The incremental-capital output ratio (ICOR) is to the Planning Commission what the fiscal deficit is to the finance ministry "" the variable around which the entire economy revolves. Since the role of the Planning Commission in economic decision-making has diminished, the significance of the ICOR as a policy variable has also declined. And while even the hiccups and the burps in the fiscal deficit are being commented upon at great length, behavioural changes in the ICOR have been completely ignored in the last six years or so.
Suddenly, ICORs seem to be back in business. The International Monetary Fund (IMF) staff country report, India "" Selected Issues, makes a prominent reference to the trend in capital-output ratios. The report calculates the average ICOR for India as well as other East Asian countries. On the basis of average ICORS for five-year periods, it finds that not only are these high in India, but have been increasing in the post-reform period. Going by their estimates, the ICOR has doubled from 3.92 in 1975-80 to 6.79 in 1991-95.
This evidence goes against the basic premise of the Fund-Bank that after structural reforms, capital-output ratios should decline. So it is admitted, somewhat grudgingly in the report, that even strong reform programs don't lead to a dramatic shift in the ICORs. This explanation lacks conviction.
The key idea behind ICOR is that there is a stable relationship between investment and the expansion of output. In fact, ICOR can be viewed as a one-factor production function linking the increments in capital stock to those in capacity output.
In Indian policy-making, it has been used for estimating the growth potential. Following the Harrodian framework, the basic growth equation for the five-year plans has been that the saving rate or its counterpart "" the rate of investment "" and the ICOR go to determine the potential or the warranted rate of output growth. Thus, in the approach paper to the Ninth Plan, the ICOR in the accelerated growth scenario has been estimated to be 4.08. With an investment rate of 28.6, the rate of growth is worked out to be 7 per cent. While it is undoubtedly a simplistic understanding of the growth process, this application does not go against the spirit of the original growth equation.
But like most other variables, the use to which ICOR has been put has varied according to the prevailing macroeconomic situation. Till the sixties, when the rate of investment was low, not much attention was paid on the ICOR. But in the seventies and eighties, when the savings rate was deemed to be conspicuously high and was not accompanied by a corresponding increase in output, it was argued that this was so because the capital output ratios were very high. Which in turn was attributed to the inefficiencies caused by a highly regulated environment. In doing so, the relationship between investment and output, as reflected in the capital-output ratio, was transformed into an ex-poste analysis of growth.
This was technically incorrect, as the actual rate of growth could deviate from the warranted rate of growth due to a host of reasons ranging from demand conditions to infrastructural bottlenecks.
But after the reforms of 1991, the movements in ICORs have been interpreted differently. In the context of structural reforms, the ICOR has acquired the role of an index of capital productivity.
Within the framework of the reforms, a change in the ICOR would reflect the quantitative impact of structural reforms on capital productivity. It is in this context that the IMF report analyses the changes in ICORs.
Using the World Economic Outlook database, the IMF report estimates ICORs for periods of five years and shows a startling increase in the ratio. The implication of this rise is that the rate of investment has to be over 30 per cent to achieve the target of 7 per cent GDP growth rate.
One basic problem with this sort of a calculation is that the mean or average of a variable like the ICOR, which is subject to high positive and limited negative values, naturally tends to be high. Consequently, one unusually high ICOR figure "" which may be because of a drop in output due to a bad monsoon "" inflates the average for the period. In doing so, it conceals and even distorts the trend.
As it turns out, this is actually the case. If the time series of gross domestic capital formation and gross domestic product are used to estimate the ICOR, it becomes clear that far from and increase there has been a secular decline in the ratio. As the accompanying graph shows, the ICOR have declined quite substantially in the post-reform period, though that is not the only period during which the ICORs have declined. Between 1980 and 1988, the ICORs were either declining or stable around a low level.
Can the decline in capital output ratios be interpreted as an increase in the productivity or efficiency of capital use? In other words, can the ICOR be seen as an index of capital productivity? As said earlier, it is a single-factor production function in which the assumptions about the relation of increments of the non-capital inputs to increments of capacity are not made explicit.
The ICOR is a ratio between two incremental flows per unit of time, investment and changes in the output as a result of that investment. And in that sense it is a catch-all variable which can change for a number of reasons, the simplest being a change in the structure of investment. If, for instance, the sectoral composition of investment changes from electricity and other infrastructural sectors to manufacturing, the aggregate ICOR will show a decline. In general, any move from capital-intensive sectors to labour-intensive sectors can lead to a declining trend in the capital-output ratio.
In this case, the aggregate ICOR will show a drop even though the sectoral ratios may remain the same. Similarly, a drop in agricultural output because of a bad monsoon can show an increase in the ratio and so can a general drop in demand.
Thus, to infer the efficiency of capital use from the changes in capital output ratio is misplaced, and as Mr Chidambaram said about the report, textbookish.
