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Home / Opinion / Online-views /  De-jargoned: Incremental Capital Output Ratio (ICOR)

Why is the rate of economic growth falling in India? One of the explanations is that the saving rate in the country is falling and lower savings and investment rate is leading to lower growth. Economic growth in any country, among other things, is a function of the level of savings and the rate of investment. Any additional investment required to increase output is termed as incremental capital output ratio (ICOR).

What is it?

ICOR basically refers to the additional capital required to generate additional output. For example, if the 10% additional capital is required to push the overall output by a percent, the ICOR will be 10. Lower the ICOR, the better it is. ICOR reflects how efficiently capital is being used to generate additional output. So a country with ICOR of 3 is better than a country with ICOR of 5.

In the “Harrod-Domar framework", an economic model, the calculation of ICOR is based on certain assumptions such as there is no diminishing return to capital, there is no lag between investment and production and there is full capacity utilization. “While these assumptions overlook the rigidities as well as flexibilities in the real world, the overall framework is a reasonable tool for providing overall benchmarks for assessing investment requirements," noted a Report of the Working-Group on Estimation of Investment, its Composition and Trend for Twelfth Five-Year Plan.

The indian case

The planning commission working group also put out the required rate of investment that would be needed to achieve different growth outcomes in the Twelfth Five-Year Plan. For a growth rate of 8%, the investment rate at market price would need to be at 30.5%, while for a growth rate of 9.5%, an investment rate of 35.8% would be required.

Savings rates in India dropped from the level of 36.8% of gross domestic product in the year 2007-08 to 30.8% in 2012-13. The rate of growth during the same period fell from 9.6% to 6.2%. The growth is further expected to fall to the level of 5% in the current financial year with a savings rate of 30%.

The bottom line

Clearly, the drop in India’s growth rate is more dramatic and steeper than the fall in the savings rates. Therefore, there are reasons beyond savings and investment rate that would explain the drop in the rate of growth in the Indian economy. Otherwise, the economy is getting increasingly inefficient.

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