Data on Gross Domestic Product (GDP) reiterates that Indian economic activity is still falling short of meeting its pre-covid capacity. H1 FY22 real GDP was 96% of what it was in H1 FY20. It may take another two quarters to match the FY20 capacity, assuming an optimistic YoY growth of 9.5% in the current fiscal. The shortfall in capacity utilization vis a vis pre-covid period is spread across all components contributing to India’s gross production/demand, including Government spending:

Figure 1: Capacity utilization post Covid (vs H1 FY20) across key demand generators

Low productivity and high inflation are gnawing at capacity utilization during this recovery phase.

Consequently, India’s notoriously large output gap (i.e., difference between ability to produce and actual production) widened further in the last 18 months. RBI, in its recent policy discussion in Dec’21 observed this gap to be “very very wide”. While eliminating this gap is a long term plan, all efforts should be directed to restore it to its pre-covid levels, at the very least. One immediate action is to ease credit supply. Bank credit, the traditional route for capital access, needs to grow atleast 10% yoy compared to 6% currently (i.e. an additional inflow of Rs 9 Lakh cr by Mar’22). At the same time, bond market liquidity needs to be maintained, adjusting for the likely crowding out of private issuers by massive Rs 13 Lakh crore of government’s debt issuances in FY22. Easing capital flow and access will in turn generate higher capital expenditure, boosting employment and domestic consumption, eventually leading into a virtuous cycle enabling animal spirit in the economy, which mutually reinforce investment, productivity growth, job creation, demand and exports. In this sense, ample credit availability is an indication of financial development and leading financial indicator of growth.

The fallout from lack of capital access can be assessed from the decadal low level of fixed capital formation as a percentage of GDP, achieved in FY21. This is feeding into rising output gap. Tapping additional sources of investments is critical to reinvigorate this fixed capital formation cycle. Bank credit may not be sufficient in meeting the requirement especially since household savings rate is dwindling consistently. The erosion of fixed capital formation is worse within manufacturing sector, deemed to be the largest employer after agriculture.

Figure 2: Consistent decline in fixed capital formation across sectors prompted by lack of durable funds

Ingenious capital channels needed to complement shrinking traditional routes

Given the risks arising from weak capital availability and allocation, it is necessary to get creative around sources of capital to fund investments going forward, both government and private.

One interesting route being explored by both Ministry of Finance and Reserve Bank of India in recent times is increasing long term capital inflows into Indian government securities (Gsecs). This can potentially ease India’s capital woes through two channels:

• Free up banking assets: Higher absorption of government bonds from a new category of investors and easing pressure on public bank capital.
• Enhance debt market liquidity: Decline in the extent of crowding out of corporate bonds by weekly government issuances. More domestic capital will be available for the private sector.