Why India’s rising public capex is important for reducing its cost of capital

India's gross fixed capital formation grew by just under 500 percent over a 30-year period, despite the recent spurt in public capex and infrastructure push. (Representative image)

One unmissable aspect of India’s Q4 FY23 GDP numbers had to be the share of gross fixed capital formation from the aggregate demand perspective. The metric was the highest that we have seen in recent periods and is largely driven by relentless public capex, compensating for subdued private inclination towards capacity expansion. For the uninitiated, a strong capex not only helps in building infrastructure and the necessary capacities that increase efficiencies and reduce inflation, but also helps in bringing down the cost of capital.

To understand this further, one must coalesce the theories of monetary economist Irving Fisher and welfare economist John Maynard Keynes. While Fisher suggested that the time preference for money and the sacrifice of present consumption to be the primary driver of rate of interest, Keynes was with the view that change in the overall stock of capital determines the rate of interest. Perhaps the biggest similarity between these two theorists is their contention that supply of capital at a certain rate of interest is the primary driver of economic expansion.

Importance of Money Multiplier

In modern economics, capital owners do not lend their money directly, and on their behalf commercial banks have emerged as the primary lenders of capital to the economy. Therefore, the rate of interest is determined by an implicit understanding among commercial bankers based on their collective available liquidity, considering withdrawal obligations. It can be argued that broad money or M3 can be treated as the proxy for this systemic liquidity, and the rate of interest can be determined by the rate at which accumulation occurs. As understood, broad money is the actual stock of capital that is available for business activity, and its rate of accumulation is based on the prevailing money multiplier.

In India, considering the rate of interest to be 6.5 percent (weighted average call rate or WACR), the money multiplier can be assessed to be in the vicinity of 4.2 times. Since the change in money multiplier is inversely proportional to the rate of interest, the higher the former, the lower the latter. Theoretically, the expansion in broad money happens because of three reasons. First, due to incremental investments (capex) increasing the stock of capital. Second, the level of maturity experienced by the capital market. And thirdly, the central bank’s rapidly expanding balance sheet on the back of large foreign reserve accumulation and resultant issuance of incremental narrow money. All these conditions satisfy Fisher and Keynes theoretical considerations regarding capital supply and its rate of interest.

Comparing this metric with that of the US, then until March 2020, the money multiplier was hovering in the vicinity of 10 times, with a rate of interest hovering near the 1.5 percent levels (effective funds rate). While the recent Covid-related monetary easing and compromised credit expansion reduced US broad money significantly, one must understand the history of American stock of capital and its relationship with the prevailing rate of interest.

Considering the example of the year 2010, when capital stock was aplenty, while the money multiplier was 11 times, the effective federal funds rate was just 0.11 percent in the US. This was preceded by gross fixed capital formation in the US rising by almost 1,600 percent over a 40-year period. Of course, American investment banking and treasury operations leveraging derivatives and exotics/structured instruments are also an important pillar of broad money expansion, the role of capex cannot be ignored.

India’s Slow Capital Formation

When considering India, gross fixed capital formation grew by just under 500 percent over a 30-year period, despite the recent spurt in public capex and infrastructure push. What this means is that India’s commercial banks are unable or rather unwilling to expand broad money and this in turn is keeping the rate of interest high. Critics often cite the example of China, stating that the money multiplier there prevails at just 3.4 times, despite the size of its economy. Nevertheless, one must consider the fact that over a 30-year period, China’s narrow money itself has expanded by over 1,500 percent, on the back of foreign exchange reserves powered monetary expansion.

Interestingly, China’s decadal growth in its gross fixed capital formation has been equivalent to India’s 30 years’ worth of activity, and the former’s capacities have expanded to nearly 150 times during the period. Consequently, China has today realised a rate of interest of around 2.8 percent, which is kept artificially higher than required to control overconsumption.

Achieved efficiencies help in reducing inflation and in turn put downward pressure on nominal rate of interest, as the preservation of real rates does not call for higher hurdle rates. This is explained by Fisher in his theory of interest. Meanwhile, a higher stock of capital lowers the rate of interest and helps achieve parity with the marginal efficiency of investment over time, with the help of rising demand for capital goods. This in turn is explained by Keynes in his theory of marginal efficiency of capital.

Therefore, an argument can be made that India’s gross fixed capital formation must grow faster than its current rate if the country is serious about reducing its cost of capital to propel its economy towards the $10 trillion threshold. Time is of the essence here. Policymakers must be aware that over a longer term, the rate of interest is invariably higher than the rate of economic expansion, as shown by French economist Thomas Piketty. At least for now, such a situation mustn’t be allowed in India, for it will surely put the nation in the dreaded middle-income trap. Stock of capital must therefore rise incessantly for the rate of interest to fall, considering India’s present economic predicaments.

In the current environment of uncertainty, since India’s public capex is the primary driver of the segment under consideration, expansion of broad money depends on government policy itself, as it drives the private sector through a multiplier effect.

Karan Mehrishi is an economist, specialising in monetary economics and fixed income. Views are personal, and do not represent the stand of this publication.