere in the world, but one unique Indian feature stands out: gold-plating, or padded-up project costs. This not only suppresses capital productivity but also distorts the viability of many projects. With institutions and regulators orchestrating Operation NPA Clean-Up in mission mode—for example, the newly-instituted Insolvency and Bankruptcy Board of India is already grappling with 35 transactions—it is imperative that all resolution mechanisms incorporate enough measures to deter future projects from gold-plating costs and getting away with it.

The above article was published in Mint newspaper and can also be read here

NPAs: The New Wedge in Centre-State Relations

NPAs are expected to acquire a two-tier, federal character with enormous implications for Centre-state relations

There was jubilation in stock markets recently after finance minister Arun Jaitley hinted at a scheme to sort out the messy tangle of bad loans in the banking sector. The equity market’s optimism beggars belief because NPAs—or non-performing assets, as bad loans are called technically—have remained impervious to an alphabet soup of previously attempted schemes. And now, NPAs are expected to acquire a two-tier, federal character with enormous implications for Centre-state relations.

In the post-1991 era, multiple schemes have been conceived and launched to tackle the menace of NPAs: DRTs (debt recovery tribunals, as suggested by Narasimham Committee-I and then subsequently amended in 2012), CDR (corporate debt restructuring), SARFAESI Act (Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest), CRILC and JLF (Central Repository of Information on Large Credits and Joint Lenders’ Forum), 5/25 scheme, ARC restructuring (asset reconstruction companies, formed as a consequence of DRTs), SDR (strategic debt restructuring), AQR (asset quality review), S4A (scheme for sustainable structuring of stressed assets) and finally the IBC (Insolvency and Bankruptcy Code).

There are multiple reasons for many of these schemes failing, which includes an inadequate legal framework for pursuing resolution; however, the one reason that remains unchanged from pre-reforms period is final policy design always providing corporate borrowers enough protection so that they can reprise the same act all over again. And while public attention has focused on Vijay Mallya—deservedly of course—there are other larger industrial groups which are habitual offenders but manage the system adroitly. Former Reserve Bank of India (RBI) governor Raghuram Rajan was compelled to state: “…it is extremely important that banks do not use the new flexible schemes for promoters who habitually misuse the system (everyone knows who these are) or for fraudsters.”

This raises issues of “moral hazard”; in the Indian context, moral hazard has taken the form of corporates or public sector banks undertaking increasingly riskier behaviour because they know the government is underwriting that risk or bearing the cost of that risk. Post the 2008 financial crisis, moral hazard has acquired some flexibility globally: it has become acceptable to bail out institutions if government feels such failure can lead to widespread systemic risk.

This may have inspired finance ministry’s chief economic advisor Arvind Subramanian to blithely suggest that government should perhaps bail out large corporate borrowers because that is how “capitalism works”. He feels only write-offs can sort out the “mountain of debt” sitting on bank books, or settle the twin-balance sheet problem (over-leveraged companies and NPA burdened banks). 

Interestingly, Subramanian has also contributed to the NPA soup cauldron: the annual economic survey recommends the creation of PARA, or Public Sector Asset Rehabilitation Agency. Not to be left behind, even RBI’s recently appointed deputy governor Viral Acharya has gamely added his two-bit: PAMC (Private Asset Management Company) and NAMC (National Asset Management Company).

So, while attempts are being made to untangle the knotted skein of corporate bad loans, albeit through an ever-growing thicket of acronyms, Jaitley has at the same time flatly turned down requests for farm loan waivers. He has received wide support. State Bank of India chairman Arundhati Bhattacharya has warned that fulfilling such pre-election promises might lead to dilution of credit discipline: borrowers might tend to defer repayment till the next elections in the hope of loan waivers. This newspaper also recently pointed out that the Indian agricultural sector needs long-term structural investments, not short-term exchequer-funded loan waivers. There is merit in each of these arguments.

But, here’s a catch: the ruling Bharatiya Janata Party also promised farm loan waivers in its Uttar Pradesh assembly election manifesto. Having won the elections and faced with the prospect of fulfilling that promise now, Jaitley has used an escape hatch to wriggle out of the commitments. Answering the debate on Finance Bill in Rajya Sabha, he has asked individual states to foot the bill for farm loan waivers. He has effectively created a two-tier, federal, moral hazard framework: Centre’s responsibility to bail out large corporates and states get to write off farm loans.

This further complicates attempts at creating a long-term, sustainable set of solutions for controlling and resolving the financial system’s NPAs. It also adds new headaches to the already vexed Centre-state relations. Competitive waiver promises have already weakened the fragile balance sheets of Andhra Pradesh and Telangana. 

It also raises issues of discrimination. If the Centre wants to bail out some 30-40 large corporate borrowers on the pretext that their debt misery was the outcome of external shocks, does not the same logic or argument apply to farm loans, especially since many states have been victims of droughts, inadequate monsoons and crop failures? There is no doubt the NPA mess needs to be resolved urgently to kick-start investments and the growth process. But then, that solutions framework cannot be built on the foundation of discrimination and selective relief.

The above article was published in Mint newspaper and can also be read here