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On January 3 and January 5, IHS Markit released its Purchasing Managers’ Indices for manufacturing and services in India for the month of December. These data points paint a sobering picture. While both manufacturing and services PMI are above the psychological threshold of 50 – a PMI value above 50 suggests an expansion of economic activity over previous month – they show a moderation compared to the months of October and November. This suggests a loss of economic momentum with the festive demand beginning to dissipate. The eruption of the Omicron variant driven third wave of Covid-19 pandemic is bound to generate additional headwinds for economic activity. An analysis published in these pages on January 5 argued that the government should consider giving a larger stimulus in the forthcoming Union Budget which is scheduled for February 1.

Today, we ask another question: Is there a case for prioritizing revenue spending over capital spending in the next budget? In normal course, capital spending by the government is always seen to be more virtuous as it adds to the future growth potential of the economy. Here are three charts which argue why a capex boost alone might not sufficient this year.

Central government capex is a very small share of overall investment in India

Union Budgets of 2020-21 and 2021-22 saw a sharp increase in the capital expenditure of the central government, with annual growth of 30.8% and 26.2% respectively. This growth is significantly higher than the annual growth seen from 2016-17, the earliest period for which capital spending numbers are available in the Centre for Monitoring Indian Economy’s (CMIE) database. However, the problem is even with this sharp rise, central government capex is a very small proportion of overall investment spending – it is captured by Gross Fixed Capital Formation (GFCF) in GDP statistics – in the Indian economy. As a share of GDP, the share is even smaller. In 2020-21 central government capital spending was 8.2% of the total GFCF and 2.2% of total GDP. These numbers underline that central government capital spending alone cannot give a boost to overall investment or GDP in the short run.

To be sure, the combined capex of centre and states has a much larger share in GFCF and GDP — around 16% and 4% respectively in 2019-20. However, the capital spending growth of states was muted in 2021-22. It grew at 7.6% on an annual basis, much lower than the 19.3% and 17.7% growth seen in 2019-20 and 2020-21. This is largely a reflection of the fiscal squeeze on state finances due to the heavy lifting they have done during the pandemic. Things are unlikely to have changed radically on this front.

What ails investment spending in the Indian economy at the moment?

There is a three-word answer to this question: lack of demand. More than four fifth of investment spending in the Indian economy comes from the private sector. The private sector will not invest unless it feels the need to do so. That need will arise only if the existing production capacity – investment by definition is made to expand or overhaul existing capacity – is inadequate to meet present or future demand. This does not seem to be the case at the moment if one looks at RBI’s latest Order Books, Inventories and Capacity Utilisation Survey (OBICUS). The survey captures the situation in the quarter ending June 2021. Capacity utilisation was at 60% in the quarter ending June 2021, while the ratio of inventory to sales was at 78.6%. Both these numbers are far from pre-pandemic levels; capacity utilisation on the lower side and inventory sales ratio on the higher side. While the June 2021 quarter numbers are likely to have been distorted by the second wave of Covid-19 infections – it peaked on May 9 in terms of seven-day average of daily new cases – the situation is unlikely to have changed drastically. Persisting weakness in consumer confidence numbers and the imminent economic disruption from the third wave only underscore this point.

Company-data supports the lack of demand thesis

While GDP numbers for the third quarter will only be available at the end of February, various analyst reports on performance of different sectors/companies support the lack of demand thesis in the Indian economy.

A report by Motilal Oswal on Marico’s performance – it is a leading fast moving consumer goods (FMCG) company in India – in the December 2021 quarter says that the company’s performance in the quarter was “characterized by slowing consumption patterns” which was a result of “continued inflation impacting overall disposable incomes”. Another January 3 report on the automobile sector by Reliance Securities says that “demand weakness continued across segments”. The report notes that “recovery is slower across segments”, which is “also visible in muted performance of rural-centric vehicles such as tractors and two-wheelers in December 2021”.

When seen against the fact that average real rural wages – they are a good proxy for informal sector earnings in India – have been stagnant in the past few months notwithstanding the recovery seen in headline GDP numbers as well as other high frequency indictors, the observations about lack of demand from analysts do not seem very surprising.

Can a capex boost alone kick start the economy’s stuttering engine?

To ask this question is not to undermine the importance of the government’s infrastructure push. These programmes will go a long way in boosting the productive capacity and investment attraction capacity of the economy in the long-run. However, to expect the central government capex to boost an economy facing a demand deficiency immediately is something comparable to expecting the tail to wag a dog. It will be better if the government were to think of ways in which the budget would boost consumption spending by a large section of the population. That will reduce unutilised capacity and trigger private investment which will generate a much bigger multiplier effect than government capex alone.

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