Corporate investment, as a share of GDP, has been declining in India for some time now (Chart 1). This trend raises an important question: what explains this prolonged decline?
A few things stand out in Chart 1. Corporate investment in India took off in 2004, when it jumped almost four percentage points, from 6.5% to 10.3%. After rising during the dream run of India’s growth story, it fell during the Global Financial Crisis (GFC), but began a steady revival till demonetisation hit the economy in 2016 (marked by a vertical line in the chart). Since then, the decline has been singular. So much so that the share has not even returned to the low levels during the GFC (see the horizontal dashed line).
This last point is the most damning. The global economic crisis was an external shock beyond India’s control, whereas demonetisation was a self-inflicted shock. To be sure, there was another external shock — Covid — in 2020-21. But the decline in investment had started a few years earlier.
What determines investment?
Think of building a factory. A factory has a long life, so you need to take many things into account over its lifetime before committing to building one. What are the factors that may influence this decision? The three most important factors are likely to be: the expected profitability from selling the goods the factory produces; the confidence with which you can predict those profit rates over the factory’s lifetime; and the cost of credit, especially if the level of investment crosses your own available funds, needed to build the factory in the first place. The story becomes even more interesting when we bring in firms of different sizes because what constrains investment varies across firm size. Let us see how.
As for the first factor, most industries have economies of scale. Larger equipment, factories, and workspaces have higher profit rates compared to their smaller counterparts. Thus, expected profitability rises with the size of investment, as shown by the upward-sloping portion of the profitability curve in Graph 1. However, each firm has an upper limit to how much it can sell and, consequently, an upper limit to the size of the factory, represented by the vertical portion of the profitability curve in Graph 1. If it invests more than that, that part of the factory will go to waste given that the firm cannot cross the sales set by its share in the total market.
The second factor — the confidence with which a firm holds these expectations — determines the position of the profitability curve. A high level of confidence, what John Maynard Keynes called ‘animal spirits’, means the profitability curve would move outward and the reverse if the capitalists are pessimistic about the future. An economy-wide shock of demonetisation pushed the profitability curve inward across the board (dashed blue curve in panel (b) of Graph 1) both because immediate profitability declined and because the credibility of future policy steps became suspect. This fall may be so drastic that it pushes small firms below the cost of credit curve altogether, forcing them out of business — exactly what happened to many MSMEs during this period.
The third factor — interest rates — could matter for two different reasons. First, a firm that is not interested in building the factory has the option of parking its money in assets bearing this rate of interest. For there to be any investment, therefore, expected profitability needs to be higher than the market rate of interest. Second, if a firm has to borrow from the market to invest, the cost of credit will play a role. This cost is likely to rise as firms take on more loans in proportion to the funds they are committing to the project. So, up to a point given by firms’ own capital, the cost curve may be flat, but it rises steadily after that. This ‘principle of increasing risk’ was proposed by Michal Kalecki, which meant the system is rigged against small capitalists, even when small and large capitalists have the same blueprint of a technology. Access to capital, a priori, begets more capital.
Does size matter?
What is interesting in this story is that for the smaller firms with very low levels of own capital, the cost curve starts rising way sooner than the larger firms and may cut the upper portion of the profitability curve (panel (a) of Graph 1). Investment for such firms, therefore, may be constrained by the availability of credit. Interest costs, therefore, would be quite high for such firms.
For the larger firms, their own capital may be so high that the cost curve cuts the profitability curve on its vertical portion (panel (a) of Graph 1). Such firms are limited by the market instead of finance. Interest costs may not be consequential.
Chart 2 shows that such a broad categorisation across size, by and large, holds for the Indian manufacturing sector. We have compiled a balanced panel data set of listed firms in the manufacturing sector between 2000 and 2024 from the Prowess dataset and categorised them in three sizes — small, medium, and large. Smaller firms have lower profitability but higher interest costs, whereas the larger firms have higher profitability but lower interest costs, as expected in Graph 1.
What does this mean for investment?
This asymmetry across firms of different sizes has some interesting implications. Even a fall in the rate of interest may not revive investment among smaller firms (dashed yellow line in panel (c) of Graph 1). For a large firm, which is not constrained by credit in the first place, such a policy would have no impact. Cost-side policy interventions, including tax cuts, may not have much expansionary impact on investment. This may help explain why corporate investment has not responded despite the corporate tax cut from 30% to 22% in 2018, along with the low-interest-rate regime followed by the RBI.
What is needed instead is to push the profitability curve outward, which would increase investment by both small and large firms. This can be achieved only if government expenditure acts as an autonomous stimulus. That will create demand actively and push the profitability curves outward. But this would mean giving up on being a fiscal hawk and instead listening to the youth protesting on the streets asking for gainful employment.
(The authors are a part of the DevMac (Development Macroeconomics) network, which seeks pluralism in Economics)