The puzzling breakdown in the link between GDP growth and private investment flow

GDP is forecast to grow at 6.5 percent and fixed investment at 6.1 percent.

The second advance estimate of GDP for 2024-25 showed that fixed investment (gross fixed capital formation) is expected to grow at a slower pace than the overall economy. GDP is forecast to grow at 6.5 percent and fixed investment at 6.1 percent.

A part of the slowdown in the fixed investment growth rate, it was 8.8 percent in FY24, can be put down to a shift in government expenditure to revenue, or items of immediate consumption, from public capex earlier. This shift was particularly pronounced for states taken collectively.

This reorientation of government expenditure doesn’t offer a clue to the reluctance of the private sector to pick up the slack. It’s a relevant question because GDP grew at 9.2 percent in FY24, and at 7.6 percent and 9.7 percent in FY23 and FY22 respectively. In two of the last three years, GDP growth rate exceeded 9 percent.

The link between GDP growth and private investment flow is weakening

Fixed investment headlines over the last four years have been mostly about the union government and states setting aside significant portions of their budget for capex. One area where it’s noticeable is in railways, where investment increased as a proportion of overall investment from 1 percent in FY12 to 2.7 percent in FY24. Over the same period, the share of investment in road transport declined from 3.7 percent to 3.1 percent. The divergence in trend between railways and road transport could be mainly on account of a much larger role for a reluctant private sector in roads.

Renu Kohli and Kritima Bhapta gauged the conversion of intended private capex with secured financing into actual gross fixed capital formation. From FY17 to FY23, it was around 10 percent, which is historically a very low rate of conversion.

In the 1990s, the conversion rate was 47.4 percent. In the next decade, it was 33.4 percent. Even two recent GDP growth spurts, between FY14 and FY17, and the period after Covid, did not increase the conversion rate.

Corporates turn into impressive savers

One plausible reason for reluctance to invest on the part of private sector is the “twin balance sheet crisis” after the excess of the noughties. The crisis is now past us but Indian corporates remain reluctant to invest.

GDP data showed that over the period FY12 and FY24, the share of gross saving by private non-financial corporates in total saving increased from 23.9 percent to 31 percent. Over the same period, share of saving by households declined from 68.2 percent to 59 percent.

Pattern of private investment is changing

Another intriguing trend is a shift in pattern of investment by private non-financial corporations. As shown in the table below, investment in intellectual property increased from 5.9 percent in FY12 to 9.5 percent of overall fixed investment in FY24. Over the same period, investment in machinery and equipment initially trended upwards before declining to 14.3 percent in FY24.

This is in contrast to the household sector, which captures investment of some unincorporated enterprises, where investment in machinery and equipment has increased as a proportion of total fixed investment.

Percentage contribution of sectors in India’s annual fixed investment (in %)

Plausible explanations for the investment puzzle

Despite economic policy emphasis on manufacturing, there’s been a lackluster response from industry. Manufacturing as a proportion of gross value added has fallen from 17.4 percent in FY12 to 14.3 percent in FY24.

The decline in the share of manufacturing may partially explain private investment trends. Investment-to-output ratio in manufacturing has declined from 9.4 percent in FY12 to 7.3 percent in FY24. This trend is at odds with even agriculture, where investment-to-output ratio has increased from 14.1 percent to 16.4 percent over the same period. It’s not as if agriculture hasn’t faced its share of problems in the last decade.

A plausible explanation for this puzzle is that quite a few decision makers in the private sector are probably not seeing enough underlying strength in demand to commit themselves in a significant way to investment. Even this explanation is hard to reconcile with at least two growth spurts over the last 15 years which didn’t seem move the needle. If anything, private non-financial corporations are even more enthusiastic to save now.

Or, perhaps we are in the midst of a large underlying shift in factors which influence private investment and it’s too early to get a clear sense of it.

One thing that is not going to catalyse private investment at this juncture is the significant level of uncertainty introduced into the global economic environment by the full-blown economic protectionism advocated by U.S President Donald Trump.