March 23, 2014
Abstract: Capital efficiency, i.e. return on capital employed, is used by shareholders to assess the performance of companies and it is determined by portfolio choice (i.e. past allocation of capital), management efficiency and business cycle effect. An analogous framework can be applied at the macroeconomic level, albeit with some limitations. Incremental capital-output ratio (ICOR), the investment-GDP ratio divided by GDP growth is a tractable measure of macro capital efficiency. High ICOR suggests inefficient use of capital.
Changes in ICOR in different growth phases of the past two decades have been attributed to one or more of the three factors stated above. The rise in ICOR during 2011-13 compared to the high growth phase of 2003-08 was partly due to the business cycle effect. But lopsided investment choices and poor management are also to blame. For example, massive investment in power generation capacity in last few years was not matched by investment in coal mining.
Keywords: portfolio choices; business cycle; management efficiency; return to capital; capital productivity; stagnation
