Gross Capital Formation – trends for India and China

25^th Sep 2013

GDP growth is taken as a measure of a country`s prosperity as well as an indication of the economy. However, GDP growth rate alone cannot be an indicator for a country`s future growth potential. We have seen the BRICS nations, which were the toast of the world, a few years back slowing down.  It’s said that for tomorrow`s fruits you need to sow the seeds today. Hence one parameter which can be looked upon one of the seeds is Gross Capital Formation (GCF).

Economists look for capital formation as a necessary recipe to grow the countries’ economies.  Obviously, more assets creation leads to more and better avenues for output creation which if used efficiently and optimally leads to increased output which is reflected in higher GDP growth. Generally speaking, developing countries often devote a higher % of GDP to investment. Countries with rapid rates of economic growth are heavily investing in more fixed assets to enable rapid economic growth.

The world bank data for 1990-2012 indicates that the countries which have had the highest average annual GCF`s, in absolute numbers, are USA, Japan, China and Germany which put together have accounted for more than 50% of the average GCF`s in this period. The World Bank data also shows that the countries with the highest average GCF (as a % of GDP) in the period 1990-2012 are Equatorial Guinea, Bhutan, Cape Verde and China which account for 0.02%, 0.002%, 0.003% and 11.47% of the global economies.

China`s story is explainable as everybody knows about the massive investment in the physical infrastructure that has occurred, which has turbo charged the economy over the past 2 decades. India`s story is different. It ranks amongst the top growing economies but only in the top 25 in terms of average GCF as a % of GDP. For comparison purposes China`s average GCF in 1990-2012 is 41.1% while India`s figure is 28.9%. However India has improved its position to the top 10 in GCF in 2000-12 with a GCF figure of 33.7%.

Analysing the growth stories of USA, Japan, Germany, China and Singapore with India, with respect to GCF throws some interesting facts. To make the analysis sharper the GCF figures during the peak growth period post 1960 were looked into. Countries like USA and Germany, which had embarked on the path of development well before 1960 and already had a good capital base, averaged 19% and 22.7%. Japan which embarked on a manufacturing led development since the 1960`s averaged 31.7% while the tiny nation Singapore, which also saw a major development post 1960, had close to 34%. This indicates that countries on a development mode need a GCF of at least 30% to develop their economies. 

China of course is way ahead with a GCF of more than 40%.  After the 2008 slowdown China`s capital investment has increased with GCF at around 47%. India too has made strides and increased its GCF to close to 36%. However, the other countries like USA, Germany and Japan have seen a decrease in their GCF`s.

So why are India and China struggling with their economies despite an increase in their GCF`s?In China the highest investment has been in new plant and machinery and realty sectors, as shown in the adjoining graph, which have proved to be white elephants. The cheap money that is available to the corporates, due to the artificially low interest rates have fueled a realty bubble.  Many high rise buildings are unoccupied and office spaces are lying unutilized. Ghost cities and towns are spread across the country. This has been also fueled by the collusion between influential political lobbies and the banks. China’s manufacturing base has been supported by the huge demand for their goods outside. With recession hitting the global markets many of the factories are closed and lying idle. Thus the increase in GCF has not given the desired results to the Chinese economy as yet.

India`s issues are different. The 2 main issues are (a) drop in private sector investment, (b) reduction in investment in machinery and equipment i.e new manufacturing facilities. The major reason for this has been the lack of confidence in the private sector thanks to the stalemate in reforms at the central government. The share of private sector GCF has dropped to 10.65% from 12.5%. This drop also coincides with the drop in GDP growth. Private sector investments, due to efficiency factors, generate better returns and India has been severely hit by the drop in private sector investments.

What should India and China do? There has been a lot of debate and answers are obvious. China needs to reform its banking sector, free up interest rates and focus on domestic consumption. India, needs to speedup reforms and mainly build up confidence in the private sector. Easier said than done but there needs to be a political will. China certainly has but India? The experience of last 3 years says otherwise!

To conclude these figures throw up 3 questions

a) Is China in a better position to grow once the global economy picks up thanks to its huge capital base? 

b) On the other side,is the capital investment in China a bubble which can burst? 

c) What are the governance norms (or rather the lack of it) that controls the capital investment strategies in developing countries?