Economic Policy Uncertainty in India has reduced significantly over the last decade. Coinciding with the years of policy paralysis, economic policy uncertainty was the highest in 2011-12. Since then, economic policy uncertainty has declined secularly. The continued decrease in economic policy uncertainty in India post 2015 is exceptional because it contrasts sharply with the increase in economic policy uncertainty in major countries during this period, including the US. As is expected, episodes of greater uncertainty, such as the taper tantrum in 2013 exhibit elevated economic policy uncertainty.

Economic policy uncertainty also correlates strongly with the macroeconomic environment, business conditions and other economic variables that affect investment.

Surges in economic policy uncertainty increase the systematic risk, and thereby the cost of capital in the economy. As a result, higher economic policy uncertainty lowers investment, especially because of the irreversibility of investment. Consistent with this thesis, an increase in economic policy uncertainty dampens investment growth in India for about five quarters. Unlike generic economic uncertainty, which cannot be controlled, policymakers can reduce economic policy uncertainty to foster a salutary investment climate in the country.

The following policy changes are recommended:

• First, policymakers’ must make their actions predictable, provide forward guidance on the stance of policy, and reduce ambiguity/arbitrariness in policy implementation.
• Second, “what gets measured gets acted upon”. So, economic policy uncertainty index must be tracked at the highest level on a quarterly basis.
• Finally, quality assurance of processes in policy making must be implemented in Government via international quality certifications.

• To measure economic policy uncertainty, the index is created by quantifying newspaper coverage of policy-related economic uncertainty.
• EPU index picks up the period of economic policy uncertainty, such as the taper tantrum of 2013, and correlates very well with other vulnerability indices like inflation volatility, stock market volatility, business sentiment index, and other macroeconomic vulnerability indices.

Decoupling of economic policy uncertainty        

• Economic policy uncertainty peaked in India during the late 2011 and early 2012 and has since been declining with intermittent increases in between.
• Economic policy uncertainty in India moved closely in tandem with global uncertainty until 2014.
• However, it started diverging since early 2015 and seems to have completely decoupled in 2018.
• India’s economic policy uncertainty has been falling.
• In recent times, the economic policy uncertainty has been increasing across the world, including US, UK and China.
  • The recent surge in global uncertainty is partly due to rising trade tensions between US and China, uncertainty about outcome of Brexit, slower world growth.
• The low economic policy uncertainty index for India in last one-year points towards resilience of the economy even in times of global trade uncertainty.

How did India address the issue of Economic uncertainty?

• The continued resolution of the twin balance sheet problem
• The implementation of Insolvency and Bankruptcy Code 2016 and
• Recapitalization of banks
• Focus on improvement in the business climate via measures to improve ease of doing business.
• Clarity in the policy for FDI liberalization may have also helped in this regard
• All these steps helped to promote investment.

Which other factors affect investment?

First important factor that affects investment decision is cost of borrowing.

Second important factor for investment is the prices that producers get for their products.

• Rise in prices are expected to trigger greater investments as businesses find it profitable to do so as long as consumption demand is sufficiently strong to overcome the impact of inflation.
• Investment growth is positively correlated to wholesale price inflation, but negatively to consumer price inflation.
• This may be due to the fact the producers would realize producer prices which are closer to wholesale prices upon selling any product, whereas consumers have to pay consumer prices and higher prices may dampen the demand.

Third important factor affecting investment is capacity utilization.

• The utilization of capacity in any quarter is expected to have a positive relationship with investment growth in the following quarter, as excess unutilized capacity in the previous quarter may lower the need for new investment in the current quarter.
• The foreign component of fixed investment, FDI and FII flows are expected to be negatively related to the volatility of exchange rate.
• This is because the returns that the foreign investors actually realize are in foreign currency terms, which depend on the exchange rate.
• If the volatility of the exchange rate is higher, it may decrease the growth of foreign inflows.
• It is seen that the relationship between growth in FDI and volatility of exchange rate is weak suggesting that foreign investors in projects have other considerations as well. On the other hand, a negative relationship, is seen between FII inflows and volatility of exchange rate.
• The negative relationship suggests that the portfolio investments which are generally short-term investments are more affected by the volatility in exchange rate, as compared to FDI flows, which are generally for longer duration

• Top-level policymakers must ensure that their policy actions are predictable, provide forward guidance on the stance of policy, maintain broad consistency in actual policy with the forward guidance, and reduce ambiguity/arbitrariness in policy implementation.
• Economic policy uncertainty index must become an important index that policymakers at the highest-level monitor on a quarterly basis.
• Quality assurance of processes in policy making, which reflect the adage of “Document what you do, but more critically do what you document” must be implemented in the government. Government departments must be mandated to seek the highest level of quality certifications.