Road To Growth Is Paved With Low ICOR

India’s slowing investment rate and rising incremental capital output ratio, or ICOR, have led to low economic growth.

Two recent, and epochal, events deserve our unstinted attention because they mark the end of an era and the beginning of another one. These are critical because of a common thread linking both: the investment rate of the economy.

The 12th Five-year Plan has just ended, bringing down the curtain on decades of India’s planned economic growth and development. This was the last Five-year Plan; as an alternative, the Planning Commission’s successor NITI Aayog has announced the release of a three-year “action plan”, a seven-year “strategy paper” and a 15-year “vision document”. There is one key difference between these documents and Five-year Plans: The government is free to disregard the Aayog’s recommendations.

The end of a centrally planned economic system also coincides with the formal interring of the Planning Commission, an organization central to not only India’s economic strategy but also to its federal temper through the added responsibility of allocating grants, Plan and non-Plan funds to states. The commission’s federal remit was not granted through constitutional mandate and this generated sufficient heartburn, especially among non-Congress states. However, the commission’s shuttering is also due to questions raised about the relevance of centralized planning in a globalized, market-led economy. And then there is politics. The commission was created through a government resolution which makes it easy for the Narendra Modi government to bury it.

But before the institution is shut down, it might be worthwhile to examine the 12th Plan performance, especially some of its macroeconomic targets. The 12th Plan ran between April 2012 and March 2017, with a Congress-led administration in charge till April 2014 and the Bharatiya Janata Party-led government steering the Plan thereafter. Prime Minister Modi announced his intentions of abolishing the commission and ending Five-year Plans during his first Independence Day speech in 2014 but allowed the 12th Plan to formally run till its original expiry date.

The plan had set an average gross domestic product (GDP) growth target of 8% for the 2012-17 period. This growth target was not achieved in any single year by either of the two political dispensations, despite a step jump resulting from a new series introduced by the Modi government. The closest India came was in 2015-16, with 7.9% annual growth. Otherwise, the average growth for the period works out to below 7%, way lower than the average annual growth rate of 8% achieved during the 11th Plan.

A low investment rate is among the many reasons for the under-average performance. The 12th Plan envisaged an average investment rate of 34%. However, the investment rate has been declining every year, starting with 33.4% during the first year of the Plan; the Central Statistical Office’s second advance estimates for 2016-17 show gross fixed capital formation at 26.9% of GDP, the lowest in more than a decade. What’s worse, investments have not been forthcoming from either the private sector (which has historically contributed the bulk of investment as a percentage of GDP) or the government sector which should ideally be investing when private investment dries up.

In a recent newspaper article, former Reserve Bank of India governor C. Rangarajan has also pointed to low productivity of capital, captured through incremental capital output ratio, or Icor, which measures how many additional units of capital are necessary to produce one additional unit of output. India’s slowing investment rate and rising Icor have led to low economic growth.

Discussing Icor might sound anachronistic, especially since the service sector accounts for 55% of India’s GDP where the relation between capital invested and output is still unclear. In addition, supply-side thrusts (such as increased government consumption expenditure) can lead to higher GDP growth despite a depressed investment climate, which can then send garbled messages about improved capital productivity. Ordinarily, a falling ICOR should be accompanied by palpable technological improvements and skill enhancements, leading to an all-round increase in productivity and efficiency.

Discussions on capital productivity seem to be back in fashion because high ICOR in recent times (higher than six during 2013-16) have been complemented by sluggish economic growth, over-leveraged corporate balance sheets and burgeoning bad debts in the financial sector. These factors have dragged down the economy’s growth impulses. In all discussions on efficiency and factor productivity, it is usually Indian labour that has to bear the cross. But this time the focus is squarely on capital productivity.

Obsessing with high ICOR becomes necessary when resolution of non-performing assets (NPAs) tops the public policy agenda. Most of the reasons behind high Icor in India are similar to those found elsewhere in the world, but one unique Indian feature stands out: gold-plating, or padded-up project costs. This not only suppresses capital productivity but also distorts the viability of many projects. With institutions and regulators orchestrating Operation NPA Clean-Up in mission mode—for example, the newly-instituted Insolvency and Bankruptcy Board of India is already grappling with 35 transactions—it is imperative that all resolution mechanisms incorporate enough measures to deter future projects from gold-plating costs and getting away with it.

The above article was published in Mint newspaper and can also be read here

Managing Business Cycles

Indian companies bulk up their investment just before the slowdown starts, aggravating the pressure on their bottom lines, rather than being ready with new capacities just when an upswing is taking place 

INDIA became a reluctant devotee of open markets ever since its close brush with bankruptcy. As a result, the country and its policymakers had no choice but to enroll for continuing lessons on the advantages and perils of open markets as well as global linkages. Even Indian businesses had to learn some hard lessons. But, without prejudice to the nature of the economic agency — whether it is the government or the private sector business organisations — the process has been like baptism by fire.

However, the Indian corporate sector has been unable to come to terms with one intrinsic open market phenomena, which is largely episodic in nature but has a close bearing on the future growth prospects of almost all companies. It is called a “business cycle” and impacts bottom lines directly. It is an unavoidable consequence of open markets and free competition. Most developed markets around the world have gathered years of experience about it and have geared many parts of their business activities to forecasting it and then taking action to either minimise its deleterious impact or to capitalise on its salubrious influence. But, most companies in India seem to be getting acquainted with this unique change process only now.

Examples bear out India Inc’s inability to spot this big trend. The Indian corporate sector’s genetic architecture still seems to suffer from a passive disposition to floating along with the tide. Sure, there are some exceptions to this languid and helpless approach, but these are only a handful. Part of the reason for this lassitude lies in history and partly it is also due to structural deficiencies in the market, over which most companies do not have any control.

Here is one example of how companies miss the timing. If one goes by the chronology of business cycles drawn up by Pami Dua and Anirvan Banerji (Business Cycles in India, August 2006), then the period between September 1991 to May 1996 is shown as an expansion period, indicating increases in output, employment, income and sales. But, data shows private sector savings quite placid during the expansionary period (1991-92: 3.1% of GDP, 1992-93: 2.7%, 1993-94: 3.4%, 1994-95: 3.5%), but peaking to 5% only in March 1996, just when the business cycle is about to contract. The story’s the same for private sector gross domestic capital formation, averaging around 13.5% of GDP, but suddenly peaking to 18.4% by April 1996, just as the slowdown begins. Predictably, the savings and the investment rates fell the next year. This seems to indicate that Indian companies bulk up their investment just before the slowdown starts, aggravating the pressure on their bottom lines, rather than being ready with new capacities just when an upswing is taking place.

Research shows that most Indian companies rely largely on external financing to finance expansion (Financial Development & Growth in India: A Growing Tiger in a Cage, Hiroko Oura, IMF, March 2008). The trend is greatly emphasised in firms younger in age and smaller in size. The paper provides pointers to another systemic challenge — dependence on external financing (including equity) is inversely proportionate to a company’s growth prospects. However, Oura also concludes that despite all the shortcomings in the economy, India’s recent growth spurt was largely due to productivity growth. Typically, most firms have two sources of financing — external and internal. Again, external can be divided into domestic and “overseas” finance. If one leaves aside equity, then the sources of financing in the domestic market are characteristically bank funding, trade credit and capital markets (for issuing bonds and a host of other short-tenure instruments, such as commercial paper).

According to studies done over time, it is shown that most Indian companies historically did not generate enough savings. For example, in the ’80s, private sector savings hardly amounted to 2% of GDP — it touched 2% in 1988-89 and reached 2.4% in 1989-90. Given this low rate of savings, the corporate sector had to depend largely on external financing, including equity financing. Over the years, as markets opened up and tax rates came down (diminishing the incentives of high leveraging), the corporate sector’s propensity to invest was then directly related to its ability to generate enough surplus so that a judicious blend of own funds, borrowed funds (which largely meant bank financing) and equity could be used as the optimum, lowrisk combination. However, to generate the kind of internal surplus, most companies had to wait for their savings to touch a critical mass. Ordinarily, by the time most companies could make use of the good times and generate enough bulk on their books, the business cycle would turn. Companies then tended to save their surplus — instead of spending it on capital expenditure — for seeing them through the tight periods.

One alternative could be then to use bank credit for the planned investment expenditure. But, that’s a non-starter given the corporate sector’s inclination to spend only when the cycle starts heading downwards. The April edition of IMF’s World Economic Outlook (aptly titled Housing and Business Cycle) mentions: “Bank credit cycles arise naturally as a result of business cycles. Specifically, bank lending typically rises during an expansion and declines during a contraction. In a downturn, firms’ demand for credit normally declines, reflecting a curtailing of investment plans in response to weaker economic prospects and greater spare capacity...The price of bank credit also varies with the business cycle because it incorporates a risk premium. During a growth slowdown, the risk of insolvency increases in both the corporate and household sectors. Banks typically respond by charging higher risk premiums and tightening lending standards, particularly for riskier borrowers. Hence, expansion of bank credit is typically procyclical, whereas risk premiums and lending standards are countercyclical.”

The only alternative left then is either the equity markets or corporate bond markets. Undoubtedly, the Indian equity markets have reached some degree of global sophistication and efficiency. However, the same cannot be said of the corporate bond market. Also, the efficiencies of the equity market are not enough to compensate for the deficiencies in debt financing. In the end, if we give allowance for the fact that the corporate sector has been maturing over the years, then the only impediment to an efficient corporate sector is the absence of a well-functioning bond market.

Published as an Op-Ed in The Economic Times (June 11, 2008).