OREANDA-NEWS. April 04, 2014. India’s investments grew more than 10 per cent a year between 2000 and 2011, despite the dip during the global financial crisis. However, they have slowed sharply since then and declined in annual terms in 2013. Moreover, the quality of investments has deteriorated.

What led to this dramatic slowdown? Potential explanations include:

The widening fiscal deficit has crowded out the private sector

High and volatile inflation raised uncertainty about the returns on investments and necessitated a tightening in monetary policy

Lack of structural reform and administrative obstacles holding back infrastructure projects hampered the investment cycle

The weaker global economy

To put these potential explanations to the test, we have developed a quantitative investment model to help determine what drives investment. Our analysis shows that high real interest rates weigh on investment. This may compel some to blame India’s central bank for the weak investment, but real interest rates are now lower than before the global financial crisis.

Our research also shows that as long as growth expectations remain relatively high compared to real interest rates, investment growth will remain strong, as we saw before the global financial crisis. Rather than interest-rate hikes, it is the lack of structural reform and administrative hurdles that have lowered growth expectations and reduced investment.

Monetary policy is by no means tight and, consequently, not the root cause of the decline in growth expectations. If anything, more needs to be done to bring inflation under control because high and volatile inflation has a negative effect on investment, according to our quantitative model.

Further, the rise in economic policy uncertainty in 2005-07 and 2012-13 has shaved around 2.5 percentage points off the average quarterly investment rate according to our calculations – around 10 percentage points in annualised terms. Uncertainty about the direction of monetary and fiscal policies and, on the back of this, negative news coverage of economic policies have hurt business sentiment and, thereby, investment.

The outlook for the investment cycle thus depends on getting inflation under control, reducing the fiscal deficit to revive lending to the private sector, and structural reform to lift growth expectations.

Much also depends on the government’s willingness and ability to move things forward. A newly elected government with a strong mandate will be better able to implement much-needed economic reforms and revive stalled investment projects.

Global economic conditions certainly matter but the execution of the domestic policy agenda will be the dominant driver of the investment cycle in coming years.

Even a government elected with a strong mandate cannot change things overnight. The investment cycle will probably improve only gradually over the next couple of years; nevertheless, the direction would be a welcome change.