Our capital formation slowdown is a hidden drag on GDP growth

India should act to reverse this slump before inadequate productive investment gets in the way of its economic ambitions

- SAUMITRA BHADURI is professor, Madras School of Economics

For two years, Indian policymakers have celebrated the country’s position as the world’s fastest-growing major economy.

However, beneath the headline numbers, a quieter concern has taken hold among economists: India is suffering from one of its most worrying slowdowns in capital formation in more than a decade. Investment no longer keeps pace with the economy's needs. Our ability to build new factories, expand infrastructure and adopt new technologies is weakening. And this has consequences not just for future growth, but also for jobs, productivity and the country’s long-term development path.

A useful way to see what drives a country’s productive capacity comes from Xavier Sala-i-Martin’s framework. Capital grows when three things happen together: the economy saves more, its financial system converts household savings into financial savings and then into efficient lending, and the investments themselves are effective.

Think of national income as moving through a sequence of stacked stages. Income is first saved. These savings must then enter the financial system, which decides how much is actually channelled to borrowers. Borrowers, in turn, must convert this funding into real investment, such as factories, infrastructure or technology. Finally, this investment adds to productive capacity only if it is efficient and well-directed.

Capital stock grows only when income successfully passes through all these layers and the resulting productive investment is large enough to more than offset depreciation—the natural wearing out of machines, infrastructure and technology. If even one layer is weak—low savings, poor financial intermediation, misallocated credit, stalled projects or inefficient investment—the final addition to capital is sharply reduced, regardless of how strong income growth may appear. In short, capital formation is only as strong as its weakest link.