What ‘investment climate’ is all about

India’s economy is growing much below its potential in the last two years. It clocked a growth of 6.2 per cent in 2011-12 and 5 per cent in 2012-13. There is consensus amongst policymakers, analysts and academicians that the remedy to the economic woes lies in reviving the ‘investment cycle’. The tight monetary policy pursued by the RBI between March 2010 and April 2012 has been a deterrent to new investment activities.

However, the RBI points to the poor investment climate rather than interest rates as the chief reason for the lack of investment appetite. This line of reasoning derives credence from the fact that real interest rates in the last three years were much lower than in the boom years of 2004-08, when investment posted fast-paced growth. So, it is worth looking into whether investment climate has really deteriorated in the past three years.

First, what is ‘investment climate’? Broadly, investment climate refers to all factors that influence investment decisions. A sound investment climate provides private firms with opportunities and incentives to invest. It is shaped by structural factors such as geographical features, market size and consumer preferences at one end and government policies that have a bearing on costs, risks and barriers to competition, at the other.

Nothing much can be done to change the structural features in the short to medium term. However, costs, risks and barriers to competition can be influenced by government policy. The manner in which a government addresses provision of public goods, infrastructure, and market failures have an important bearing on the costs a firm faces, apart from the time involved in complying with regulatory requirements.

In this context, poor contract enforcement can amount to over 25 per cent of sales or more than three times what firms typically pay in the form of taxes. In addition, firms attach a lot of importance to risks associated with protection of property rights, policy uncertainty, macro-economic instability and interpretation of laws. Further, the government can influence competitive pressure through its regulation of market entry and exit and its response to anti-competitive behaviour by firms. As such, improving the investment climate involves reducing unjustified costs, risks and barriers to competition.

Governance issues

The investment climate is shaped not only by policy but also governance — how formal policies are implemented in practice. The World Development Report 2005 , with the theme ‘A Better Investment Climate for Everyone’, points out that policy uncertainty and macro-economic instability rank as the leading investment climate concerns of firms.

Uncertainty in the interpretation of regulations is another big concern as 95 per cent of firms report a gap between formal polices and their implementation. Poor investment climate often hits the smaller and informal firms the hardest.

As many factors influence the investment climate, a crucial question in this context is, where should government prioritise, or what should be the first point of intervention by the government? The World Development Report 2005 suggests that there is no winning formula.

The course of action would be guided by an assessment, through surveys, of the constraints businesses face, the potential benefits from easing of these constraints, the link of constraints with broader national goals and implementation constraints.

Policy paralysis

Before addressing constraints, improving political stability should be the first priority of the government, followed by improving macro-economic stability, as without these, changes in other dimensions will have limited impact.

It is equally crucial to address broader governance issues such as corruption and credibility.

Where does India stand in all this? While India does not suffer from political instability, continuing political tension in the past two years has forced government to ‘go slow’ on important areas of economic reforms, such as the implementation of GST.

The macro economy, an important determinant of the investment climate, has deteriorated in the past two years. The government, which was expending energy in addressing governance-related issues, turned its attention to economic management when faced with the possibility of a sovereign rating downgrade in September 2012.

Though P. Chidambaram assuming the charge of the Finance Ministry in late July 2012 has helped matters, the government has to walk the talk in achieving fiscal consolidation and pushing through important reforms.

When it comes to the global ‘ease of doing business’ ranking, much of India’s improvements seen in 2008 and 2009 had been given up by 2013. Except for closing a business and registering property, there has been a decline in India’s rank over the years in areas such as starting a business, enforcing contracts and dealing with licences.

India’s ranking gives credence to the perception that the bureaucratic apparatus could not gear up to the challenges of fast growth.

Hopefully, the government will be left with enough energy to address these issues after tackling political, macro-economic and governance challenges.

(The author is Professor in Economics and Acting Dean, Xavier Institute of Management, Bhubaneswar. Views are personal.)

COMMENT NOW