Do we need greater investment? Let’s go by capital efficiency analysis.
During the past decade (2013-14 to 2022-23), India’s annual total investments have ranged between 30% and 34% of GDP, barring a dip to 28% of GDP in 2020-21. This is if we measure this proportion using current prices or nominal data (let us refer to it as the ‘nominal investment ratio’). Usually, all ratios— investment, savings, fiscal deficit, current account balance, corporate profits, et al—are measured in nominal data or at current prices. However, there is a growing debate that one should be more focused on the real investments-to-real GDP ratio (the ‘real investment ratio’), rather than the nominal investment ratio. What is the difference between these two ratios? What should we be looking at and what are the key implications?
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A comparison of the two ratios in India reveals an interesting fact. The real investment ratio has been higher than the nominal investment ratio every year since 2012-13 and has remained between 34% and 37% of GDP during the past decade, except for 32% of GDP in 2020-21. What makes the debate very pertinent is that while the nominal investment ratio stood at about 32% of GDP each in 2021-22 and 2022-23, down from 39% of GDP in 2011-12, the real investment ratio was 36.7% of GDP in 2021-22 and 35% of GDP in 2022-23. It is important to put these two data points in an appropriate context as the latter suggests that the decline in India’s investment ratio is not very significant. So the entire debate calling for a higher investment ratio may be misplaced.
First, we need to understand the importance of the nominal and real investment ratios. When do we consider the former and when is the latter used? Usually, when an entity invests, it is done in nominal terms. Every rupee invested (at current prices) in the economy must be financed either by domestic or foreign savings (the latter is counted as the current account deficit or CAD). Although investments are measured in real terms (or at constant prices), there are no estimates of real savings and/or the real CAD. Thus, from a funding perspective, it is important to track the nominal investment rate.
At the same time, if the prices of investment goods are falling, real investments could grow faster even though nominal investments may be falling or growing slowly. And thus real investment growth must also be analysed. Further, when analysts discuss investment efficiency (by means of the incremental capital-output ratio or ICOR), they use the real (net) investment ratio, and not nominal. If the ICOR is improving (the ratio is falling, i.e.), it means fewer additional units of investment are producing the same unit of output, and so the economy can generate the same level of real GDP growth with lower real investment. The call for pushing investments higher must be analysed in this context.
What does India’s data suggest? Has our investment efficiency improved? According to the World Bank, the ICOR is measured as the average real net fixed investments-to-NDP (net domestic product) ratio of two successive recent years divided by the real NDP growth rate of the current year. So, the average real net fixed investments-to-GDP ratio for 2021-22 and 2022-23 divided by the real NDP growth in 2022-23 would provide the ICOR for 2022-23. Using this methodology, we find that India’s ICOR averaged 3.1x in the 2000s decade (2000-01 to 2009-10, excluding 2008-09), 3.7x in the decade after that (2010-11 to 2019-20, excluding 2019-20), and is estimated to have averaged 3.2x in 2022-23 and 2023-24 (estimate). The ICOR was 3.3x for 2022-23 (as per the first revised estimates) and calculated at 3.1x for 2023-24 (based on the second advance estimates and some assumptions). While the pandemic may have made an impact, recent figures are better than in the 2010s decade and comparable with the 2000s (though the ICOR averaged 3.3x if re-calculated on a 2011-12-series base).
If so, the economy needs real net fixed investment totalling 25-26% of NDP, which is higher than the average of 23.6% of NDP over 2022-23 and 2023-24, to achieve a real GDP growth of 8% per annum. Alternatively, investment efficiency needs to improve, with the ICOR falling to 3x (or lower), as was the case during 2003-04 to 2007-08 and 2014-15 to 2016-17. The overarching argument, thus, remains unchanged: even though real investments are growing at a much faster rate and the real investment ratio is higher than the nominal investment ratio, India must elevate the ratio by at least 2 percentage points to attain our target of 8% real GDP growth per annum.
There is another point. The real investment ratio measures real investments (nominal level deflated by the investment deflator) as a proportion of real GDP/NDP (nominal figure deflated by the GDP/NDP deflator). The GDP/NDP deflator is a composite of deflators for consumption, investments and foreign trade. Hence, a higher real investment ratio vis-à-vis the nominal ratio reflects an investment deflator growing at a slower pace than the GDP deflator, with consumption prices outpacing those of investment goods. For instance, during 2013-14 to 2022-23, while the GDP deflator reported a compound annual growth rate (CAGR) of 4.5%, the investment deflator posted a CAGR of 3.9%. Further, whether we take 2004-05 or 2011-12 base data, the gap between the real and nominal investment ratios widens as we move away from the base year. For the 2004-05 base, the difference between the real and nominal investment ratio was 3.3 and 4.1 percentage points respectively in 2010-11 and 2012-13. For the 2011-12 base, the difference widened to 3.5 percentage points between 2017-18 and 2019-20 and was unchanged in 2022-23 and 2023-24. The investment deflator increased at a slower pace than the GDP deflator, irrespective of whether the global (or India’s) investment cycle was very strong (between 2003-04 and 2012-13) or weak (from 2012-13 to 2021-22).
Clearly, more work needs to be done to understand the sustained gap between India’s real and nominal investment ratios. However, there is no doubt that India’s investment-to-GDP ratio needs to go up, along with an improvement in ICOR, for 8% real growth to become achievable.
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