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Public spending's crowding-out effect short-term in India: Study

There is a clamour for increased government spending to give a thrust to the slowing Indian economy and spur private investment that has historically helped GDP grow faster than public investment. But public investment always comes with the risk of crowding out of private investment.

, ET Bureau|
Last Updated: Jan 23, 2020, 02.56 PM IST
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There is a clamour for increased government spending to give a thrust to the slowing Indian economy and spur private investment that has historically helped GDP grow faster than public investment. But public investment always comes with the risk of crowding out of private investment.

A recent study, however, shows that crowding out effect is usually short-term and there is crowding-in and an increase in private investment in the long run if public investment is increased in infrastructure, with lesser allocation to non-infrastructure segments such as industrial and commercial activities that directly compete with private enterprises.

The analysis, by Jagannath Mallick of State Bank Institute of Leadership, is based on annual investment data from FY1961 to FY2018 and quarterly data from Q1 of FY1996 to Q3 of FY2018.

g1
Share of private and public investments in nominal GDP and their relation with real GDP growth


Shock Investment Therapy Adjusts in 6 Years
It is evident that a given shock* in growth of public investment in infrastructure has a negative impact on growth of private investment. Impact of the shock peaks in the second year and gradually dies out by sixth year. This suggests that it takes about six years for growth of private investment to adjust to the equilibrium following the shock. This shows that in the short-run, infrastructure component of public investment has a crowding-out effect on the growth of private investment.

(*Shock in infrastructure investment means an expected or unpredictable event that leads to positive or negative infrastructure investment)

Infra Investment’s Impact Varies
The effect of infrastructure investment on private investment is not uniform over the years. This means that when there is an increase in infrastructure investment of the public sector, immediately it draws down resources available for the private sector. But once that public sector investment sets up the infrastructural facilities, the private sector starts up responding positively.

g2
Share of public investment in infrastructure to total public investment


Removing Supply-side Bottlenecks
The study says supply-side* bottlenecks have been at play rather the standard macroeconomic variables for recent slump in private investment. There is a large gap between the demand for and supply of infrastructure and the injection of private capital in key infrastructure sub-sectors has been slower than anticipated and public investment in infrastructure declined significantly in recent years. Consequently, there is stagnancy in infrastructure investment.

(*Supply-side constraints include lack of quality transport system, energy & power)

A Short-run Negative Impact
Using quarterly data in the post-reform years (1991 onwards), the study shows that increasing overall public investment (both infrastructure and non-infrastructure) also has a negative effect on private investment in the short run. Such negative effect turns to be positive in the medium term. The main explanation is that a rise in public investment raises government expenditure which drives the fiscal deficit, which is mainly financed by domestic borrowing from private sector. This, in turn, reduces availability of funds for private investors.

Moving Away from Non-infra Public Investment
The study suggests policymakers to reduce public investment in relatively unproductive components of non-infrastructure, which continue to dominate over its infrastructure component. It says the government should reduce investment in sectors that compete directly with the private sector to boost growth.

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