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Thursday, July 09, 2009

It's the private corporate investment, stupid

The first graph in The setting for the budget speech tells the story of the importance of private corporate investment. The text there says:

The economic reforms of the early 1990s got private corporate investment up from the region of 4% to a peak of 10%. This six percentage point increase of private corporate investment generated a strong business cycle expansion.

The decline of private corporate investment back to values like 5% was the essence of the business cycle downturn of 2001-2002. After this, we have seen an immense expansion of private corporate investment -- all the way to 16%. This is the essence of the benign business cycle conditions of recent years.

The most important question that will shape business cycle conditions in 2009-10 and 2010-11 is: by how much will private corporate investment decline? It is important to see that today, each percentage point of GDP is Rs.55,000 crore, so we are discussing massive numbers. If a decline of private corporate investment takes place from 16% to 10%, then this is a reduction of demand by 6 percentage points of GDP or Rs.330,000 crore. When private corporate investment goes down, the overall impact on GDP is magnified through multiplier effects.

The shocks to GDP that are generated by these fluctuations of private corporate investment are so large that monetary or fiscal policy, as presently organised in India, can simply not counteract them. The only place where public policy can make a difference to this is to identify the policy instruments through which private corporate investment can flourish.

Some say the budget has done a fiscal stimulus by expanding the fiscal deficit by 0.8 percentage points. Others say that in tough times, it's not correct to engage in deficit reduction. These arguments have to confront the irrelevance of the direct impact of these fiscal numbers. Whether the fiscal deficit goes up by 0.8 percentage points or it goes down by 2 percentage points, these are tiny numbers when compared with the real prize: private corporate investment.

If we play things right, and persuade domestic and foreign investors that India is on the right track, then this would perhaps add five to ten percentage points to the investment/GDP ratio, which drowns out a 2 percentage points of GDP reduction in the fiscal deficit which (in my opinion) is a critical element of the policy stance required to reassure the private sector that India is on the right track.. And if we play things wrong, then a five to ten percentage points of GDP reduction in private corporate investment will drown out a 0.8 percentage points of GDP fiscal stimulus.

The key message: focus on private corporate investment, not on either monetary or fiscal stimulus. India does not have the institutional capability to use monetary or fiscal policy to do business cycle stabilisation on the scale that we are seeing in the West. Let us not transplant the intuition and rhythm of policy that we see in the US and the UK into our setting, where we have dysfunctional institutions. In the medium term, we need to do fiscal, financial and monetary institution building so as to have that kind of apparatus. In the short term, the only real lever we have, that can stabilise the economy, is the outlook for economic reforms.

What determines private corporate investment?

Suppose you spend Rs.100 to build a factory, and suppose (for the moment) that this is all-equity financing. Suppose you take the company public and the market gives you a valuation of Rs.200. In other words, the hard work that you put in to build the business using Rs.100 of risk capital has created wealth of Rs.100.

This ratio -- the market price of a project divided by the cost of building it -- is called Tobin's `Q'. When Q > 1, CEOs and entrepreneurs would feel like building projects. The bigger Q is, when it's beyond 1, the bigger the incentive to engage in investment. When Q is near 1 or below it, the incentive to invest withers away. The sword of entrepreneurship is guided by the eyes that seek out high valuations.

The price to book ratio of the broad market is a poor man's Tobin's Q. It is a poor estimator because while the numerator (market cap of Nifty) is correct, the denominator (the replacement cost of building the Nifty companies) is only roughly approximated by the book value of the Nifty companies.

This argument emphasises the clear and direct link between stock prices and the investment optimism of CEOs. When stock prices are high, CEOs are more likely to build factories, and vice versa. In other words, the path to high private corporate investment runs through high stock prices.

The chatter on television and newspapers frequently says "Oh, but a budget must not only be judged by what it does to stock prices" or "Oh, but the stock market does not understand these things". I would emphasise two points. First, whether the stock market is right or wrong, it is the driver of how CEOs behave. So regardless of what we think about the quality of information processing of the stock market, it matters. Whether we like it or not, the stock market drives the resource allocation. Second, there is an enormous academic literature which gives us reason to respect the sophistication and capability of the stock market in information processing. The future is of course un-knowable, and every forecast of the future will have a substantial zone of error. But there are few better estimators of what might come, than the pooling of knowledge and opinion of millions of financial market participants in an open, transparent setting.

So what are stock prices saying?

The graph (click on it to see it more clearly) superposes Nifty and the S&P 500 indexes. Both indexes start at 100 on 1 May 2009. The S&P 500 index shows little movement, which suggests that the dominant story lies in domestic events.

When the election results came out, Nifty achieved values like 118 in the graph, i.e. 18% up compared with pre-election conditions. This was good news for Tobin's Q and thus private corporate investment. It was the best news possible for the outlook for business cycle conditions.

Why did we feel optimistic at the time? It was felt that two scenarios had been avoided: the scenario of confused / weak governance with attendant political problems, and the scenario of a UPA-1 where economic reforms were blocked by the CPI(M). The hope that UPA-2 would do better gave us higher stock prices, going all the way to 27% up compared with pre-election levels.

We've had a sharp decline, from indexed values of 127 to an indexed value of 112; a decline of 12%. In other words, a bit less than half the gains have been erased. This is not good for Tobin's Q and hence not good for the outlook for private corporate investment and hence not good for the outlook for business cycle conditions.

Worldwide, there has been a political shift away from left parties given that voters are nervous about economics and want top quality leadership in terms of economic policy. When the going gets tough, voters turn to The Man. In India also, this should be seen in the context of a long-term secular decline of the vote share of the Left: both trend and cycle are going against the left. A key reason why the UPA-1 won the election was the benign business cycle conditions that prevailed 2004-2009, and the fiscal bounty that came with it. Conversely, things will be very painful in political terms if business cycle conditions go back to 2001-02 levels. It is odd for India to have shifted towards giving more power to the left within the Congress at a time like this.

Early in this blog post, I show the most recent available data which proxies for private corporate investment: the monthly time-series for IIP capital goods and for imports of capital goods. Both these are quite dated. In a few months, we will know what happened to the month-on-month changes of these two series in July and August, which would reflect the consequences of the budget speech.


  1. Good basic point, ignore the deficitGDP ratio and its cahnges, focus upon getting investment going. How best to do this? I suspect more Sotonomics type policies are called for: implementing repeal of ULCRA, streamlining legal processes for housing, especially Nano ones etc.

  2. I always thought lower interest rates (expansionary monetary policy) was the way to go if private investment needed propping up - especially if rates are not yet close to zero, and currency strength is not a priority.

  3. Devendra Nevgi said :

    Hi Ajay, Been a follower of your blog for a while now. I had a few points here :

    1. There has been considerable debate on impact of asset prices on the real economy and subsequently private investments, globally and in India. And yes confidence and animal spirits are important in driving private investment. Its unfortunate if Indian CEOs make higher investments when stock markets are at its peak, may be due to lower cost of say equity. Like Indian govt did not trigger off serious fiscal consolidation when Tax/GDP ratio was higher in earlier years.

    2. I do agree with your views in past that monetary transmission in India is weak and the fiscal multipliers are smaller as India integrates globally and savings ratio remains higher. Further leakages within the system are higher too. I am not sure if the Ricardian Neutrality principle works in India in times of higher fiscal defecit.

    3. Tobin Q in US has been a fair long term indicator over or undervalued businesses.
    But are Indian Balance Sheets fully mark to market to arrive at a fair replaceable value. ?

    Thanks And Regards

  4. Devendra, I'm emphasising a simple point. CEOs and entrepreneurs care about the Q or the price/book ratio which measures the reward to successful business-building.

    If spending Rs.100 on building a cement factory gets you a valuation of Rs.200, lots of people will try to build a cement factory. If spending Rs.100 on building a cement factory gets you a valuation of Rs.100 upon success (which is not certain) then nobody's going to build a cement factory.

    I'm emphasising the relationship between this "Q" and the decisions of CEOs, entrepreneurs, private equity funds, etc., in choosing investment projects worth implementing.

  5. The way the market behaves also depends on what level they are on. The sharp run up in the first half of the year means that the markets were long over due for correction.

    As far as fiscal deficit goes, if we can control the leakage, the money spent on infra and other public goods will serve us well for sure.

  6. Ajay,

    I do not mean to detract from the importance of private investment as a driver of growth for India, but find it hard not to be skeptical about using the level of the stock market index as a proxy for business confidence. If Tobin's q is such an important investment driver, how do you explain the fact that it has spent most of the last century below 1.0 for the US market taken as whole? It appears to me that it the lags the investment cycle and is at best an indicator of how overheated the stock market is at any given time...


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