Wednesday, 4 September 2013

Does greater Investment-to-GDP Ratio equals more growth and long-term development ? [J.M. MARTIN]

Recent statistics from the Central Reserve Bank of Peru show that the ratio Investment to GDP ( i ) has reached 27.9 % "in its annualized quarterly average " in the period of April-June 2013, which represent the highest level in the last 20 years. It also states that a high percentage of " i" may allow long-term sustained growth .

How true is that statement? The economic theory and logic have always suggested that the higher the investment, the greater potential to obtain sustainable growth, although empirical studies are less assertive, the truth is that more investment is definitely not bad .

However, it must be stated that Investment is part of the calculation of the GDP, and it's not alone, as it's accompanied by private consumption, government consumption, changes in inventories and net exports (exports - imports ).

In other words, a static analysis of this ratio can allow the simple existence of the aforementioned substitution effect between macroeconomic aggregates, which cast doubt on the relative importance of investment in that country, since consumption also plays a major role in the business confidence. Or it may be that investment is relatively higher in relation to GDP, since there has been a sharp decline in consumption, which can also be harmful to an economy.

Thus, many countries, especially the most developed, depend crucially on private consumption and public consumption, where the increment of 1 % of the investment (i.e. from 10 % to 11 %) could have a more significant impact than one from 26% to 27 % in an emerging country. This is due to the productivity of investment, which is not standard nor uniform, no doubt there, but much depends on where it's located, how it's located and how it's maintained. In this respect, emerging countries still have much work to do.

In this regard, "Economy Watch" has collected, official sources from different countries of the world, for instante Investment to GDP ratio, establishing a ranking. Possibly, a less experienced young economist would say that countries with higher ratio would be the most developed. Unfortunately this claim would be dismissed.

Indeed, the vast majority of countries over 28% of the Investment to GDP ratio are Asian or African, in the case of the former, it includes China and Indonesia, called " Developing Asia ". As one descends on the list, several countries in Latin America and the Middle East appear. Therefore, it's not surprising that the average Investment to GDP ratio among advanced countries is only 18 % . Peru, of course, would be approximately around half of table at No. 66 from the more than 120 countries. 

What role does the Investment to GDP ratio have then? Definitely not an indicator of economic development, nor an indicator of long-term growth. Simply, it could be associated with higher growth in the short/medium term, as long as the marginal impact of Investment on GDP persists. Accordingly , once extinguished, the impact of Investment to GDP ratio would be more or less irrelevant  in the sense that it would not be associated with rapid growth nor long term growth.

Soon, EMECEP Consulting will have a report on this matter with a dynamic and cross-section analysis of the Investment to GDP ratio in order to test the alternative hypothesis outlined in this article.

Head of Economic Research / Chief Economist