Incremental Capital Output Ratio

Incremental Capital Output Ratio

Subject: Economy

Context: Article suggests steps to make our economy attain a high growth path.

Details:

• India’s Growth post 2011-12:

• Auto regressive integrated moving averages (ARIMA) studies point to a potential output of less than 6 per cent for 2021-26 of India.

Factors affecting growth in India–both cyclical and structural factors:

• Resource intensity-High resources intensity of consumables has led to the decline in the share of manufacturing value added to output from 25 per cent during 1983-94 to 16.6 per cent in 2019-20 and therefore cant invest in technology, innovation and compensation of skilled workers.
• Three Es — buoyant expectations, expansion in expenditure on investment and consumption and efficiency in use of resources.
  • Consumer sentiments in the medium term can be improved through stable policy regime, improving law and order, taking measures for ease of doing business, improving innovation, facilitating openness in the economy, including in trade regime, creating stability and predictability of tax regimes, developing and enhancing efficiency of infrastructure, solving problems of specified sectors improving labour force participation.
• Labor force participation ratio-A 5 percentage point increase in labour participation rate would increase GDP growth by 0.71 percent.
• Structural changes– like Demonetisation, GST and Covid.
• Fluctuations in growth patterns for industries–utilities, manufacturing and construction
• Service actor-Relatively stable growth in services partly because most of these are non-traded and hence insulated from global changes.
• Constrained capital formation-
  • Non-food credit (NFC) as ratio of GDP declined until Q4 of 2017-18 but increased later.
  • A longer period of growth slowdown from Q1 2016-17 can also be attributed to lower Gross fixed capital formation (GFCF) and Private final consumption expenditure (PFCE).
  • Net financing from the household sector increased from 21 per cent of total investment in 2011-12 to 45 per cent in 2020-21.
• Issues of the informal sector-difficulty in accessing resources
• Export growth in the entire period was less than the GDP growth, though it was volatile.
• Incremental Capital Output ratio (ICOR) is a surrogate measure of efficiency of the economy.
  • In the first phase of growth, ICOR was 4.51 and in the second phase, it reached 5.52.
  •  Formalisation of the economy and sectoral shift to services in general can lower ICOR.

Concept:

Incremental Capital Output ratio:

• Capital output ratio is the amount of capital needed to produce one unit of output.
• For example, suppose that investment in an economy is 32% (of GDP), and the economic growth corresponding to this level of investment is 8%. Here, a Rs 32 investment produces an output of Rs 8. Thus, the Capital output ratio is 32/8 or 4
• Another variant of capital output ratio is Incremental Capital Output Ratio (ICOR) -indicate additional units of capital or investment needed to produce an additional unit of output.
• This ratio is used to measure the efficiency of an industrial unit or country as an economic unit. The lesser the ICOR, the more efficient the organization.
  • Lower ICOR shows that only a low level of investment is needed to produce a given growth rate in the economy. This is considered as a desirable situation. Lower capital output ratio shows that capital is very productive or efficient.
  • High ICOR indicates an inefficient economic environment as a large amount of capital is being used to produce low value goods. The higher the ICOR, the lower the productivity of capital or the marginal efficiency of capital.

Structural reforms (structural factors):

• Structural reforms tackle obstacles to the fundamental drivers of growth by liberalising labour, product and service markets, thereby encouraging job creation and investment and improving productivity.
• They are designed to boost an economy’s competitiveness,growth potential and adjustment capacity.
• Typical structural reforms include policies that:
  • make labour markets more adaptable and responsive
  • liberalise service sectors, boost competition in product and service markets, specific sectors, or improve the overall business environment
  • encourage innovation
  • improve the quality of public taxation systems
  • address the challenges of population ageing on the welfare state.
• Example– In order to get out of the macro-economic crisis in 1991, India launched a New Economic Policy, which was based on LPG or Liberalisation, Privatisation and Globalisation model.
  • The broad range of reforms under the LPG model included:
    • Liberalising Industrial Policy: Abolition of industrial license permit raj, Reduction in import tariffs, etc.
    • Beginning of Privatisation: Deregulation of markets, Banking reforms, etc.
    • Globalisation: Exchange rate correction, liberalising foreign direct investment and trade policies, Removal of mandatory convertibility cause, etc.