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Investments and economic growth -- Barking up the wrong tree

G. Ramachandran

WHEN the future does not seem to promise good news about the economy, almost everyone turns to the Centre and the Reserve Bank of India with appeals and suggestions. These are usually meant for those who make decisions pertinent to fiscal, trade, industr ial and monetary policies. The appeals and suggestions are directed at policymakers with the hope that some components of policy would be reformed or tweaked so as to restore confidence in the economy.

The process of influencing policy aimed at building confidence in the economy is complex and, quite naturally, requires persistent and non-trivial effort. The investment in such effort is justified by the expectations of a rise in demand and prosperity, in any order, as a result of recharged confidence. Rising demand followed by rising prosperity is as acceptable as rising prosperity followed by rising demand if inflation does not get out of hand.

Rising prosperity and demand produce gains that can be internalised by consumers and producers in the private sector. There are gains that accrue to government and these can be spread across the public domain. Rising demand and consumption lead to new jo bs, rising business revenues and profits, and rising collection of direct and indirect taxes. Increases in tax collections may then be used to fund further spending by the government.

The expectation that gains would flow into the private domain provides the incentive to the private sector to proffer policy suggestions. The case for fiscal expansion made by Mr Sunil S. Bhandare (Business Line, August 3) is an example. The expectation that gains would flow, even if with a lag, into the public domain provides the justification to policy-makers to accept suggestions proffered by the private sector.

Mr Bhandare has recommended an annual increase of about Rs 15,000 crore in capital expenditure by the Centre over the short term. The recommendation is based on the distressing economic data pertinent to capital formation and expenditure. The principal a ssumption is that the Centre's investments would stimulate capital expenditure by the private sector.

This article argues that the Centre is not the principal determinant of investment by the private sector. State government investments are the principal driving force for investment aimed at economic growth. State governments inspire confidence among pri vate investors, and, therefore, determine aggregate investment.

These arguments are based on an empirical analysis in 1994 (Business Line, November 18, 1994). The analysis was repeated in 1999 and 2001. Results of the 1994 analysis were presented and discussed in India 500 (Business Intelligence Unit, May 1999) and B est States to Invest (Business Today, December 22, 1999). The most recent analysis reinforces the previous results.

Empirical data and analysis

The analysis of the relative impact of investments by the Central and State Governments on investment by the private sector and, therefore, on aggregate investment, is based on publicly available data. The principal sources are the Centre for Monitoring Indian Economy (CMIE) and the State governments. Investment by the State government; the private sector; and the Centre comprise the data for each State. Aggregate investment is the sum of these investments.

Spearman's rank correlation methodology is used to analyse the relative impact. The simple methodology deals with the absence of a consensus on when an investment decision is deemed to be made and what triggers it, and when a decision is translated into an investment. It overcomes the commercial ambiguities related to the completion of an investment.

Results

* State governments drive investments

* The association between the State government and aggregate investment is the highest. The correlation is 0.9514.

* The association between the private sector and aggregate investment is the second highest. The correlation is 0.9208.

* The association between the private sector and State government investment is the third highest. The correlation is 0.8265.

Central Government plays second fiddle

* The association between the Central Government and aggregate investment is the third lowest. The correlation is 0.5922.

* The association between the Centre's and State government's investment is the second lowest. The correlation is 0.5281.

* The association between private sector and Central Government investment is the lowest. The correlation is 0.4641.

Drive in or drive out

A State government is indeed the magnet that draws private investments towards the State. It acts as a magnet by making judicious foundation investments in the State. The cumulative impact is that such judicious investments push the State's aggregate inv estment. The private sector and the State governments drive aggregate investment in the States.

However, if a State government were indifferent to its responsibility towards the capital and investment needs of the State, it would fail to inspire confidence among private investors. Private capital would take flight or ignore the State. There is litt le the Centre can do to stop the flight or make a State an attractive investment prospect. The association between private capital and the Centre's investment is the weakest.

Weak second fiddle

There is little doubt that capital and investments make a vital difference to the welfare of a State's citizens. However, the Centre is not the determinant of the magnitude of investments in a State. It has a weak impact on the decision of the private se ctor and the State governments and, therefore, on aggregate investment. It plays a weak second fiddle and does not possess the power to impress private investors.

The Centre should soon review its policy towards direct and portfolio investments. The results of the 2001 analysis have come at a time when an embattled Centre is struggling to shore up its reputation as a responsible manager of the nation's savings and investments. The Centre can choose to continue to play a weak second fiddle but that would vitiate private savings and private capital and, therefore, aggregate savings and investment.

Who wants to be a billionaire?

The States have the necessary incentives to belong to the club of billionaires. They can do this by making their States most attractive to private capital -- small and big, foreign and domestic. They may acquire the membership of the club of billionaires if they garner the resources to make the foundation investments and then present their strengths to sources of private capital.

A State would be unable to garner resources if it does not practice austerity and pursue efficiency in capital utilisation with uncompromising effectiveness. The localisation of the incentives pertinent to fiscal prudence would spur mutuality at the lowe st level of governance and economic activity so that every citizen can aspire to be a billionaire and live in a State that nurtures billionaires. A State that nurtures billionaires would not have to pass the hat around, especially to the Centre, to feed and nurture its needy citizens.

Good for governance

A careful examination of the role and impact of governance would show that food, shelter, clothing, education, healthcare, air, potable water, reliable law and order, and transaction costs respond to the policies and actions of the local and State govern ments than that of the Centre. The supply of the above requires funds and budgets that can incorporate and internalise the benefits of efficiency, austerity and private capital. Moreover, the local environment comprehensively determines the yield on pers onal investments made in education, health, housing and businesses that produce taxes and revenues.

The empirical results show that people would repose faith in fiscal competence when State governments begin to play their role seriously and move the levers related to investment in the States. Else, there would be a flight of human capital to other Stat es or to other countries. A voting class that can aspire to belong to the club of billionaires strengthens governance, especially in a one-person, one-vote democracy.

Private capital has bite

There is a general view that private capital is restricted to investments by big institutions and multinationals. Private capital includes every paise invested by households, one-person businesses and tiny partnerships too. Such capital produces the best results when the locale in which it operates is a nurturing magnet.

Private capital has bite and it does what all organisms do: Look for a safe and nurturing environment. Private capital would take flight, or be repelled or charred if the local environment is hostile. North Block and Yojana Bhavan are not the relevant lo cal environment.

Barking up the right trees

Mr Bhandare has barked up the wrong tree by suggesting a format for fiscal expansion by the Centre. The empirical analysis shows that fiscal expansion by the State governments that is based on maximising output from foundation investments in the States a nd mutuality with private capital is a better choice. Any other format of expansion would be wasteful. It is inconceivable that the Centre would ever succeed in nurturing the economy or in curbing fiscal profligacy if State governments do not act on the incentives to promote fiscal responsibility and economic growth.

(The author is a financial analyst.)