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.

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, Indias
saving rate is still far lower compared with Chinas, 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 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.

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 Indias economic growth.

Public Investments: Public investments have declined as 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.

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, 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.

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 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.

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
40.0
Capital formation in 1950s was low as 7.8% of
GDP, which improved gradually in next few 30.0
decades with constant focus on improvement in
20.0
physical stock. Over time, GCF has more than
quadrupled to the current 35.8% levels of GDP. 10.0
Rise in capital formation has been particularly 0.0
higher post liberalisation that began in early 1990s.

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
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 gained consistently through 1980s,

through focus on Five-Year Plans. The Savings Trends, % of GDP
impetus received in 1990s, primarily through 40.0
liberalisation led to a rise in investments, 35.0
30.0
particularly in the past one decade. 25.0
20.0
There are many factors that have aided rise in 15.0
investments, particularly increase in savings 10.0
5.0
and the process of de-licensing, among
0.0
others. Savings improved due to rise in
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
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 Decadal Average GCF, CAGR %

35.0 31.3 18.0 15.7 16.5
30.0 16.0 13.6 14.0
23.6 14.0
25.0 21.9 12.0 10.0
20.0 18.1 10.0
15.2 7.3
15.0 8.0
11.2
6.0
10.0 4.0
5.0 2.0
0.0 0.0
1951-60

1961-70

1971-80

1981-90

1991-00

2000-10
1951-60

1961-70

1971-80

1981-90

1991-00

2000-10
GCF: By Institutions
GCF Decadal Averages, % of GDP
In India, capital formation, as measured by 14.0
Public Private Household
GCF according to institutions comprises 12.0
capital formation by public, private and 10.0
household sectors. 8.0
6.0
Post-independence, share of public and 4.0
private sector remained even lower 2.0
compared with household sector for nearly 0.0
a decade. As India focussed on creation of

1951-60

1961-70

1971-80

1981-90

1991-00

2000-10
physical stock through Five-Year Plans,
public sectors share in total investments
towered over the other sectors.

Contribution to GCF by the public sector

remained highest from 1960s until 1996.
Government contribution dominated total Decadal CAGR Growth, %
investments in the economy as India 25.0
Public Private Household
ushered in liberalisation in the early 1990s. 20.0

Spurred by economic reforms and a 15.0

favourable business environment, private 10.0
sector now leads in investments in the
economy with 36% share in total capital 5.0
formation. Private investments grew in
0.0
2000-10 and overtook household
1951-60

1961-70

1971-80

1981-90

1991-00

2000-10
investments to become the largest
contributor to total investment. During this
period, GDP growth also rose to 9%.

Decadal Percentage Share Percentage Share

60.0 Public Private
50.0 FY10
40.0 4.8
30.0 25.7

20.0 32.6
10.0
0.0 Public
1951-60

1961-70

1971-80

1981-90

1991-00

2000-10

Private
36.9
Household
Valuables
GCF: By Sectors
It is interesting to study GCF by sectors -- agriculture, industry and services. Capital Formation In Services
Comprises Investments In:
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
Trade
independence, industry has gained share in capital formation at the expense of agriculture
Hotels
and services. While industry currently leads in capital formation, it actually lost share Transport
from 50% of total capital formation in 1991-00 to 46% in the last decade (2000-2010) as Storage
services made a comeback. Communication
Finance
Investments in agriculture have stagnated since independence. It has lost its Insurance
share in total investments while industry and services have both registered rapid Real estate
rise in the same period. Banking
Investments in industry is the highest. Manufacturing has driven the rise of Social, personal services
investments in industry. Public administration
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.

GCF by Sectors, % of GDP GCF Composition As % of Total

15.0 60.0
Agriculture Industry Services Agriculture Industry Services
50.0
10.0 40.0
30.0
5.0 20.0
10.0
0.0 0.0
1971-80
1951-60

1961-70

1981-90

1991-00

2000-10
1961-70
1951-60

1971-80

1981-90

1991-00

2000-10

Composition in 1950s Composition FY10

Agriculture Industry Services Agriculture Industry Services

8.2
48.0 18.8
44.0
33.2 47.8
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.

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 countrys 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.
Transports 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 havent kept
pace with rising population and demand and therefore presents an opportunity for improvement.

GCF As % of GDP
1951-60 1961-70 1971-80 1981-90 1991-00 2000-10
12.0 9.7
10.0
8.0
6.0 4.7 4.4
4.0 2.5 1.9 1.9 2.7
1.0 1.5
2.0
0.0
Agriculture &

Transport, stora

Finance, insura

Social &
& water supply
Mining &

Trade, hotel &

Construction

nce, real estate

Manufacturing
quarrying

personal
Electricity, gas

services
ge & comm.
restaurant
allied

GCF By Industry, % Share In Total

1951-60 1961-70 1971-80 1981-90 1991-00 2000-10
40.0 31.6
30.0
20.0 15.9 14.3
8.4 6.5 9.4
10.0 3.3 4.6 5.9
0.0
Agriculture &

Transport, stor

Finance, insura
& water supply
Mining &

Social &
Construction

nce, real estate

Trade, hotel &
Manufacturing

age & comm.

quarrying

personal
Electricity, gas

services
restaurant
allied
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 Savings Composition, % share

35.0 30.7
30.0
FY10
25.0 23.1 6
19.6
20.0 16.9 24
15.0 12.6
9.8
10.0
5.0 70
0.0
1981-90
1951-60

1961-70

1971-80

1991-00

2001-10

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 Gap ( S-I)= Net

Savings (GDS)
(GDCF) 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
1961-70 1971-80 1981-90 1991-00 2001-10
-5.0
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 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

ICOR Trends International ICOR Comparison , 2000-06

7 6.6 7.6
8
6 7 5.7
4.6 4.6 4.6 4.5 6 5.1
5 4.3 4.0 4.2
5 4.3 4.5 4.7 4.3 4.2 4.5
4 3.5 4
3 3
2
2 1
1 0
Brazil

India

Philppines
Indonesia

Korea
China

Thailand
Mexico

South Africa

0
1960-69
1950-59

1970-79

1980-89

1990-91

1991-97

1997-03

2003-07

2010
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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