What drives corporate investment?

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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.

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.