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Betting on Infrastructure

India has a good savings rate & a mechanism should be devised by which this money moves into infrastructure-related activities...

The New York Subway is among the world's oldest, noisiest, busiest and dirtiest metro networks. Spray-painted graffiti consisting pictures and slogans is visible everywhere, including on the trains, although the authorities try to clean up. Cleaning up graffit is such a thankless task that the exasperated authorities passed a law restricting sales of spray cans only to adults with ID.

The slogans range from the random and obscene to the religious. As the song goes "The words of the prophets are written on subway walls". For instance, "Jesus Saves" is a common saying and that slogan is often flanked on the NY subway by "Moses Invests".

This is an old joke focussed on the legendary financial acumen of the Jewish community, which has a large presence in NY. Saving, investment and consumption are three things New Yorkers understand instinctively. It is, after all the financial capital of the world.

These three variables interact intimately with each other. At the personal level, to live a good life, you need to find a judicious balance between savings, investment and consumption. Saving and investment without consumption is a recipe for an ascetic. Consumption without savings or investments is unsustainable. Savings without investments guarantees that the value of the savings is eroded by inflation.

A simple understanding of savings, growth and consumption from an individual's point of view will tell us that the three are also linked. Saving is necessary. But it's not enough. There is a need to find returns for savings at rates that beat inflation. Returns of that nature usually come from investments in businesses servicing growing demand. Demand is generally driven by strong consumption.

In national accounting as well, these three variables are linked. If we examine GDP through the lens of expenditure, it can be split into consumption plus investment. If investment is low, and consumption high, we have one sort of economy. If investment is high and consumption low, we have another type of economy. GDP grows quickly when there's ample investment and the consumption is also high. Such a model of high investment and consumption is only sustainable, however, when there are ample savings.

Through the 1970s, when India's GDP grew at less than 2 per cent per year, private consumption contributed about 80 per cent of GDP, implying very low investment. Currently, consumption contributes around 58 per cent while investments contribute about 42 per cent. This change in the ratio has helped to drive up growth rates. India has a relatively high savings rate, amounting to about 34 per cent. The difference between the domestic savings rate and the investment rate is funded by deficits.

A nation that invests or consumes without adequate savings must borrow money from somewhere. This could be from outside, bloating external deficits. Or it could be through printing money and thus depreciating the currency.

Borrowing, or deficit financing as it's called, to create productive assets is a reasonable action. But taking on debt also always carries risks. A nation that borrows to fund consumption, without making enough worthwhile investments, runs large risks of economic crisis and maybe even collapse.

There are plenty of examples of such disasters from recent history. The US grew quickly through the 1990s and the early 2000s. But much of that growth was built on debt taken to fuel consumption, rather than productive investments. The investments as such were largely in real estate at over-valued prices. The national US savings rates was negative through much of this period and the economy collapsed when the subprime crisis came along.

Japan has also been in continuous recession for the past 20 years. Again, national debt is over twice the value of GDP. In this case, it's because successive Japanese governments made unproductive investments. Japan has twice the transportation capacity it needs for example, and it has massive over-capacity in many other areas.

Then, there's Greece, Ireland, Iceland and perhaps, Spain and Portugal. All the collapses in Europe are cautionary examples of what can happen when consumption goes out of control, or massive debt in incurred to invest in unproductive assets such as redundant, over-valued real estate.

Ideally, an economy should have high domestic savings to fuel investment. It should also have a judicious mix of investment and consumption. Well-directed investments generate growth and higher returns down the line. Consumption keeps the engine ticking over by generating demand.

Some types of investments are typically long-gestation. Take for example a project to build a power plant. It takes several years to build, it costs a lot and the returns are zero until the plant is operational. Once it is generating power, it should make profits for itself (sadly most of India's power sector is loss-making). It should also help fuel growth downstream because power-consumers can expand their respective capacity.

This story is replicated across other core industries and in infrastructure. A cement plant, a steel plant, a new road, a telecom network, a new port, new railway lines – all these are highly capital intensive and long gestation.

An economy like India must invest in infrastructure because the lack causes massive bottlenecks. On the personal front, I had to stop twice while writing this piece because of power cuts that forced me to shut down my desktop. A cold chain or a cement plant has to invest in massive captive power capacity because the grid is unreliable.

Goods exported from India often have to be transshipped to major container ports like Singapore or Colombo, adding to time and costs. Frequent drops and failures of telecom networks hamper IT and ITES businesses, forcing them to invest in expensive dedicated lines. Poor roads and choked rail networks reduce the speed of domestic commerce.

The lack of LNG terminals and pipelines, which would enable gas imports for or energy-deficit nation, make it difficult for power plants and fertiliser plants to operate at full capacity. Poor public transport makes life difficult for urban residents, who generate 70 per cent of GDP. Upto 40 per cent of India's fruit spoils for lack of either refrigeration, or an inability to get to market. Around 30-50 per cent of urban water supply is wasted due to poor water supply systems.

One could carry on giving examples. But I hope the point has been made. India needs investments in infrastructure. At the same time, the government lacks the financial capacity to fund these, apart from being bad at designing policy and implementing processes to encourage private investments in these areas.

India does have a high national savings rate. Most of the savings are generated by households and the household savings rate has dropped from a high of 36 per cent to around 31 per cent. Households are also risk-averse, and prefer to invest in gold, real estate or bank fixed deposits. Much of these investments are also inefficient. The money is sometimes locked away, earning no return or it's funnelled at second-hand. There has to be some way to induce those investments to move directly into infrastructure-related activity. This is a major task for policy planners.

My argument for investing in infrastructure related businesses is simple. If the economy stagnates, few investments will do well. If the economy is to grow, infrastructure capacity must grow. And, as it happens, those sectors have been beaten down to fairly reasonable valuations.

There is a continuing slowdown so it's unlikely that share prices across the infrastructure space will recover very quickly. That gives a long-term investor a chance to build a portfolio at leisure without over-paying for it. Like the infrastructure space itself, any investments there have to be long-gestation. If there is a sector-specific bet that will pay off handsomely sometime in the next five years, it should be here.