Times changed. The old neo-classicals in a new garb stormed the portals of economic power. The finance ministry marginalised the Planning Commission. And fiscal deficit dethroned the ICOR to become the new variable around which the entire economy revolved. And while even the second decimal place change in the fiscal deficit was commented upon at great length, behavioural changes in the ICOR were completely ignored in the last five years or so.
But suddenly, ICORs seem to be back in business. No sooner than the quick estimates of gross domestic product for the year 1996-97 were released, the finance ministry and advocates of liberalisation are inferring that there has been an increase in the efficiency of capital use in the economy. And not unexpectedly, the reason for the improved efficiency is liberalisation. In the context of structural reforms, ICOR has acquired the role of an index of capital productivity. Within the framework of the reforms, a change in the ICOR is seen to reflect the quantitative impact of structural reforms on capital productivity.
An IMF report, late last year, analysed the causes and consequences of the changes in average ICORs for India as well as other East Asian countries. On the basis of the World Economic Outlook database, the IMF report estimated that average ICORs for periods of five years and showed a startling increase in the ratio. The report found that not only were the ICORs in India high, they had been increasing in the post-reform period. Going by their estimates, the ICOR doubled from 3.92 in 1975-80 to 6.79 in 1991-95. Since this finding goes against the basic premise that after structural reforms capital-output ratios should decline, the report admitted, somewhat grudgingly, that even strong reform programs dont lead to a dramatic shift in the ICORs.
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The implication that was deduced was that the rate of investment had to be over 30 per cent to achieve the target of 7 per cent rate of growth in GDP. To carry this logic, for the 9 per cent rate of growth targeted by most political parties, the corresponding rate of investment would have to be absurdly high.
Such simplification of the dynamics of the growth process is misplaced. The basic 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. To use it as a tool to estimate the growth potential is a leap in logic. Following the analytical framework of growth postulated by Roy Harrod in the thirties, the basic growth equation suggests that the savings rate or its counterpart, the rate of investment and the ICOR, go to determine the potential or the warranted rate of growth of output. Not the actual.
In the approach paper to the Ninth Plan, as indeed in all the earlier plan documents, the ICOR in an accelerated growth scenario has been estimated to be 4.08. With an investment rate of 28.6, the rate of growth has been worked out to 7 per cent. While undoubtedly a simplistic understanding of the growth process, this application does not go against the spirit of the original growth equation.
But like much else, the use to which ICOR has been put has been varying. In the fifties, when the rate of investment was low, not much attention was focussed 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 because the capital-output ratios were very high. Which in turn was attributed to the inefficiencies caused by the 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 is technically incorrect, as the actual rate of growth can deviate from the warranted rate of growth due to a host of reasons ranging from demand conditions to infrastructural bottlenecks.
The basic problem with this sort of calculation is that the mean or average of a variable like the ICOR (as done in the IMF study), 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 resulting from bad monsoons 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 can be seen that far from increasing, there has been a secular decline in the ratio. As the accompanying graph shows, the ICORs declined quite substantially in the post-reform period.
But can a decline in the capital-output ratios be interpreted as an increase in the productivity or efficiency of use of capital? In other words, can the ICOR be seen as an index of capital productivity? As pointed out above, ICOR is a single-factor production function in which the assumptions made about the relation of increments of the non-capital inputs to increments of capacity are not explicit. It is a ratio between two incremental flows per unit of time and investment, and changes in the output resulting from that investment. This 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 a capital-intensive sector to a labour-intensive one can lead to a declining trend in the capital-output ratio. In this case, the aggregate ICOR will show a drop even though sectoral ratios remain the same. Similarly, a drop in agricultural output due to 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 the capital-output ratio, as is being done by the advocates of the reforms, is nothing but convenient empiricism.