Capital misallocation and its implications for India’s potential GDP: An evidence from India KLEMS

In this paper, we estimate ‘distortions’ in the allocation of capital across various economic sectors in India, which has certain predictable impacts on the potential output of an economy. We calibrate our model using the India KLEMS dataset. We show that several industries in India, broadly in the services segments, are possibly ‘over-capitalised’ in a sense that capital usages here are too high for the output that they produce. In other words, the same level of output in these sectors could also be produced by much lesser capital. On the other hand, several manufacturing sectors are ‘under-capitalised’ by the similar criteria. Together, it implies that the aggregate output would have been higher if a redistribution of the excess capital from ‘over-capitalised’ services to the ‘under-capitalised’ manufacturing sectors was possible. In other words, a shift in the investment that focus away from select services segments to the manufacturing activities may potentially lift the growth momentum of Indian economy, by correcting some of these ‘distortions’. By eliminating this ‘distortion’ alone, India’s aggregate output could have been possibly increased by 30–35% between 1990 and 1999 from their observed level and by even greater extent of nearly 40% after 2000. Alternatively, if we are able to reduce the ‘distortion’ to the levels observed before 2005 in India, we may be able to generate an additional 30% output over and above the levels observed between 2005 and 2015. We, therefore, conclude that the government may conduct any further policy on the ease of capital movement with some caution with respect to industries that are ‘over-capitalised’.