Capital Formation In India
Varun Bisht Economist 022-61541942 Rajrishi Singhal Head – Policy & Research 022-61541730 Policy & Research Unit, Dhanlaxmi Bank, Trade View, Kamala Mills, P.B.Marg, Worli, Mumbai 400001
Capital Formation Trends in India India’s gross domestic product grew an average 9% annually for some years before the global financial crisis of 2008. Between 2004 and 2008, business confidence acquired a swagger and investments increased at a rapid pace. India was in an enviable position with problems of plenty – capital was rushing in and high GDP growth was taken for granted. Planners wanted to push growth rate beyond 10%, citing positive demographics and investments that India was attracting. Indeed, India did find a sweet spot between 2004 and 2008, with investments driving growth. Post-crisis, the world has changed. Developed economies haven’t been able to shake off the effects of the economic crisis. India too has experienced a slowdown in capital flows, such as foreign direct investment, and savings and investment rates have also faltered. The country’s growth rate slowed and touched a low of 6.8% before recovering to 8.5%. As soon as growth recovered, euphoria was back. So was bluster about decoupling and how the Indian economy was robust enough to grow despite adverse global conditions. This year, India is again expecting a slower growth of 7.5-8%. With inflation soaring and growth faltering, questions are being asked about the brief and evanescent growth witnessed in FY10 and FY11. Comparisons are also being made between nature of economic growth during 2004-2008 and the growth rate of the past two years that was undoubtedly driven by consumption and spurred mainly by stimulus programmes. Investment seems to be slowing down and that seems to be affecting overall growth rate. In fact, investments or capital formation is perhaps one of the keys to realising India’s dream of high economic growth. At the same time, stagnant capital productivity levels -- measured through incremental capital output ratio -- have put the focus back on the need to increase the investment rate to achieve higher economic growth, at least until capital efficiency catches up. Simultaneously, the spotlights have been trained on the stagnant savings rate as well. We feel that given the depth and severity of the global economic crisis, it will be a while before the volume of capital flows into India goes back to the 2004-08 levels. If investment is to power economic growth, it will then need concerted efforts to step up the savings rate.
Capital Formation Capital formation is addition to productive capacity of the economy. It is also known as investment in national accounting. Terms like capital formation, or additions to physical stock, or investment are synonymous in economic parlance. Capital formation forms the backbone of an economy. India has steadily improved its capital stock since independence. We try to explain the theory and trends of investments in India.
Gross Capital Formation Steadily Improved: Gross capital formation in the 1950s was as low as 7.8% of GDP. This improved in the following decades with the Five-Year Plans constantly focusing on improving physical stock.
Measures of Capital Formation: Gross capital formation, gross fixed capital formation and gross domestic capital formation are few other definitions to study capital formation. In India, the Central Statistical Organisation provides data on capital formation by institutions and sectors.
Savings: Savings provide necessary means for investment in the economy. Savings rate has improved post-liberalisation to 36% of GDP, which points to rise in economic activity and national income in India. The country currently is among the high-saving economies of the world. However, India’s saving rate is still far lower compared with China’s, which is around 50% of GDP.
Contribution To Gross Capital Formation: Currently, private sector leads in investments in the economy at 37% of total investments. Public investments are around 26% and household investments account for 32%. Public share in investments has fallen over time, which indicates the government’s inability to stimulate investments in the country. The way forward is to boost investments through private-public partnerships that can help India solve its infrastructure problems.
Private Investments: With liberalisation of the economy and a favourable business environment, private sector now leads in investments in the economy. Private investments are largely funded by household savings. Over the years, private savings have also improved, which have further aided private sector capital formation. The private sector, being the biggest contributor to gross capital formation, now has a crucial role to play in leading India’s economic growth.
Public Investments: Public investments have declined as government lacks enough resources to boost investment in a big way. Also, the government’s propensity for dissavings, because of poor expenditure management, has left it with fewer resources to fund investments in the country. As government lacks enough muscle to raise investments further, the private sector and foreign fund inflows have become critical for increasing investment levels in the country.
Household Investments: Household investments account for 32% of total investments. Household includes individuals, non-corporate business bodies, private and charitable institutions such as educational and religious organisations. Therefore, investments by these bodies in terms of physical capacity creations such as on land, buildings, factories, etc, are termed as household capital formation. Household investments are funded by rising household savings. Household savings accounts for nearly 70% of total savings and are the chief source of investments for both private and public investments.
Key Aspects
Measurement: Investment activity in an economy refers to addition to physical capital stock. It is measured by gross capital formation. In India, the Central Statistical Organisation provides data on different components of gross capital formation, broadly defined as gross fixed capital formation (GFCF) plus change in stocks. Gross fixed capital formation provides a picture of gross value of goods added to fixed domestic capital stock during a year. GFCF includes plant, machinery, equipment and improvements to land. Change in stocks provides value of inventory and work in progress.
Transition Since Independence: Capital formation in the 1950s was low, but it improved in the following decades. Capital formation improved more than four times to a high of 36% of GDP in 2010. With investments rising over the years, India’s economic growth rate reached a high of 9% before the 2008 global crisis. Although all economic growth cannot be attributed to investments, importance of capital formation remains paramount in economic development.
Key To Long-Term Growth: Importance has been laid on capital formation in economic development as it can lead to sustainable long-term growth. Although capital formation has increased in India since independence to touch 36% of GDP, it still remains below rates achieved in high-growth economies, such as China. Investment levels in China have risen to a high of 50% of GDP, which also underlines the high economic growth it has been able to sustain for the past 25 years.
Constraints To Investments: Another aspect of capital formation that needs mention is constraints to finance it. Investments are typically funded from domestic savings (although foreign capital flows also contribute towards growth in investments). So, inadequate growth in savings rate can be a constraint for investments. Savings rate in China has increased to around 50% of GDP, which makes it possible for the Chinese economy to sustain high levels of investment. China also attracts huge foreign direct investment every year.
Only Investment Not Enough: It is an oversimplification to say high investments can result in longterm high economic growth. There are many economies that initially showed a rapid rise in economic growth through improvement in capital formation, but ultimately slowed down. Examples of Soviet Union in the 1960s and the East Asian experience in the 1980s and 1990s provide evidence that high rates of investments aren’t the only way forward. Investments have to be followed with improvement in productivity. Excess of capital without productivity results in slower growth and also lower returns on investments. Simply put, mobilisation of labour and capital are not sufficient for sustainable high long-term growth. Incremental capital output ratio (ICOR), a critical ratio that measures the amount of incremental capital needed to produce one incremental level of output, is a key measure of capital productivity. ICOR levels in India have remained unchanged at 4.5 in recent years. A lower ICOR is critical to achieve a high rate of growth with a given level of capital formation. There’s more on ICOR later in the report.
Perspectives For India: Many studies on investment behaviour in India have pointed out that economic growth, rising incomes and economic liberalisation have led to a rise in private investments in India. Public sector investments have lost share in recent years, which is manifest in infrastructure deficit and other bottlenecks to economic development. Private sector investments hold the key for economic growth and should be encouraged with conducive business and policy environment.
Investment Trends
GCF Trends, % of GDP
GCF gained consistently through 1980s, through focus on Five-Year Plans. The impetus received in 1990s, primarily through liberalisation led to a rise in investments, particularly in the past one decade. There are many factors that have aided rise in investments, particularly increase in savings and the process of de-licensing, among others. Savings improved due to rise in incomes and also due to factors such as spread of branch banking that extended the reach of banking to the remotest parts of country. As bank branches proliferated, financial savings saw a consistent rise since the 1980s.
10.0 5.0 2000-10
1991-00
1981-90
1971-80
1961-70
0.0
1950-51 1953-54 1956-57 1959-60 1962-63 1965-66 1968-69 1971-72 1974-75 1977-78 1980-81 1983-84 1986-87 1989-90 1992-93 1995-96 1998-99 2001-02 2004-05 2007-08 18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0
16.5
15.7 14.0
13.6 10.0 7.3
2000-10
15.2 11.2
1951-60
40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0
1991-00
15.0
23.6
18.1
20.0
Savings Trends, % of GDP
1981-90
30.0 21.9
0.0
1971-80
31.3
25.0
10.0
Decadal Average GCF, CAGR %
Decadal Average GCF, % of GDP 35.0
20.0
1961-70
30.0
1951-60
40.0
1950-51 1953-54 1956-57 1959-60 1962-63 1965-66 1968-69 1971-72 1974-75 1977-78 1980-81 1983-84 1986-87 1989-90 1992-93 1995-96 1998-99 2001-02 2004-05 2007-08
Capital formation in 1950s was low as 7.8% of GDP, which improved gradually in next few decades with constant focus on improvement in physical stock. Over time, GCF has more than quadrupled to the current 35.8% levels of GDP. Rise in capital formation has been particularly higher post liberalisation that began in early 1990s. In 2005, it rose to 30% and has stayed there since then. India also witnessed surge in economic growth during this period to 9% levels.
GCF: By Institutions
GCF Decadal Averages, % of GDP
Decadal Percentage Share 60.0
Public
25.0
Public
2000-10
1991-00
1981-90
Private
Household
20.0 15.0 10.0 5.0 2000-10
0.0 1991-00
Spurred by economic reforms and a favourable business environment, private sector now leads in investments in the economy with 36% share in total capital formation. Private investments grew in 2000-10 and overtook household investments to become the largest contributor to total investment. During this period, GDP growth also rose to 9%.
Decadal CAGR Growth, %
1981-90
1971-80
Contribution to GCF by the public sector remained highest from 1960s until 1996. Government contribution dominated total investments in the economy as India ushered in liberalisation in the early 1990s.
Household
1971-80
Private
1961-70
Post-independence, share of public and private sector remained even lower compared with household sector for nearly a decade. As India focussed on creation of physical stock through Five-Year Plans, public sector’s share in total investments towered over the other sectors.
Public
1961-70
14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0
1951-60
In India, capital formation, as measured by GCF according to institutions comprises capital formation by public, private and household sectors.
1951-60
Percentage Share Private
FY10
50.0 4.8
40.0
25.7
30.0 32.6
20.0 10.0
Public 2000-10
1991-00
1981-90
1971-80
1961-70
1951-60
0.0 36.9
Private Household Valuables
GCF: By Sectors It is interesting to study GCF by sectors -- agriculture, industry and services. Currently, in capital formation, share of agriculture is 8.2%, industry accounts for 47.8% while share of services is 44% of the total. Over the years, especially since independence, industry has gained share in capital formation at the expense of agriculture and services. While industry currently leads in capital formation, it actually lost share from 50% of total capital formation in 1991-00 to 46% in the last decade (2000-2010) as services made a comeback.
Capital Formation In Services Comprises Investments In:
Trade Hotels Transport Storage Communication Finance Insurance Real estate Banking Social, personal services Public administration
Investments in agriculture have stagnated since independence. It has lost its share in total investments while industry and services have both registered rapid rise in the same period. Investments in industry is the highest. Manufacturing has driven the rise of investments in industry. The services sector, including trade, hotels, transport, communication and finance, social and personal services, has also registered consistent rise in investments since independence. Services’ share in total investment has been led by trade and hotels and social and personal services.
5.0
Composition in 1950s Agriculture
2000-10
1991-00
1981-90
1971-80
1961-70
1951-60
0.0
Industry
Services
Composition FY10
Industry
Services
Agriculture
Industry
Services
8.2 48.0
18.8
44.0 33.2
47.8
2000-10
10.0
Agriculture
1991-00
60.0 50.0 40.0 30.0 20.0 10.0 0.0
Services
1981-90
Industry
1971-80
Agriculture
1951-60
15.0
GCF Composition As % of Total
1961-70
GCF by Sectors, % of GDP
GCF: By Sub-Sectors Currently, capital formation in sub-sectors is highest in the manufacturing sector. Agriculture and allied services has lost its share in GCF continuously since independence. It also reflects agriculture’s declining share in India’s GDP. Electricity, construction and mining have registered a rise in their share in GCF. Other sub-sectors -trade, transport and finance -- have stagnated or declined in share. On a sub-sector level, manufacturing accounts for the largest share in capital formation at 31% of total. Lower investments in agriculture also reflect lower per capita incomes in rural India as production has stagnated. As rural India houses two-third of the country’s population, there needs to be more focus on the sector, especially in improving capital stock (such as irrigation canals) to improve output. Manufacturing investments have risen to 9% of GDP. This needs to be further increased so that more jobs can be created to absorb the rural masses displaced by low growth in the agricultural sector. Falling share of electricity, gas and water supply illustrates the poor attention given to basic amenities available in India. Private participation has been advocated to improve water and gas distribution, as is the case in many developed economies. Transport’s share in investments has remained low. Investments in Indian Railways have fallen to 1.3% in the last decade from 12% (of the total) in the 1950s. This also explains why Railways haven’t kept pace with rising population and demand and therefore presents an opportunity for improvement.
GCF As % of GDP 1951-60
1961-70 9.7
1971-80
1981-90
1991-00
2000-10
4.7
4.4
Social & personal services
Finance, insura nce, real estate
Trade, hotel & restaurant
Construction
Electricity, gas & water supply
Manufacturing
1.5
1.9
2.7
Transport, stora ge & comm.
1.9
1.0 Mining & quarrying
2.5
Agriculture & allied
12.0 10.0 8.0 6.0 4.0 2.0 0.0
GCF By Industry, % Share In Total 1951-60 40.0
1961-70 31.6
1971-80
1981-90
1991-00
2000-10
30.0 20.0 10.0
15.9 8.4
6.5
3.3
4.6
5.9
9.4
14.3
Social & personal services
Finance, insura nce, real estate
Transport, stor age & comm.
Trade, hotel & restaurant
Construction
Electricity, gas & water supply
Manufacturing
Mining & quarrying
Agriculture & allied
0.0
Savings: The Source of Investments Savings provides the means for investments. Typically, investments are funded through domestic savings mostly and the remainder through foreign capital. The categories of savings are similar to that of investments. Domestic savings are from three sources -- households, private and public sector. Household savings form the largest part of total savings. Corporate savings have improved in recent years while public savings have declined. As domestic savings contributes the most to capital formation, it can also be a limiting factor to investments. Thus the importance of foreign investments gets highlighted. Foreign capital can bridge the gap in capital formation if domestic savings are not sufficient enough. Savings have been improving over the years with rise in economic growth and incomes. Savings constituted 33.7% of GDP in FY10, though pre-crisis it was higher at 36.9% in FY08. Gross domestic savings stood at 9.7% of GDP in 1951-1960. Savings improved gradually in the 1980s and 1990s as the economy started opening to reforms. Sharpest rise in savings was in 2000-2010. Household savings at present is 23.5% of GDP and constitutes around 70% of total savings. With rise in incomes, household savings have risen. Household savings comprises physical and financial savings. Traditionally, physical savings have always exceeded savings in financial products. This trend has been reversed during FY10. Financial savings have improved with rise in financial inclusion and reach of banking industry. Private savings account for 24% of total savings. It stood nearly around 10% of total savings for four decades since independence. As India embraced a market-based economy, corporate savings started increasing. Corporate savings have risen sharply because open markets provided competition, market access and better efficiency. Economic reforms in the 1990s increased corporate savings sharply to around 17% in the same decade. It improved further in 2001-2010 to 21%. Public sector has been the worst performer among the three sectors. Public sector savings stood around 21% in 1951-1960 and increased to around 25% in the next two decades. In subsequent decades, it lost its share. In the 1990s, it fell to 5.2% of total savings. 1990s saw losses in public enterprises and huge deficits by government that pushed public savings into negative territory. Household savings being the largest provides resources not only for household investments but also for private and public investments. Household savings through bank deposits, small saving schemes, mutual funds, equity market, insurance, corporate bonds gets channelled to private and public enterprises that then use it for investments.
Savings Decadal Averages, % of GDP 30.7
FY10
23.1 16.9 9.8
6
19.6
24
12.6
2001-10
1991-00
1981-90
1971-80
1961-70
70 1951-60
35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0
Savings Composition, % share
Household
Private
Public
Savings Investment Gap Domestic savings largely fund investments in India, but tapping foreign capital flows is also crucial to improve capital formation further. The historic savings-investment gap of 1-3% of GDP has traditionally been funded by foreign capital flows. Foreign capital inflows can address investments constraints in infrastructure and other areas. However, the continuing economic crisis in the US and the Euro-zone raises concerns about sustainability of capital flows into India.
Investment (GDCF)
Savings (GDS)
Gap ( S-I)= Net Capital Flow
% of GDP
% of GDP
% of GDP
1961-70
10.8
9.7
-1.2
1971-80
14.3
12.3
-2.0
1981-90
20.9
19.0
-1.9
1991-00
24.2
23.0
-1.2
2001-10
31.1
30.6
-0.5
35.0
Investment
Savings
Gap
30.0 25.0 20.0 15.0 10.0 5.0 0.0 -5.0
1961-70
1971-80
1981-90
1991-00
2001-10
Incremental Capital Output Ratio ICOR is the ratio of incremental investments to incremental output and is a key metric in macroeconomics. Higher the ICOR, lower is the productivity – it means more incremental units of capital are needed to produce one incremental unit of output. ICOR in India has remained at 4.0-4.6 levels since 1990s. There have been some improvements in ICOR in the post-reforms period, which points to improvement in productivity. In fact, India’s ICOR has been lower on a cross-country comparison with other developing countries -- such as, Brazil, Mexico. Capital efficiency in China is slightly higher compared with India. ICOR Trends: ICOR declined post-independence, which points to improvement in productivity. ICOR was at 6.6 in 1970s which declined in subsequent years with improvement in productivity. However, in the recent Five-Year Plans, ICOR has stagnated at 4.5. In the 10th Plan, ICOR had declined to 4.1. However, since then it increased and stabilised at 4.5. Improvement in efficiency is required to improve growth in the county. Improvements In ICOR: Efficient use of capital reduces ICOR, which can lower investment requirements to achieve a higher growth rate in the economy. Although ICOR has improved since 1970s and in between for a few years, it is yet to decline meaningfully to improve growth rates further. 9% GDP Growth Distant Dream: Achieving a sustainable 9% GDP growth rate has become a difficult task with stagnant investment rates. Assuming that capital productivity remains unchanged at 4.5, achieving 9% annual growth rate requires an investment at 40.5% of GDP. This looks difficult in current conditions, and also as global investment climate has remained turbulent since the 2008 crisis.
Five-Year Plans
Investment Rate
Growth rate
ICOR
IX
24.6
5.5
4.5
X
31.8
7.8
4.1
XI
36.4
8.2
4.5
XII* Required
40.5
9.0
4.5
International ICOR Comparison , 2000-06 7.6 5.7
Thailand
South Africa
Philppines
Mexico
4.3 4.2 4.5
Korea
4.3 4.5 4.7
Indonesia
5.1
India
4.5
8 7 6 5 4 3 2 1 0
China
4.2
2010
4.6
2003-07
1970-79
1960-69
3.5
4.0
1997-03
4.6
1991-97
4.6
1990-91
4.3
1980-89
6.6
1950-59
7 6 5 4 3 2 1 0
Brazil
ICOR Trends
Further Readings:
Athukorla, Prem Chandra and Kunal Sen (2002)- “Saving, Investment and Growth in India” Bosworth, Barry, Susan Collins and Arvind Virmani (2006)- “Sources of Growth in Indian Economy” Barro, R.J and Sala-I-Martin (1995) – “Technological, Diffusion, Convergence and Growth” Krugman, Paul (1996) – “Pop Internationalism” Klenow, Peter J and Andres Rodriguez Clare (1997) – “Economic Growth: A Review essay” Mohan, Rakesh (2008) – “A Story of Sustained Savings and Investment in India” Young, Alwyn (1994) – “Tyranny of Numbers: Confronting the Statistical Realities of the East Asian Growth Experience”
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