Investments, Models and Related Concepts

insightsonindia.com /2014/12/20/investments-models-and-related-concepts/

INSIGHTS 21/12/2014

INVESTMENTS, RECENT MODEL AND RELATED CONCEPT

Investment in common parlance means exchanging money

for a ‘return or profit yielding asset’. Individual earning
money can either invest his money or consume it. When he
invests that money, asset will supplement his future
income. So if a certain part of income is set aside regularly
for investment, his income will grow constantly (provided
that investment yield returns).

Same thing happens in case of GDP growth rate. Gross

domestic Product is aggregate of ‘final’ goods and services
‘produced’ in an economy (country). Think over it! What
kind of goods and services are produced? What happens
to those goods and services? Obviously, all kinds of goods and services which are ‘consumed’ are produced (except
those imported), further some ‘goods and services’ which are produced are exported only to be consumed outside
the country. Similarly, imported goods are produced outside India, but are consumed in India. Broadly, there are 4
widely used classifications of GDP based on aggregate consumption –

1. Private consumption – goods and services which are ‘consumed’

2. Investment – Explained in next para
3. Government Consumption – It is taken net of Taxes earned and expenditure by government
4. Net Exports: Export – Import: if export more than import – then adds difference to GDP, otherwise deduct it.

(Note that imports will automatically get included in ‘private consumption’ category as goods imported are either
directly consumed or are taken inputs for other goods. So by deducting Imports in part 4, we in effect only include
profit earned by domestic traders on same imports.)

This is consumption method of computing GDP, alternate method is of ‘Income’. Think of whole economy of the
country. Whatever is being produced here is being sold by one person to other. So value of total production is
nothing but total income of different factors involved in production. These factors are – Labor/employee (gets wages
or salaries), Materials (their suppliers get some share of profit), Capital (investors get interest), Property (gets rent),
proprietor or entrepreneur (gets profit margin). So, GDP = Aggregate consumption of ‘final’ goods produced (as
explained above) = Aggregate Income all factors of production.

If you just ordered a book from flipkart for Rs 500, then your consumption is of Rs 500 and Income of different
factors right from supplier of paper/wood to service provided by flipkart, is also Rs 500.

Investments or Gross Capital Formation – This includes three categories –

1. Fixed Capital Formation

2. Valuables
3. Changes in Inventory
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Note that in macroeconomics – ‘investments’ only includes physical assets; it excludes financial assets such as,
shares, debenture etc. for obvious reasons. Transactions in financial assets just transfers ‘ownership’ of underlying
assets from one person to another. It doesn’t result into any value addition or new capital formation. For example, if
you purchased shares of some company, production capacity of economy remains same. Production in economy
will change if new physical asset is acquired.

(To avoid this confusion, word ‘capital formation’ is more often used than ‘investment’.)

In national accounts, meaning of investment is taken as aggregate of these three. Fixed capital formation refers to
investment in Buildings, plant, machinery and equipments.

Valuables means investment by households in assets such as gold, precious metals stones, artifacts, paintings etc.
There are disagreements for classifying valuables under ‘capital formation’. It is said that they are just a store of
value and doesn’t result into any productivity, which is peculiar character of capital assets. But directives of United
Nations provides for current classification. Problem is more with country like India where Gold always remains in
huge demand. This pushes up Gross Capital Formation exceptionally high in India. Investments in Gold hovers
around 1.5% of GDP. Further, under inflationary pressures, people find safe investment in gold instead of plant and
machinery or business. This is so because, as per history, price of gold is always expected to rise (in long term)
much faster than interest rates in Indian economy.

Further, inventories are the stocks held by businesses which are unsold at end of the year. Any increase in stock at
end of the year, increases investment in business and vice versa.

So, these three items forms part of Investments or Gross Capital formation. This was that part of GDP (goods and
services produced) which was not consumed by people (or businesses), but was saved and Invested in respective
assets. So as explained in the beginning, this investment will yield us additional return next year in form of GDP
growth.

(Interesting thing is that at macroeconomic levels level Savings equals to Investments/capital formation (given
closed economy). In case of an individual saving may not be his investment, unless he invests his savings. In this
case we are not considering any currency; we are directly dealing with money value of different goods and services
produced. So goods and services, not consumed by people, automatically gets saved and invested.)

(In 2012-13, Savings rate was 30.1% of GDP and Investment rate was 34.8% of GDP. Apparently, Balance
investment came from abroad.)

(Another very interesting this to note is, in an economy difference between ‘Savings and Investments’ is always
equal to difference between ‘Exports and Imports’. Since Investment includes ‘increase or decrease in Inventory’,
any import increases domestic inventories and export decreases the same. Also, Current Account balance is
difference between imports and exports of visible and invisible (services) goods. If exports are more it will be
surplus and if imports are more it will be deficit. We can say that Investments = Savings + Current Account deficit)
read more .

It is known as ‘incremental capital output ratio’ (ICOR). As investment increases, we’ll get additional GDP which will
be on back of this incremental Investment. Say, ICOR is 4, then 40% of additional investment/capital formation will
result into GDP growth rate of 10%. ICOR explains how much investment is needed in economy to raise GDP by 1%
point. Additional Investment will add up to the current investment in the economy, and will produce additional goods
and services. Hence, there are two sources of higher growth rate. One is increasing productivity of current
investment; other is to promote higher investment and lesser consumption.

However, Consumption is equally important. It provides demand for current production in the country. Good
consumption creates demand and pushes prices of the products upward. Higher prices are signals for investors to
Invest in the economy. If there is good consumption then economy can draw appreciable amount of foreign
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investment. Domestic consumption is USP of Indian Economy, which attracts investment from all around the world.

Now putting things into perspective, India’s GDP grew last year by 4.7% and in 2012-13 by 4.5%. Economic survey
doesn’t provide for capital formation rate of this year, but for 2012-13 it was 34.8%. During preceding years India’s
ICOR remained around 4, that time capital formation was 35- 36%, so India got 8-9% growth which is explained by
figure i.e. 36%/4% = gives growth rate of 9%.

In contrast, China’s Investment rates have been as high as 45-50%, which is main reason behind its double digit
growth.

But in last two years, ICOR has risen much higher. That’s why despite of ‘capital formation’ of 34.8%, growth rate
remained at meagre 4.5%. Further, Capital formation rate includes ‘valuables’ which this time amounted to 2.6% of
GDP, which was highest in recent years. Reason for such low growth despite of high investment in economy is
infamous policy paralysis of the government. Due to environmental and labor laws, many ongoing projects halted
and productivity of the economy nosedived. Other issues were corruption scandals like those of 2G and coal block,
cancellation of blocks and spectrum licenses by SC, Ban on mining by SC etc. Consequently, big projects which
already had long gestation periods started accumulating interest costs and this kept even new investment at bay.

This is how investment works in macroeconomics. We have learned importance of investment for growth. This
implicitly signifies social importance of investments. Investment creates jobs in an economy, which further results in
increasing savings, consumption and investment. As we saw in socialistic era government has very limited capacity
to provide jobs. Private sector is expected to absorb majority of human resource of the country. When private sector
is weak whole burden falls on government. We can verify this by noticing current rush for government services.
Further, investments results in increased production capacity and this in turn results in pushing down of prices.

As we all know India suffered with below 1% growth under the British rule. After Independence we obviously opted
for planned development. So this planning has to consider the means of development. Since resources at the
disposal of government were very limited, they had to chart out preferences and pick out sectors, which can far
reaching multiplying impacts at whole economy at least costs. For this they chose their target to be Industry. Among
industry, there were options for consumption goods industry, capital goods or small scale industry.

Through the second plan, Nehru Mahalanobis Model of growth was adopted as per which state sponsored
investment was to be made in heavy capital goods industry. These industries will provide resource base for
consumption goods industry which will be owned by private sector. This overtime build industrial base in the country,
but quite inefficient one. Government backed PSUs became burden on the economy and led to crash of economy in
1991. This whole story was covered in last articles.

This period culminated in LPG reforms after which private sector assumed dominant role in the economy and
government starting rolling back. As already said India’s Industrial base was quite redundant and Infrastructure was
in quite bad shape. Unfortunately, government instead of addressing problems of manufacturing industry got
complacent and focused on service sector. Manufacturing sector can only perform only if there is sufficient
supporting infrastructure, such as power supply, roads, airports etc. (Infrastructure can decrease ICOR
dramatically). Bad infra also kept foreign direct investment at bay. Service sector on the other hand has specific
requirement and global internet revolution made it a huge success. Service sector in generally employment
inelastic. All this resulted into jobless growth for almost 2 decades. It was realized that a healthy manufacturing
industry is imperative for inclusive growth. This was an example draw from China. China as promoted its industrial
sector with much impetus. Its per capita income was less than India in 1990, but is now 3 times.

So new investment model was to be one in which private sector was instrumental. While it was obvious private
goods should be left alone for private sector, but situation was different for public goods.

Private goods are those in which provider can ‘exclude’ consumer through his pricing power. This can be possible

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only if he can charge per user. For example Movie Show, Burger, Train/Bus/Air Travel etc. here those consumers
who doesn’t want to vail services or who can’t afford can be excluded. Another characteristic of private good is that
of ‘Rivalry’. This signifies that private consumed on being consumed are left lesser for others.

In contrast Public goods are those in which neither exclusion is possible, nor are they rival. For example, Law and
order service provided by police is a public good, in which service is provided to whole society and consumption
doesn’t result in lesser availability for others.

It is very hard for private sector to provide public goods as there will be pricing problem. Private sector works for
profit and in this case may end up exploiting consumers by over charging them. Further, private sector doesn’t have
legitimacy to demand money for public services provided, if any. Government collects tax for provision of wide array
of public goods and services.

But it has been recommended time and again by many committees that respective governments should leave
maximum work to done by private sector, retaining only work which can’t be delegated. This was so because
government services were substandard and was infested with corruption, red tape, favoritism etc. Consequently,
now government has evolved new methods in which private sector has involved itself in provision of public goods
and services too.

For example telecom services could be easily provided by private sector, so BSNL and VSNL left space for private
players. But Airport, Highway services etc. have partial public character, so government in these cases (among
many) adopts public private partnership.

Public Private Partnership

Public Private Partnership means an arrangement between a government / statutory entity / government owned
entity on one side and a private sector entity on the other, for the provision of public assets and/or public
services, through investments being made and/or management being undertaken by the private sector entity, for
a specified period of time, where there is well defined allocation of risk between the private sector and the
public entity and the private entity who is chosen on the basis of open competitive bidding, receives
performance linked payments that conform (or are benchmarked) to specified and pre-determined performance
standards, measurable by the public entity or its representative.

Different PPP arrangements vary on the basis of who undertakes (public or private entity) finance, designing,
construction, operations, customer interface, support service etc. Apparently, degree of involvement of private sector
in a particular PPP project differs on these bases.

Notwithstanding all this PPP doesn’t amount to privatization (both are different), not even partial as it involves full
retention of responsibility by the government for providing the services and PPP is just a time bound contractual
arrangement.

Various models adopted are –

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 Types and Models of PPP

Schemes Modalities

Build-own-operate The private sector designs, builds, owns, develops, operates and manages an asset
(BOO) with no obligation to transfer ownership to the government. These are variants of
Build-develop- design-build-finance-operate (DBFO) schemes.
operate (BDO)
Design-construct-
manage-finance
(DCMF)

Buy-build-operate The private sector buys or leases an existing asset from the Government, renovates,
(BBO) modernises, and/ or expands it, and then operates the asset, again with no obligation
Lease-develop- to transfer ownership back to the Government.
operate (LDO)
Wrap-around addition
(WAA)

Build-operate-transfer The private sector designs and builds an asset, operates it, and then transfers it to the
(BOT) Government when the operating contract ends, or at some other pre-specified time.
Build-own-operate- The private partner may subsequently rent or lease the asset from the Government.
transfer (BOOT)
Build-rent-own-
transfer (BROT)
Build-lease-operate-
transfer (BLOT)
Build-transfer-operate
(BTO)

Apart from these there are Management Contracts under which private service provider is hired

Just for management, Further, there may be joint venture for big projects such oil exploration etc.

of private and public entities.

Government Policies for PPP projects

Viability Gap Funding

The scheme aims at supporting infrastructure projects that are economically justified but fall marginally short of
financial viability. Support under this scheme is available only for infrastructure projects where private sector
sponsors are selected through a process of competitive bidding. The total Viability Gap Funding under this scheme
will not exceed twenty percent of the Total Project Cost; provided that the Government or statutory entity that owns
the project may, if it so decides, provides additional grants out of its budget, upto a limit of a further twenty percent of
the Total Project Cost. Bids are made in form of government support required. Party bidding for least government
support wins the project.
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Funding can be provided by both central and state governments.

India Infrastructure Finance Company Ltd.

This a government company created in 2006 to provide long term finance to viable infrastructure projects through
the Scheme for Financing Viable Infrastructure Projects through a Special Purpose Vehicle. The sectors eligible for
financial assistance from IIFCL are transportation, energy, water, sanitation, communication, social and commercial
infrastructure. IIFCL accords overriding priority to Public-Private Partnership (PPP) Projects.

Infrastructure Debt Fund

Infrastructure Debt Funds (IDFs) are investment vehicles to accelerate the flow of long term debt to the sector. IDFs
aim at taking out a substantial share of the outstanding commercial bank loans. IDFs are set up by sponsoring
entities either as Non-Banking Financing Companies or as Trusts/Mutual Funds. it prescribes 70:30 Debt equity ratio
for the fund.

3P India

In latest budget Finance minister announced, creation of an institution called 3P India with a corpus of Rs 500 crore,
to provide support for mainstreaming of PPPs. The planned 3P India entity will examine issues related to
regulation, financing structure, management of contracts and stressed Public-Private Partnership projects.
Some recent announcements for PPP projects are – Rs 4200 crore Jal Marg on Ganga, 8500 Kms of Highways,
Ultra-Modern Solar Plants, Thermal Power Tech, Airports

Under recent law passed relating to land acquisition, PPP projects can acquire land provided they receive consent
of at least 70% landowners.

Budget 2014-45, gives a renewed focus to PPP model. This model has been in place for quite a time, but
enthusiasm among investors has gradually vaned. Main thrust for these projects have been infra sector. There have
been huge investments in Highways, electricity distribution networks, airports, seaports, UMPPs etc. But, many of
these projects are lingering, because of regulatory hurdles and macroeconomic situations. Recently, govt.
announced a body called ‘3Ps India’.

1. Capacity to invest for long gestation projects

Very rationale for PPP model is lack of investible capital in government’s hand. 12 FYP, targets for 1 trillion $
investment in infra, out of which half is expected from private sector. But, there are serious doubts about capacity of
private sector itself. Can private sector be expected to invest in projects which have payback periods, as long as 25-
30 years? No, unless they are getting some support by govt. Moreover, Corporate Debt markets are
underdeveloped in India. So investors depend on bank and capital market, which have their own limitations. Banks
can’t lend for such a long periods because they have other commitments too and their risk assessment on basis of
which they charge interests, is difficult. In Primary capital markets , money is mobilized by selling a good business
plan, which promises good returns, but such promises are rare in PPPs.

2. Risk – return Calculus

Investment decision of a private firm is purely based on Risk and Return. Generally both are directly proportional.
But, PPP projects are alleged to involve, disproportionately high risks. Various risks are –

Political uncertainty – Because of long payback period, they are expected to come under frequent political
change. Attitude, will, ideology of parties in power differs.
Land acquisition and Environment Clearances
Multiplicity of regulation – Because of public nature of the works, they come under supervisor and scrutiny
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 of multiple Independent regulators, such as environmental, local development boards, labor, CAG etc. So,
this increases gestation period and compliance costs.
Cost escalation – Last decade have seen unprecedented inflation, more particularly in construction sector.
This normally outshone every expectation. In absence of flexibility of pricing, investor have no option other
that abandoning the project.
Long term – Because of this, it is not possible to account for each and every exigency which may crop up in
the future. So it is desirable to have flexibility in contracts.
Public activism – In many cases it is seen that, while projects are awarded on one hand, there is
widespread public agitation on the other. Risk and costs of this should be undertaken by the govt.
Lack of exit options – Because of overall low capacity in the economy there are, no exit options for
investors. Govt. recently decided to scrutinize investments to remedy this and to provide exit option at certain
periods.

3. Pricing Barriers

Public goods and services can’t be delivered on charging cost plus profit prices. Subsidized pricing is hallmark of
these services. There need to be better coordination in govt. and investors over giving remunerative deals to
investors and yet, ensuring low price and quality provision of services.

4. Flawed project assessments: most of the recent PPP projects were undertaken in 2006-2010 when
economy was performing well. That time investors were influenced by strong, but excessive optimism which
is now costing them dear.
5. Every project has individual problems and potential, there cannot be any blanket policy for all the sectors or
even specific projects. Each need to be handled on case to case basis. There are regional and Sectoral
variations, for pricing, expected returns, regulatory issues etc.
6. So far Planning commission borrowed the concept from overseas projects, ignoring to mould them to
domestic situation.

Investment in an economy can be done mainly either by government or by private players. These private players
may include foreign players or domestic players. PPP aims at utilizing strengths of two. Government has huge risk
taking capacity, that private sector lack. But private sector has effective and innovative record, provided good
governance is there. Under concept of good governance which holds, minimum government and maximum
governance, such innovative arrangements are instrumental. This way public can be provided choices, which further
results into competition between service providers and finally improving prices and qualities.

This however gives result to issues of accountability. When private player is handling national/natural resources such
as oil and coal, it becomes crucial to monitor them so that reasonable prices are ensured. For same logic Delhi High
court allowed CAG to verify books of private Discoms while observing some limits.

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