Why Corporate Investment Is Declining in India

GS-III: Indian Economy | Investment | Growth | MSMEs | Fiscal Policy

Context

• Declining investment: Corporate investment as a share of GDP has been declining in India for some time.
• Rise after 2004: Corporate investment increased sharply in 2004, rising from 6.5% to 10.3%.
• Growth phase: Investment continued to rise during India’s high-growth period.
• Global Financial Crisis: Investment declined during the GFC but later began a steady revival.
• Demonetisation: The revival was interrupted by demonetisation in 2016, after which the decline became persistent.
• Current concern: Corporate investment has not even returned to the low levels witnessed during the GFC.
• Covid: Covid-19 was another external shock in 2020-21, but the investment decline had already begun several years earlier.

What Determines Investment?

• Expected profitability: Firms consider the expected profitability from selling the goods produced by a new factory.
• Confidence: Firms need confidence in their ability to predict profits over the lifetime of the investment.
• Cost of credit: Interest rates and the cost of borrowing become important, especially when investment exceeds a firm’s own available funds.
• Firm size: The factors constraining investment differ significantly between small and large firms.

Role of Interest Rates

• Alternative use of money: A firm that does not invest can park its money in assets earning the prevailing interest rate.
• Investment condition: Expected profitability therefore needs to be higher than the market interest rate for investment to take place.
• Borrowing cost: Firms that borrow to invest also face the cost of credit.
• Increasing risk: The cost of credit tends to rise as firms take on more loans relative to their own funds.
• Kalecki’s principle: Michal Kalecki’s ‘principle of increasing risk’ suggests that the system is tilted against small capitalists.
• Access to capital: Access to capital, a priori, begets more capital.

Does Firm Size Matter?

• Small firms: Firms with very little own capital face a rising cost curve much earlier.
• Credit constraint: Their cost curve may cut the profitability curve, making investment primarily constrained by availability of credit.
• Higher interest costs: Smaller firms therefore face relatively higher interest costs.
• Large firms: Larger firms may have enough own capital for the cost curve to intersect the profitability curve only on its vertical portion.
• Market constraint: Large firms are therefore more likely to be constrained by market demand rather than finance.
• Indian evidence: Data from listed Indian manufacturing firms between 2000 and 2024 broadly supports this distinction.
• Firm-level pattern: Smaller firms have lower profitability and higher interest costs, while larger firms have higher profitability and lower interest costs.

Why Lower Interest Rates May Not Revive Investment

• Small firms: Even a fall in interest rates may not revive investment among smaller firms if their fundamental constraint is profitability.
• Large firms: For large firms that are not credit-constrained, lower interest rates may have little impact.
• Tax cuts: Cost-side interventions, including tax cuts, may therefore have limited expansionary effects on investment.
• 2018 corporate tax cut: Corporate tax was reduced from 30% to 22% in 2018, but corporate investment did not respond significantly.
• Low-interest regime: Similarly, the low-interest-rate regime followed by the RBI did not generate the expected investment revival.

What Can Revive Corporate Investment?

• Push profitability outward: The profitability curve needs to move outward to increase investment by both small and large firms.
• Demand creation: This requires government expenditure to act as an autonomous stimulus.
• Government spending: Public expenditure can actively create demand and push profitability curves outward.
• Small and large firms: Increased demand can encourage investment across firms of different sizes.
• Fiscal policy: This approach would require moving away from excessive emphasis on fiscal restraint.

Core Argument

• Problem is not only credit: Corporate investment cannot be revived simply by reducing interest rates or taxes.
• Firm asymmetry: Small firms are primarily constrained by credit costs, while large firms are more constrained by market demand.
• Profitability matters: Weak expected profitability and uncertainty can suppress investment across firms.
• Demand stimulus: Government expenditure can create demand, improve expected profitability and encourage private investment.
• Final principle: To revive corporate investment, policy must focus on expanding the profitability curve rather than merely reducing the cost curve.

Conclusion

India’s prolonged decline in corporate investment reflects the interaction of profitability, confidence, interest costs and firm size. The limited response to lower interest rates and corporate tax cuts suggests that cost-side measures alone are insufficient.

A stronger demand stimulus through government expenditure can improve expected profitability and encourage investment across both small and large firms. However, this requires moving beyond excessive fiscal restraint and focusing on growth, investment and gainful employment.

UPSC Mains Practice Question

Q. “India’s corporate investment slowdown cannot be explained merely by high interest rates or taxation.” Examine the role of profitability, business confidence, firm size and government expenditure in reviving private investment.