Road to growth is paved with low Icor
India’s slowing investment rate and rising incremental capital output ratio, or Icor, have led to low economic growth.
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Two recent, and epochal, events deserve our unstinted attention because they mark the end of an era and the beginning of another one. These are critical because of a common thread linking both: the investment rate of the economy.
The 12th Five-year Plan has just ended, bringing down the curtain on decades of India’s planned economic growth and development. This was the last Five-year Plan; as an alternative, the Planning Commission’s successor NITI Aayog has announced the release of a three-year “action plan”, a seven-year “strategy paper” and a 15-year “vision document”. There is one key difference between these documents and Five-year Plans: The government is free to disregard the Aayog’s recommendations.
The end of a centrally planned economic system also coincides with the formal interring of the Planning Commission, an organization central to not only India’s economic strategy but also to its federal temper through the added responsibility of allocating grants, Plan and non-Plan funds to states. The commission’s federal remit was not granted through constitutional mandate and this generated sufficient heartburn, especially among non-Congress states. However, the commission’s shuttering is also due to questions raised about the relevance of centralized planning in a globalized, market-led economy. And then there is politics. The commission was created through a government resolution which makes it easy for the Narendra Modi government to bury it.
But before the institution is shut down, it might be worthwhile to examine the 12th Plan performance, especially some of its macroeconomic targets. The 12th Plan ran between April 2012 and March 2017, with a Congress-led administration in charge till April 2014 and the Bharatiya Janata Party-led government steering the Plan thereafter. Prime Minister Modi announced his intentions of abolishing the commission and ending Five-year Plans during his first Independence Day speech in 2014 but allowed the 12th Plan to formally run till its original expiry date.
The plan had set an average gross domestic product (GDP) growth target of 8% for the 2012-17 period. This growth target was not achieved in any single year by either of the two political dispensations, despite a steep jump resulting from a new series introduced by the Modi government. The closest India came was in 2015-16, with 7.9% annual growth. Otherwise, the average growth for the period works out to below 7%, way lower than the average annual growth rate of 8% achieved during the 11th Plan.
A low investment rate is among the many reasons for the under-average performance. The 12th Plan envisaged an average investment rate of 34%. However, the investment rate has been declining every year, starting with 33.4% during the first year of the Plan; the Central Statistical Office’s second advance estimates for 2016-17 show gross fixed capital formation at 26.9% of GDP, the lowest in more than a decade. What’s worse, investments have not been forthcoming from either the private sector (which has historically contributed the bulk of investment as a percentage of GDP) or the government sector which should ideally be investing when private investment dries up.
In a recent newspaper article, former Reserve Bank of India governor C. Rangarajan has also pointed to low productivity of capital, captured through incremental capital output ratio, or Icor, which measures how many additional units of capital are necessary to produce one additional unit of output. India’s slowing investment rate and rising Icor have led to low economic growth.
Discussing Icor might sound anachronistic, especially since the service sector accounts for 55% of India’s GDP where the relation between capital invested and output is still unclear. In addition, supply-side thrusts (such as increased government consumption expenditure) can lead to higher GDP growth despite a depressed investment climate, which can then send garbled messages about improved capital productivity. Ordinarily, a falling Icor should be accompanied by palpable technological improvements and skill enhancements, leading to an all-round increase in productivity and efficiency.
Discussions on capital productivity seem to be back in fashion because high Icor in recent times (higher than six during 2013-16) have been complemented by sluggish economic growth, over-leveraged corporate balance sheets and burgeoning bad debts in the financial sector. These factors have dragged down the economy’s growth impulses. In all discussions on efficiency and factor productivity, it is usually Indian labour that has to bear the cross. But this time the focus is squarely on capital productivity.
Obsessing with high Icor becomes necessary when resolution of non-performing assets (NPAs) tops the public policy agenda. Most of the reasons behind high Icor in India are similar to those found elsewhere in the world, but one unique Indian feature stands out: gold-plating, or padded-up project costs. This not only suppresses capital productivity but also distorts the viability of many projects. With institutions and regulators orchestrating Operation NPA Clean-Up in mission mode—for example, the newly-instituted Insolvency and Bankruptcy Board of India is already grappling with 35 transactions—it is imperative that all resolution mechanisms incorporate enough measures to deter future projects from gold-plating costs and getting away with it.
Rajrishi Singhal is a consultant and former editor of a leading business newspaper. His Twitter handle is @rajrishisinghal.