3.1. Studies on Factors Affecting Investment
Broadly, four main theories can be used to explain investment behaviour, namely: (i) acceleratory theory, which emphasizes on demand-side factors as measured by the level of output; (ii) neoclassical theory, which underlines the role of capital costs; (iii) ‘Q-theory’, which hypothesis about the role of excess market valuation over replacement costs leading to investment and; (iv) liquidity theory, which recognises market imperfections due to asymmetric information between firm and funds suppliers and, accordingly highlights the role of internal sources of funds as a key factor affecting the investment decisions of firms (Fazzari et al. 1998; Celik et al., 2018). Further, few studies found liberalization and financial openness also affects the FDI flows (Ullah and Inaba, 2014; Arif-Ur-Rahman and Inaba, 2020).
The existing empirical literature has examined these established theories along with several other macroeconomic factors to understand the direction and magnitude of their effects on investment. One of the most crucial factors affecting private investment is aggregate demand, usually proxied by output or output growth (Greene and Villanueva 1991; Fielding 1997). Besides output, studies have also investigated the impact of monetary policy and changes in the interest rate on investment. Theoretical literature suggests that higher interest rates increase borrowing costs and thereby limit investment activities, which has been supported by studies such as Wuhan and Khursid (2015) for China. On the other hand, as per the McKinnon-Shaw hypothesis (1973), higher interest rates can incentivize foreign capital inflows and encourage savings through financial intermediaries, which can, in turn, raise investible funds in a phenomenon known as the “conduit effect”.5
Similarly, there are mixed empirical results when it comes to the effect of fiscal policy on investment. A set of studies(Martinez-Lopez, 2006; Cavallo and Daude, 2011) find evidence for a crowding-in hypothesis, wherein higher public investment in infrastructure and other public goods crowds in private investment by creating an investment friendly environment and thereby improving marginal productivity of private capital. But expansionary fiscal policies requiring excessive government borrowings can lead to both real and financial crowding out and, thus, a fall in private investment. Moreover, the rising deficit can lead to distortionary taxation, discouraging private investment (Carlton, 1979; Bartik, 1992).
There have also been studies examining the effect of inflation- an indicator of economic stability and macroeconomic stability – on investment. Results reveal that high inflation levels can raise concerns amongst investors about a potential fall in demand and hence, producing at excess capacity. As a result, firms may be reluctant to invest when inflation levels rise above a threshold level (Bloom et al., 2001). Further, high and rising inflation lowers purchasing power and adversely affects the supply of financial resources. In addition, the studies by Byrne and Davis, (2004); and Dasilva-Filho, (2007), argue that higher rates of inflation create uncertainty which in turn affects the investment through reduced real returns. In contrast, stable prices reduce uncertainty and allow for a more favourable allocation of resources (McClain and Nicholes,1993).
The development of financial markets, particularly capital markets, facilitates investment through access to financial resources via bonds, debentures and equity markets. Developed financial markets are instrumental for ensuring efficient capital allocation through a competitive price mechanism and channelling the same to productive investments (Ngerebo, 2006; Ndikumana, 2000). In contrast, financial repression policies regarding credit controls discourage private investment. The study by Ang(2009) supports that financial sector development matters to investment in India and Malaysia. Similarly, Lim (2014) - who utilized a panel data of 129 countries spanning 1980–2009 – reported that financial development and institutional quality were essential for explaining cross-country differences in capital formation.
Besides domestic factors, empirical studies have also examined the impact of external factors on investment, including external debt, capital inflows, terms of trade(TOT), foreign direct investment (FDI) and exchange rates. The role of external debt emanates from the complementary effect that external financial resources can have on domestic savings and hence, investment; this is especially the case in many developing countries where savings tend to be low owing to lower income levels (Were, 2001). However, rising debt can lead to debt overhang, utilization of internal sources for debt servicing, financial distress, credit supply restrictions and high default probabilities particularly in times of financial turbulence, which eventually lowers investment (Bernanketet al., 1999; Busettiet al. 2016). The role of external constraints - such as debt shock and debt service – can also influence private investment (Borensztein, 1990). Giordano et al. (2019) analyse investment at the firm level for Italy and report that indebtedness and the debt-service ratio dampen private investment.
Similarly, the impact of FDI on investment could be either positive or negative. FDI inflows can lead to positive spillovers by improving access to advanced technologies, newer markets, better management and branding networks. As a result, an economy's overall productivity increases, stimulating domestic investment (Chen et al, 2017). However, FDI can also crowd out domestic investment if local firms are underdeveloped, and as such, foreign firms have an undue advantage in the domestic economy in terms of their technological and managerial expertise. In addition, resources like skilled labour, fiscal resources, etc., may be limited in developing countries, and local firms may be unable to compete with foreign firms for these resources (Jansen, 1995).
The real exchange rate (RER) impact on investment moves both ways-positive as well as negative. Currency depreciation boosts exports and, through the multiplier effect, domestic output. As a result, firms may increase investment in the economy to take advantage of the higher domestic and foreign demand. At the same time, if the country is import-dependent and its import content of the exports is high, depreciation can put pressure on its balance sheet by increasing the cost of imported inputs. The worsening fiscal situation accompanied by falling profits for firms (as production costs increase due to costlier imports) will dampen investment activities in the economy (Bahmani-Oskooee et al., 2016). Additionally, currency depreciation affects investment as it changes the cost of capital raised in the overseas market.
Lastly, the recent empirical literature has identified business confidence and economic uncertainty as key investment factors. Khan and Upadhayaya (2019) utilize the quarterly data for the USA and conclude that business confidence has the predictive ability for the investment cycle. As investment is forward-looking, investors look at future expectations and prefer to channel resources to stable economies, where there is less ambiguity and arbitrariness in policy implementation; accordingly, uncertainties affect the investment through these expectations (Economic Survey, 2018-19).
3.2 Studies on the Investment Slowdown in developing countries like India
The theoretical and empirical literature has examined the underlining reasons for the investment slowdown in developing countries during the post-GFC era, both at the global and national levels. According to Banerjee et al. (2015), uncertainty about the future state of the economy and expected profits is the dominating factor governing investment rather than financing conditions. Koseet al. (2017) find the investment slowdown in the economies of BRICS (Brazil, Russia, India, China, South Africa) and commodity exporters. The plausible factors for slowing investment rate in many emerging and developing economies include weak growth prospects, terms-of-trade shocks for oil exporters, private debt burdens, and increased geopolitical and geo-economic risks. Weak growth in developed economies, such as the United States and EU countries, has also worsened growth prospects in developing economies and hence, discouraged private investment in such economies. Further, as given in the paper, rising financial market uncertainty and macroeconomic policy uncertainty after the GFC have also played an important role in slowing down investment (Banerjee et al., 2015; Kose et al., 2017).
There have also been several studies which have examined recent trends in investment behaviour and its various determinants in India. Chakraborty (2007) finds crowding out phenomena in India from 1970-71 to 2002-03. Apart, the study could not evidence the significant impact of credit, cost of finance, and the output gap. in determining private corporate investment. In contrast, Bahal et al. (2018) report the crowding-out effect in India over the period 1950–2012. However, the opposite is true when they restrict the sample to post-1980 or conduct a quarterly analysis since 1996, marking a heterogeneous response of investment inter-temporally. There have also been state-wise studies such as the one by Malik (2012), who empirically analyse the determinants of investment in 15 Indian states for the period 1993–1994 to 2004–2005. The results reveal that gross fiscal deficit, infrastructure development, labour productivity and market size are vital factors for explaining inter-state differences in investment.
There have also been some recent studies on the investment slowdown in India. Tokuoka (2012) use macro and firm-level microdata to understand the importance of macroeconomic and structural factors in explaining the slowdown in corporate investment. The study finds that macroeconomic factors could largely explain the behaviour of private corporate investment in India but could not fully account for the current downturn. This implies that the changing business environment also significantly impacts corporate investment. Results reveal that business climate, cost of doing business, financial sector development and state of infrastructure are important macroeconomic dimensions affecting the recent deceleration in investment in India; however, study could not answer the role of monetary policy in explaining investment behaviour.
Similarly, Anand and Tulin (2014) use the quarterly data for the period 1996 to 2012 and conclude that changes in real interest rates and standard macro-financial variables could hardly explain the investment slowdown. The fall in investment is attributed in large part to deteriorating business confidence and rising policy uncertainty which caused investors to defer or cancel new investments. Complimenting Anand and Tulin (2014), an RBI study (2013) concludes that investment rates continue to be low, in the face of lower interest rates due to decline in marginal productivity of capital in post-GFC period. Thus, poor expectations on rates of return have dampened the effect of interest rates on investment and discouraged private investors from investing. Another recent study, RBI (2019) has reported that the slower growth in capital formation post-2011-12, mainly in private investment, is attributed to corporate deleveraging in select industries as reflected in the improving interest coverage ratios along with the slower credit expansion by financial intermediaries.
In addition to key investment determinants such as economic size, interest rate and bank credit, Raj et al. (2018) found that the investment rate in India has been characterised by a three-year cycle between 1950- 51 to 2017-18. The study hails that timely assessment of cyclical investment is required to correct and follow appropriate policy measures to safeguard against future slowdown. Analysing annual data ranging from 1995–2017 with OLS method, it was hailed that uncertainty in the overall macroeconomic and business environment, slower demand, real interest rates, and public investments had significant impacts on private business investments in India (Dastidar & Ahuja 2019). Bhardwaj and Kumar (2019) noted that size matters a lot for investment in monetary policy channels-credit and interest.
Based on the above arguments and empirical evidences, it is clear that slowdown of private investment in India could be due to a host of factors such as output, fiscal policy, monetary policy, macroeconomic stability, economic uncertainty external stability, real exchange rates,. It may be noted that most empirical studies have relied on the accelerator model to explain investment behaviour. However, the accelerator model may be better suited for advanced economies as it is based on assumptions of a perfect capital market, absence of liquidity constraints, and abstraction from the role of government. Accordingly, past research has highlighted the role played by financial sector development, measured by activities of financial intermediaries and capital markets, towards determining investment in developed economies (Gurley and Shaw, 1955; Greenwood & Smith, 1997). According to the existing literature, the investment slowdown in India can be linked to debt burden and tight financial markets (RBI, 2019), heightened levels of policy uncertainty and an unfavourable business environment (Tokuoka, 2012; RBI, 2013; Anandand Tulin 2014); the slower pace of public investment (Bahalet al., 2018) and macroeconomic uncertainty attached with fluctuating external demand (Dastidar and Ahuja, 2019). Most of these studies also reported that the economic activity, real interest rate, fiscal deficit and bank credit were India's major determinants of investment activity. Nevertheless, almost all the studies have focussed on investment at an aggregate level and as such, have not analysed the effect of these factors on institutional level investment, such as corporate and household sectors investment. In addition, the literature has overlooked the role of various institutional and financial factors such as the credit gap, monetary policy transmission effect, bonds market development; business confidence; and economic uncertainty.6In recent years’ financial sectors have advanced in developing economies, and constraining factors of investment, likewise imperfect capital markets, less liquidity, higher interest rate and poor mobilization of financial resources - have eased. These hygienic factors have been well experienced by India since the beginning of the 21st century. Thus, there may be a need to revisit the suitability of the basic accelerator model for explaining investment behaviour in developing economies.
In this context, the current study bridges these research gaps by including multidimensional indicators in its empirical analysis to study the nature of investment behaviour in India more comprehensively.
[5] An analysis of determinants of private investment in Zimbabwe for the period 2009-2011
[6] Dastidar and Ahuja (2019) considered the news-based policy uncertainty index; however, many studies have considered the precise measurement of uncertainty through cross-sectional dispersion in the subjective expectations of firms interviewed (Giordano et al., 2019).