The book ‘Capital in the Twenty-First Century’ by French economist Thomas Piketty has quickly become a bestseller. The main thesis of the book is that the return on capital tends to be higher than the rate of economic growth. Hence, Piketty argues, society becomes more unequal over time with wealth concentrating in hands of the owners of capital.
Even if we believe that the Piketty view is right – and there are several counter arguments that already have been raised against it – lifting India’s economic growth today is itself conditional upon boosting the return on capital.
The return on investment has plummeted in the past couple of years, limiting the incentive to invest more in areas such as infrastructure and, thereby, lowering economic growth. This, in turn, has led to falling return on human capital (wage growth) since lower economic growth leads to lower job creation or lower demand for labour. The newly elected government will have reverse this trend, if it is to raise economic growth.
The primary reason for the fall in return on investment is the already sizable investment that is stuck in stalled projects, thereby earning no return. The risk-return trade-off has therefore, increasingly become unfavourable. The adverse impact of stalled projects can be seen in worsening capital productivity in the economy in recent years. One of the ways to measure capital productivity is the incremental capital-output ratio (ICOR) – the fixed investment required to produce an additional unit of output.
The lower the ICOR, the higher the productivity of capital. ICOR fell to a low of 4.4 during the high-growth phase of fiscals 2004 to 2011. Productivity fell over the next 2 years, which was reflected in a worsening of ICOR – it averaged 8 during fiscals 2013 and 2014, nearly double the levels seen in the high-growth years, indicating that efficiency of capital halved since then.
The return on investment is lower at present in both infrastructure and manufacturing sectors. In manufacturing it has fallen due to low capacity utilisation as a result of slowing consumption demand. In infrastructure projects, however, it has taken a direct hit due to the deteriorating business climate. CRISIL Research estimates that road projects have seen nearly 23% cost overruns mainly due to delays in project clearances by the government and problems in land acquisition. ICOR in infrastructure projects began worsening in fiscal 2009 and deteriorated significantly in fiscal 2012.
Infrastructure investments are not easily reversible, so they can turn out to be costly to those making these investments if business conditions become unfavourable. Although this raises the risks in infrastructure investments for capital owners, its benefits spill over to other parts of the economy, making infrastructure investment an important source of economic growth. It is, therefore, crucial to minimise the business risks in such investments.
This is what partly happened during India’s high growth phase between 2004 and 2011. A host of economic and financial reforms prior to and during that period made it easier for infrastructure projects to take off, raise funds and complete on time.
However, the high growth phase also saw such investments taking place without proper assessment of financial viability. Painfully slow decision-making and project clearance processes added to the cost of such projects.
The government’s ability to fund infrastructure investment is today very limited. So, if it is to attract private capital, it must minimise the risks in such investment and ensure that projects are allowed to be completed on time. Otherwise, the owners of capital will divert investment away from infrastructure projects to sectors such as the real estate that tend to have lower positive spill-overs to the economy. Or, the capital may just continue to be held in the form of cash (bank deposits, liquid mutual funds) where the risk is low, but the return is also low.
The owners of capital can also send it outside the country and invest in other countries where the risk-return trade-offs are more favourable. Indeed, between fiscals 2012 and 2013, nearly $18 billion left the country in the form of outward FDI. In fiscal 2014 (up to February) another $6 billion flowed out. This is more than one fourth of FDI received by India from the rest of the world during this period.
This, then, is the Piketty paradox. To come out of the low growth cycle, we need more investment. But more investment will come forth only if the risk-reward matrix becomes favourable. That means, the return on existing investment must rise first. The returns on human capital will begin to rise only after that.
While high growth alone will not be enough to create the millions of jobs that India’s growing labour force needs, even lesser number of jobs will be created without it. This will lower the incentive to invest in quality education, thereby potentially lowering productivity of labour and, hence, the return on human capital. Finally, if the gap between the return on capital and labour has to narrow, then government policies must ensure that labour is empowered with quality education and skills.
Dr. Vidya Mahambare is the Principal Economist, Director of CRISIL limited and is currently responsible for conducting extensive macroeconomic research and providing the outlook for key economic parameters including growth, inflation, exchange rates and interest rate, along with her team ...
Dipti Deshpande is Senior Economist at CRISIL. Prior to joining CRISIL in 2010, she worked with the Institutional Equities Research business at Edelweiss Securities, Mumbai. She has also in the past worked with Care Ratings in their sub-sovereign ratings and economic research team ...
