Why have private investments dropped? (GS Paper 3, Indian Economy)
Context
- The failure of private investment, as measured by private Gross Fixed Capital Formation (GFCF) as a percentage of gross domestic product (GDP) at current prices, to pick up pace has been one of the major issues plaguing the Indian economy. Private investment witnessed a steady decline since 2011.
GFCF and its Significance
- GFCF refers to the growth in the size of fixed capital in an economy.
- Fixed capital refers to things such as buildings and machinery, for instance, which require investment to be created.
- So private GFCF can serve as a rough indicator of how much the private sector in an economy is willing to invest.
- Overall GFCF also includes capital formation as a result of investment by the government.
- GFCF matters because fixed capital, by helping workers produce a greater amount of goods and services each year, helps to boost economic growth and improve living standards.
- In other words, fixed capital is what largely determines the overall output of an economy and hence what consumers can actually purchase in the market.
- Developed economies such as the U.S. possess more fixed capital per capita than developing economies such as India.
Trend in private investment in India
- In India, private investment began to pick up significantly mostly after the economic reforms of the late-1980s and the early-1990s that improved private sector confidence.
- From independence to economic liberalization, private investment largely remained either slightly below or above 10% of the GDP.
- Public investment as a percentage of GDP, on the other hand, steadily rose over the decades from less than 3% of GDP in 1950-51 to overtake private investment as a percentage of GDP in the early 1980s.
- It, however, began to drop post-liberalization with private investment taking on the leading role in fixed capital formation.
- The growth in private investment lasted until the global financial crisis of 2007-08.
- From 2011-12 onwards, however, private investment began to drop and hit a low of 19.6% of the GDP in 2020-21.
Reasons for the fall
- Many economists in India have blamed low private consumption expenditure as the primary reason behind the failure of private investment to pick up over the last decade, and particularly since the onset of the pandemic.
- Their reasoning is that strong consumption spending is required to give businesses the confidence that there will be sufficient demand for their output once they decide to invest in building fixed capital.
- Historically, however, an increase in private consumption has not led to a rise in private investment in India.
- In fact, a drop in consumption spending has boosted private investment rather than dampening it.
- The inverse relationship between consumption and investment is likely because the money that is allocated towards savings and investment, either by the government or by private businesses, comes at the cost of lower consumption expenditure.
- Other economists believe that structural problems may likely be the core reason behind the significant fall in private investment as a percentage of GDP over the last decade or so.
- They have cited unfavorable government policy and policy uncertainty as major issues affecting private investment.
- Policy uncertainty can discourage private investment as investors expect stability to carry out risky long-term projects.
Conclusion
- The biggest cost of low private investment would be slower economic growth as a larger fixed capital base is crucial to boost economic output.
- It should be noted, however, that private investors are considered to be better allocators of capital than public officials, helping avoid wasteful spending.
