#237 Looking Under the Hood

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India Policy Watch: In Search Of Growth

Current policy issues in India

— RSJ

A quick macro update. The RBI’s Monetary Policy Committee (MPC) met this week and, as was widely expected, kept the repo rate unchanged at 6.5 per cent for the fifth consecutive time. The Governor gave the usual explanation of global political risk, higher volatility in global financial markets, and continued inflationary expectations as the reason for keeping the policy stance unchanged as ‘withdrawal of accommodation’. And the Governor was quite clear that there is no ‘inadvertent’ signalling to the market that it has actually moved to a ‘neutral’ stance with its prolonged pause on rate hikes:

“Reaching 4 per cent (inflation target) should not just be a one-off event. It has to be durably 4 per cent and the MPC should have confidence that 4 per cent has now become durable.

We are very careful in our communication. There is no inadvertence in any of our communication. So, if somebody is assuming that it is a signal to move towards a neutral stance, I think it would be incorrect.”

Well, that takes care of any possibility of a rate cut before next year's elections. And what’s the need, really? Between now and the elections, there’s always an inflation risk on vegetable and food prices. Also, while crude oil price has been on a downward trend during this year which has helped on the inflation front, there’s no guarantee how that will trend given the global geopolitical situation remains uncertain. Most importantly, what’s the need to signal any rate cut when the GDP growth numbers are coming in significantly above even RBI’s somewhat optimistic forecasts at the start of the year? Q2 GDP grew at 7.6 percent, almost a full percentage point above estimates, leading the central bank to up its full-year forecast to 7 per cent. All good news so far. Further, the RBI note had this optimistic comment for the near term:

“The healthy twin balance sheets of banks and corporates, high capacity utilisation, continuing business optimism and the government’s thrust on infrastructure spending should propel private sector capex.” 

Well, you can go back to the past six quarters, and you will find similar sentiments about an impending private sector capex boom from both the government and the private sector. But it is turning out to be a bit of a mirage. While both the corporate and bank balance sheets are the healthiest they have been in the past two decades, there is a continued ‘wait and watch’ approach on capex, which has mystified most observers. While the consumption growth remains robust, there are early signs that this lag in private capex is beginning to slow down corporate revenue growth. From the Business Standard:

“.... the slowdown in corporate revenue growth over the last one year has begun to reflect in India Inc’s capital expenditure as there is a close correlation between growth in net sales and investment in fixed assets. The net sales of 725 companies, excluding BFSI and state-run oil & gas firms, were up 4.2 per cent year-on-year (Y-o-Y) in H1FY24 – the lowest half-yearly increase in the last three years and down sharply from 12.2 per cent growth in the second half of FY23 and 31.3 per cent growth in the first half of FY23.”

As if on cue, the Chief Economic Advisor (CEA), picked the issue of sluggish private capex at a CII event this week. Instead of the expected anodyne address at events of this nature, he made some very insightful points. First, he correctly pointed out that to expect consumption to continue to drive GDP growth while private capex sits out for as long as it has defies logic. Consumption, as we have pointed out more than a few times here, is the residual factor. And that’s exactly the point the CEA made (again quoting the Business Standard):

“Waiting for demand to arise before they start investing will actually delay the onset of such demand conditions happening, because usually consumption has to be the residual. Investment leads to employment, which leads to income generation and which in turn creates consumption and then the savings are recycled back into the investment. So the more the corporate sector delays its investment, this virtuous cycle will not materialise.”

Then he mused on what might be holding the private sector back despite strong balance sheets, robust GDP growth and a general sense of global optimism about India’s prospects:

“So what is holding it (corporates) back? It is easy to say that there is general demand uncertainty. Post Covid, recovery has started. But one thing we have to remember is that this decade is going to be the decade of uncertainty, whether we like it or not. So for us to wait for the uncertainties to abate or recede, [its] like waiting for the waves to subside before taking a dip in the ocean. That is not going to happen.”

I won’t be surprised if there will be more plain-speaking to corporate India coming in the next few quarters on private capex from the government—three reasons for that. 

First, the government has pushed its capex targets in the last two budgets and, somewhat surprisingly, kept pace with them. The public capex has grown at a CAGR of over 30 per cent in the last three years. It is now about 3.3 percent of GDP as opposed to the 1.5 per cent it used to be pre-pandemic. The government has found resources to fund this capex by trimming subsidies following the pandemic and by the continued growth in tax collections because of the efficiencies brought in with GST and the rapid digitalisation of the financial system. However, given the fiscal deficit constraints, this public capex growth will be difficult to sustain at this clip. Couple that with the recent data that shows household savings at a multi-decade low of 5.1 per cent of GDP, there is no other lever of growth to pull except private capex.  

Second, given global uncertainty and the ‘higher for longer’ expectations in developed economies, the annual FDI flows have been the lowest in this fiscal year than at anytime in the past decade. The venture money in the form of investments by VCs and PEs has also dried up with a general ‘funding winter’ that has left all but a few startups untouched. While there’s stronger global demand for the MSME sector that’s visible across the board, it will start hitting the wall of lack of funds in the near term unless large capex projects take off and the general sentiment of investment picks up in the private sector, which then lifts all boats. 

Third, this government is instinctively fiscally conservative and likes to stick to its targets. It has set a target to reduce the fiscal deficit by 1.5 per cent of GDP in the next two years. That apart, the imminent inclusion in global bond indices will also mean a greater level of scrutiny of public accounts. The government would like to project an image of fiscal prudence to boost confidence of investors. So, I don’t see a continued heavy lifting through public capex as has happened in the past couple of years.

Which then brings us back to private capex and that question of what’s stopping it from taking off. I think CEA has a point on the general aversion of the corporates to any kind of uncertainty which has continued for so long that it seems like despite all the talk, they are unable to take the final leap in making that investment. Will this go away in due course? I guess it is possible that the Lok Sabha elections may be the final trigger which may kickstart the process.

But that apart I think there are two other points that remain unaddressed. One, the promoters are yet to come to terms with the new regime of greater scrutiny by banks when they borrow, an insolvency process where they can lose control of their companies and the limited degrees of freedom to do the kind of ‘excesses’ they did in the past in the garb of capex. These ‘reforms’, while good for the economy as a whole, haven't been fully assimilated in the minds of Indian promoters. The better-governed promoters will start taking the leap, and others will reluctantly come along after appreciating this is the only way things are going to get done from here on. Two, while there have been good steps to improve the ease of business, there is a huge opportunity to push for more fundamental factor market reforms to improve risk-taking and bring in a new generation of entrepreneurs in sectors beyond services. Possibly, this should be the big agenda if the inevitable third term materialises in May 2024. Private capex is the big lever still waiting to be pulled. 

Growth cannot come out of thin air, after all.

Numbers that Ought to Matter: In the ongoing Parliamentary session, the Ministry of Health and Family Welfare answered a question on the number of medical colleges and MBBS seats in India. There are 706 medical colleges in India, admitting 1,08,848 MBBS students annually. Over the last ten years, the number of MBBS seats in India has more than doubled (there were 51,348 seats on offer in 2014). However, the total number of seats on offer is quite low despite India now having the largest number of medical colleges in the world. On average, each medical college has just 154 seats. By 2020, China had 420 colleges offering 286,000 seats (i.e. 680 seats per college). Government policy should focus on helping existing colleges scale up. For more context, read edition #159.

Also, do check the new Rajya Sabha and Lok Sabha websites. They are useful data sources. Navigating the questions and government responses is much easier now. However, a lot of data remains locked in PDF files. That’s for another day.

A related project idea: Someone should parse the “Question Subject” field and classify it into meaningful categories. Maybe AI tools can help here. This data could be a proxy for the subjects that India cares most about. The next step would be to track if the subjects inviting the most questions successfully influence government policy. Any takers?

A Framework A Week: A Taxonomy of Defence Innovation

Tools for thinking about public policy

— Pranay Kotasthane

On November 30th, the Defence Ministry approved IAF’s capital acquisition proposal for 97 Tejas Mk1A aircraft. This move signals a major shift — India’s armed forces have accepted the Tejas platform as a replacement for their inventory of old and outdated, mostly Russian, aircraft.

This news item got me thinking about the process of defence innovation. What are the factors governing defence innovation? How are these factors related to each other? Why do some countries do better on this front than others? A search for answers to these questions led me to an excellent framework by Tai Ming Cheung in the Journal of Strategic Studies.

Instead of identifying a simplistic policy answer, Cheung looks at defence innovation as a system composed of several interrelated factors, as shown in the chart below.

In Cheung’s classification, there are seven types of factors:

* Catalytic factors are exogenous inputs that disrupt the defence innovation system. Examples include external threats, top-level leadership support, and revolutionary breakthrough opportunities.

* Contextual factors account for all path-dependent variables such as historical legacy, level of development, market size, etc.

* Input factors are the ingredients of defence innovation. Examples include Foreign Technology Transfers, budget allocations, human capital quality, and Civil–Military Integration.

* Organisational factors refer to the capabilities and mandates of organisations set up to deliver defence products.

* Institutional factors refer to shared norms, plans, strategies, intellectual property protection, and government-market relations.

* Networks and sub-systems include formal and informal networks linking various sub-systems.

* Output factors shape the final products coming out of the system. Examples include sales, marketing, commercialisation, and maintenance.

This approach allows the author to create a typology of defence innovation regimes, wherein specific pathways within the chart get amplified. Two such types relevant to India are incremental and rapidly catching-up regimes.

In incremental catch-up regimes, catalytic factors don’t play a significant role. Such countries produce incremental improvements by parsing input factors such as technology transfers through organisational factors (military and state agencies) and institutional factors (plans, strategies, and norms). The paper identifies India as a prominent example of this regime. Cheung illustrates the model as follows.

Rapidly Catching-up Regimes are underdeveloped defence innovation systems pushed by catalytic factors towards increased resource allocations and a strong research and development sub-system. Cheung classifies North Korea and China in this category. This model is illustrated in the chart below.

Readers should check the full paper and other regime types based on this framework. But the relevant question for us is this: has India transitioned from an incremental catch-up regime to a rapidly catching-up one?

There are some positive signs. Catalytic factors are playing a far bigger role now than in the past. This is mainly because China’s aggression and Pakistan’s relative decline have led to a new emphasis on the defence innovation system. The PM’s recent sortie in the Tejas illustrates that another catalytic factor—“top-level leadership support”—now has a more prominent role. There is also more focus on civil-military integration, diffusion networks, and technology development than in the past. And given that India enjoys a positive relationship with the US, the possibilities of “Foreign technology transfers” (a crucial input factor) are substantially higher than in the past.

The weakness is in the organisational realm. That part of the system is still governed largely by state-run entities with low technology absorption capabilities and fewer incentives for efficient production. The capabilities of universities and laboratories are also quite limited. The procurement system, classified as a network and sub-systems factor, is another weak link that discourages innovation while protecting inefficient government-run firms.

My subjective assessment using this framework is that India is catching up faster than before. It doesn’t seem to be “rapidly” catching up, though. Further, the more radical pathways, which lead to rapid breakthroughs in defence innovation systems, remain out of reach.

Whatever your assessment, Tai Ming Cheung’s framework is useful and helps clear many cobwebs of defence innovation.

HomeWork

Reading and listening recommendations on public policy matters

* [Question] What, according to you, is the Indian government’s best sports policy to date? Please drop a comment with your reasoning. We will put across your views and ours in an upcoming edition.

* [Podcast] The latest Puliyabaazi discusses the politics of polarisation. Gaurav Sood, a political scientist who has worked on this topic for over a decade, gives a detailed account of the psychological underpinnings of polarisation.

* [Article] This article on industrial policy challenges some of our Bayesian priors. More importantly, it links to many recent papers showcasing empirical research on industrial policy measures.

* [Article] A good article explaining how DARPA functions.

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