When ‘animal spirits’ reigned

Lately, a view has gained currency about the 2000s having been a freak decade for the Indian economy, with the spurt in its growth rates, noticeable from 2003-04, largely the result of a worldwide flood of easy money pouring into emerging markets (EM).

This rising tide of global liquidity, originating from the loose monetary policies of western central banks, lifted all EM boats — including India, which saw its annual growth average 8.4 per cent between 2003-04 and 2010-11, against 5.8 per cent in the 1990s.

There is something persuasive about the above view, best articulated by Ruchir Sharma, head of Morgan Stanley’s EM division. At 7.2 per cent, average GDP growth for EMs during 2003-07 was twice that for the prior to two decades, Mr Sharma has noted in his recent bestseller, Breakout Nations .

Moreover, no developing nation — save Fiji, Zimbabwe or the Republic of Congo — got left behind in this liquidity-fuelled boom, where total fund flows into EM stocks grew by 92 per cent between 2000 and 2005, and by a staggering 478 per cent in 2005-10.

From Mr Sharma’s standpoint, India’s growth acceleration during the last decade was nothing unique, being merely part of an EM-wide phenomenon.

Now that the global credit bubble has burst and average EM growth rates have slipped to 4-4.5 per cent, the ‘new normal’ for India will also be at 6 per cent or thereabouts.

This line of argument resonates with what monetarists like John B. Taylor, too, have been saying about the effects of the low interest rate policies of the US Federal Reserve and the European Central Bank during 2003-05. These, the Stanford University professor believes, set the stage for investors to search elsewhere for yields and that’s when capital began gushing eastwards and southwards.

Beyond global liquidity

For all its elegance, the flood-of-global-liquidity theory does not adequately explain the higher trend growth that India experienced over the last decade. If monetary loosening by western central banks was the trigger, shouldn’t it be equally applicable in the current scenario — where policy rates in the US, Europe or Japan are lower than even in 2003-05 and have been ruling so since late 2008? Why aren’t India or the other EMs, then, really levitating today?

Well, because the India Growth Story of the 2000s wasn’t simply a byproduct of western monetary excesses. Far from being foreign capital-fuelled, it was substantially internally-funded.

This becomes apparent when one looks at the story’s most dynamic element or its chief protagonist: The Indian private corporate sector.

Chart 1 shows two measures of India Inc’s dependence on borrowed funds – debt-to-equity and total outside liabilities-to-net worth ratios — based on the Reserve Bank of India’s (RBI) sample of non-government, non-financial public limited companies.

Between 1990-91 and 1996-97, both ratios fell — the former from almost one to 0.6 and the latter from 2.4 to 1.45 — only to rise to 0.7 and 1.7 at the turn of the decade. Since then, though, they have dropped to 0.4 and 1.25 per cent, respectively.

Declining gearing ratios indicate financing of companies’ activities more through owned funds (paid-up equity capital, reserves and surpluses), as opposed to borrowings. It means making profits and retaining much of these earnings to plough back into the business.

The RBI data reveals precisely that. Between 2003-04 and 2008-09, the combined profits after tax of its 1,094 common sample companies rose 2.8 times (from Rs 24,938 crore to Rs 70,065 crore). But their reserves and surpluses went up 3.3 times (from Rs 145,400 crore to Rs 482,535 crore), which was also more than the 2.8 times increase in borrowings (Rs 142,547 crore to Rs 394,284 crore) during this period.

Resources from within

This predominant reliance on internally generated funds is also captured in the national accounts data on aggregate savings and investment (gross domestic capital formation) of the Central Statistics Office.

From chart 2, it can be seen that private corporate investment as a percentage of GDP crossed double digits only once, in 1995-96, till 2003-04. But subsequently, it has consistently hovered above 10 per cent, peaking at 17.3 per cent in 2007-08. Further, rising investment has been accompanied by rising corporate savings as well, with the gap filled mainly by domestic household financial savings.

The last point is important. The India Growth Story was fundamentally about the country’s overall investment rate climbing from 25 per cent through the 1990s and early-2000s to an average 35 per cent-plus from 2004-05.

This significant step-up was overwhelmingly funded by domestic, not foreign, savings. There is no better proof here than the basic macroeconomic identity, which holds that any excess of a country’s domestic investment over savings equals the current account deficit (CAD) in its balance of payments.

Thus, at its peak in 2007-08, India’s investment rate touched 38.1 per cent, while gross savings amounted to 36.8 per cent of GDP. The balance 1.3 per cent — the CAD — is all that was financed through external capital flows.

Foreign in perspective

So does it imply foreign money was not important? Well, it was, but only at the margin and not as much as Mr Sharma would have us believe.

Actually, the country received inflows much more than necessary to bridge its CAD.

To the extent these surplus dollars were mopped up by the RBI to build its forex reserves, leading to a corresponding release of rupee liquidity, they helped keep domestic interest rates low and prop up investments.

Either way, the real story of the 2000s, as far as India was concerned, was one that witnessed unprecedented domestic investment activity, neither driven nor financed primarily by global capital.

This was a decade where Indian private capital truly came into its own, having displayed similar ‘animal spirits’ earlier in the mid-1990s – which was, however, a momentary sparkle extinguished by RBI’s monetary tightening measures and the 1997 Asian financial crisis that followed.

Today, there are no ‘animal spirits’ to drive investments. With corporate profits, household incomes and government finances all under pressure, the domestic savings rate, too, has fallen. All this, even as the CAD has crossed 4 per cent of GDP. India, ironically perhaps, needs foreign capital more now than during its investment boom last decade!

But a revival in growth and investment cannot take place without Indian entrepreneurs rediscovering their ‘animal spirits’.

If and when that happens, the chances are it would, as before, be bankrolled in the main by domestic savings and not any rising tide of global liquidity.

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