Economic Insights Beyond GDP: ICOR | 13 Sep 2023

Source: ET

Why in News?

India's latest Gross Domestic Product (GDP) data is making headlines with a remarkable 7.8% growth during the April to June quarter of 2023, solidifying its position as one of the world's fastest-growing major economies.

• However, India's economic narrative extends beyond the numerical figures. Incremental Capital Output Ratio (ICOR) is also gaining traction, offering insights into capital efficiency and resource allocation.

What is GDP and ICOR?

• GDP is one of the most widely used indicators of economic performance and development. It measures the total value of goods and services produced within a country in a given period of time.
  • While GDP has its merits, it does not offer a complete view of economic well-being. It overlooks factors like efficiency, income distribution, and institutional quality, which are essential for sustainable growth.
  • Merely increasing investment may inflate GDP, but true sustainable growth relies on productivity enhancements.
  • Therefore, economists and policymakers often use other complementary indicators to assess the efficiency, sustainability, and quality of economic growth.
• One such indicator is the ICOR; it has evolved from the Harrod-Domar Growth Theory and examines the relationship between fresh investments and economic growth, indicating how much additional capital is required to generate a 1% higher output.
  • A lower ICOR signifies greater efficiency and productive use of capital.
  • According to an SBI report, India is experiencing an upward trend in savings and investments, which is accompanied by a simultaneous decrease in the ICOR.
    • The current ICOR in India stands at 3.5 (as of FY22), however, this was 7.5 in FY12. 

What are the Factors Behind Declining ICOR in India?

• Economic and Technical Innovation: India has been a hotbed for cost-conscious innovation, where companies develop cost-effective solutions that require minimal capital investment and minimum wear and tear replacement.
  • For example, companies like Tata Motors developed the Nano car, a low-cost alternative for the middle-class population, showcasing how frugal innovation can lead to lower ICORs.
• Economic Diversification: India's shift towards a more services-oriented and technology-intensive economy reduces the capital intensity of economic activities.
  • Services, such as IT and software development, typically require less capital per unit of output compared to traditional manufacturing.
    • Unified Payments Interface (UPI) developed by National Payments Corporation of India (NPCI) has become a cost-effective and efficient digital payment system that has accelerated financial inclusion and made transactions more accessible to a broader population.
  • However, it's essential to exercise caution and maintain a balanced approach by also nurturing the manufacturing sector.
• Decentralized Manufacturing: The rise of decentralized and distributed manufacturing using 3D printing and other technologies reduces the need for centralized factories and heavy capital investment in large-scale production facilities.
  • India's first 3D-printed post office has been inaugurated in Bengaluru.
• AI and Machine Learning Integration: Artificial Intelligence and Machine learning (ML) are playing a pivotal role in lowering the ICOR in India by enhancing efficiency and productivity across various sectors.
  • For instance, in healthcare, AI-driven diagnostics reduce reliance on costly equipment, lowering the healthcare sector's ICOR.
  • In manufacturing, ML-based predictive maintenance decreases downtime and extends machinery life, reducing the need for frequent capital replacements.
  • Also, AI-enabled precision farming in agriculture enhances resource utilization, resulting in higher crop yields with reduced capital expenditure.

What are the Limitations of Using ICOR as an Economic Indicator?

• Informal Economy Impact: India's informal economy is vast and dynamic, but it largely operates outside the scope of formal data collection.
  • The informal sector's interactions with the formal sector can be complex and challenging to capture accurately in ICOR calculations.
  • As a result, ICOR may not fully account for the informal sector's contribution to economic growth and capital efficiency.
• Price Distortions: ICOR is based on nominal values of investment and output, which are affected by price changes over time.
  • Therefore, inflation or deflation may distort the true relationship between investment and output, leading to misleading results of ICOR.
  • Also, obtaining reliable ICOR calculations can be hindered by the availability and accuracy of data.
• Infrastructure Bottlenecks: Despite a declining ICOR, India continues to grapple with infrastructure bottlenecks.
  • This could mean that while new capital investments are relatively efficient, existing infrastructure constraints could hinder the overall economic efficiency and productivity.
• Regional Disparities: Regional variations in India can significantly affect the interpretation of ICOR. A declining national ICOR might hide disparities where some regions benefit from more efficient capital use while others lag behind.
• Natural Resource Depletion: A lower ICOR may not reflect the depletion of natural resources, which can lead to long-term sustainability challenges.
  • Capital-intensive industries that exploit natural resources might show a declining ICOR while harming the environment.

How can ICOR be Improved?

• Regional and Sectoral Analysis: Instead of only national-level analysis, there is a need to conduct regional and sectoral assessments of ICOR.
  • This allows for a more granular understanding of where capital investments are most efficient and where improvements are needed. Targeted policies can then be designed accordingly.
• Blockchain for Transparent Data Recording: Utilizing blockchain technology to ensure transparent and tamper-proof recording of economic data, can reduce the risk of data manipulation or inaccuracies. This can enhance the reliability of ICOR calculations.
• Public-Private Collaboration: Fostering collaboration between public and private sectors to jointly address capital allocation inefficiencies.
  • Public-private partnerships can leverage resources, expertise, and innovation for more efficient infrastructure and development projects.