CAPITAL FORMATION IN INDIA

Submitted by: Anshu Goyal

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 Indias 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 havent 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 countrys 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 Indias 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. 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. 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 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, Indias saving rate is still far lower compared with Chinas, which is around 50% of GDP. 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 governments 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. nts: 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 Indias economic growth. government lacks enough resources to boost investment in a big way. Also, the governments 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. 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 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. 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, Indias 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. -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. onstraints 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.

can result in long- term 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 arent 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. Theres more on ICOR later in the report. 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 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. -Year Plans. The impetus received in 1990s, primarily through liberalisation led to a rise in investments, particularly in the past one decade.

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. Decadal Average GCF, % of GDP GCF Trends, % of GDP Savings Trends, % of GDP Decadal Average GCF, CAGR % 11.2 15.2 18.1 21.9 23.6 31.3 0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0 1951-60 1961-70 1971-80 1981-90 1991-00 2000-10 0.0 10.0 20.0

30.0 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 0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0 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 7.3 10.0 13.6 15.7 14.0 16.5 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0 1951-60 1961-70 1971-80 1981-90 1991-00 2000-10

GCF: By Institutions

comprises capital formation by public, private and household sectors. -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 sectors share in total investments towered over the other sectors. 1996. Government contribution dominated total investments in the economy as India ushered in liberalisation in the early 1990s. 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 Percentage Share GCF Decadal Averages, % of GDP Decadal CAGR Growth, % Percentage Share 0.0 10.0 20.0 30.0 40.0 50.0 60.0 1951-60 1961-70 1971-80 1981-90 1991-00 2000-10 Public Private

0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 1951-60 1961-70 1971-80 1981-90 1991-00 2000-10 Public Private Household 0.0 5.0 10.0 15.0 20.0 25.0 1951-60 1961-70 1971-80 1981-90 1991-00 2000-10 Public Private Household 25.7 36.9 32.6 4.8 FY10 Public 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. share in total investments while industry and services have both registered rapid highest. Manufacturing 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. GCF by Sectors, % of GDP GCF Composition As % of Total Composition in 1950s Composition FY10 0.0 5.0 10.0 15.0 1951-60 1961-70 1971-80

1981-90 1991-00 2000-10 Agriculture Industry Services 0.0 10.0 20.0 30.0 40.0 50.0 60.0 1951-60 1961-70 1971-80 1981-90 1991-00 2000-10 Agriculture Industry Services 18.8 33.2 48.0 Agriculture Industry Services 8.2 47.8 44.0 Agriculture Industry Services Capital Formation In Services Comprises Investments In:

administration

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 agricultures declining share in Indias 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. stments in agriculture also reflect lower per capita incomes in rural India as production has stagnated. As rural India houses two-third of the countrys population, there needs to be more focus on the sector, especially in improving capital stock (such as 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 f 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 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 havent kept pace with rising population and demand and therefore presents an opportunity for improvement. GCF As % of GDP GCF By Industry, % Share In Total

2.5

1.0 9.7 1.9 1.5 1.9 2.7 4.7 4.4 0.0 2.0 4.0 6.0 8.0 10.0 12.0 Agriculture & allied Mining & quarrying Manufacturing Electricity, gas & water supply Construction Trade, hotel & restaurant Transport, stora ge & comm. Finance, insura nce, real estate Social & personal services 1951-60 1961-70 1971-80 1981-90 1991-00 2000-10 8.4 3.3 31.6 6.5 4.6 5.9 9.4 15.9 14.3 0.0 10.0 20.0 30.0 40.0 Agriculture & allied Mining & quarrying

Manufacturing Electricity, gas & water supply Construction Trade, hotel & restaurant Transport, stor age & comm. Finance, insura nce, real estate Social & personal services 1951-60 1961-70 1971-80 1981-90 1991-00 2000-10

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. 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 19511960. Savings improved gradually in the 1980s and 1990s as the economy started opening to reforms. Sharpest rise in savings was in 2000savings 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

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 2001en 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 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 share Savings Composition, %

9.8 12.6 16.9 19.6 23.1 30.7 0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0 1951-60 1961-70

1971-80 1981-90 1991-00 2001-10 70 24 6 FY10 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 savingsinvestment 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 Eurozone 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 -5.0 0.0 5.0 10.0 15.0 20.0 25.0 30.0 35.0 1961-70 1971-80 1981-90 1991-00 2001-10 Investment Savings Gap

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, Indias ICOR has been lower on a crosscountry comparison with other developing countries -- such as, Brazil, Mexico. Capital efficiency in China is slightly higher compared with India. -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. 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. 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 ICOR Trends International ICOR Comparison , 2000-06 3.5 4.3 6.6 4.6 4.6 4.0 4.6 4.2 4.5 01234567

1950-59 1960-69 1970-79 1980-89 1990-91 1991-97 1997-03 2003-07 2010 5.1 4.3 4.5 4.7 5.7 7.6 4.3 4.2 4.5 012345678 Brazil China India Indonesia Korea Mexico Philppines South Africa

Thailand

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 es say

Mohan , Rakesh (2008) A Story of Sustained Savings and Investment in India

Young , Alwyn (1994) Tyranny of N umbers: Confronting t he Statistical Realities o f t he East Asian Growth Experience

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