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July 31, 2019

Indian Economy: Parsing productivity

What do trends in efficiency of investment portend for future growth?


Investment freeze has remained a stubborn bugbear in India’s current growth downturn. But,an equally important – yet less scrutinized factor is – the productivity of investment. Growthcan come from an increase in investment. Or, it can come from ratcheting up its productivity. The incremental capital output ratio (ICOR)1 is a crude but useful measure that explains therelationship between fixed investment and growth over periods of time. As a rule, ICOR is notto be assessed annually. This is because the ratio is prone to a high degree of volatility.Besides, a lumpy investment in a given year is unlikely to yield growth in the same year,making it look less productive. Therefore, we look at the average ICOR over a five-year period.


Efficiency of fixed capital investment as measured by ICOR saw a sustained improvementover the last decade. It declined to average 4.5 in fiscals 2015-2019 from 5.5 in fiscals 2010-2014, implying incremental growth exceeded incremental investment. In short, capitalproductivity improved. This can be explained by two factors:


  • Benefits of previous investments: This accompanied moderation in fixed investmentgrowth and pick-up in gross domestic product (GDP) growth, supported by aconsumption impulse. The sharp surge in growth led to over-investment in the postGlobal Financial Crisis period. As growth slowed, capacities remained unutilized, andICOR stayed high during the second term of the United Progressive Alliance government.But, as demand picked up (reflected in sharp and sustained rise in private consumptiondemand), capacity utilization improved, leading to a fall in ICOR.
  • Investment in low gestation period projects in the past five years: Within fixedinvestment, there is a clear shift from lumpy investments to those with faster turnaroundtime in returns and growth. This was seen in sectors such as auto, among industrialsectors. Within infrastructure, faster investment growth was seen in sectors such asurban infrastructure and roads, backed by government’s policy orientation.

Going forward, the impact of investments made over the last few years in infrastructure,especially roads, highways, metro, and other transport sectors, is likely to start yieldingreturns and improve the efficiency of invested capital. An overall improvement in the ease ofdoing business is possible if systemic reforms initiated, such as implementation of theGoods and Services Tax and the Insolvency and Bankruptcy Code, are pursued.


1Measured by fixed investment required to produce an additional unit of output. As per the Harrod-Domarmodel, the analysis of ICOR assumes no diminishing return to capital, no lag between investment andproduction and full capacity utilization - which overlook the rigidities and flexibilities of the real world.However, there still exists merit in evaluating this ratio, which indicates efficiency of investment in theeconomy.