Capital formation


Capital formation is a concept used in macroeconomics, national accounts and financial economics. Occasionally it is also used in corporate accounts. It can be defined in three ways:
  • It is a specific statistical concept, also known as net investment, used in national accounts statistics, econometrics and macroeconomics. In that sense, it refers to a measure of the net additions to the capital stock of a country in an accounting interval, or, a measure of the amount by which the total physical capital stock increased during an accounting period. To arrive at this measure, standard valuation principles are used.
  • It is used also in economic theory, as a modern general term for capital accumulation, referring to the total "stock of capital" that has been formed, or to the growth of this total capital stock.
  • In a much broader or vaguer sense, the term "capital formation" has in more recent times been used in financial economics to refer to savings drives, setting up financial institutions, fiscal measures, public borrowing, development of capital markets, privatization of financial institutions, development of secondary markets. In this usage, it refers to any method for increasing the amount of capital owned or under one's control, or any method in utilising or mobilizing capital resources for investment purposes. Thus, capital could be "formed" in the sense of "being brought together for investment purposes" in many different ways. This broadened meaning is not related to the statistical measurement concept nor to the classical understanding of the concept in economic theory. Instead, it originated in credit-based economic growth during the 1990s and 2000s, which was accompanied by the rapid growth of the financial sector, and consequently the increased use of finance terminology in economic discussions.

    Use in national accounts statistics

In the national accounts is the total value of the gross fixed capital formation, plus net changes in inventories, plus net acquisitions less disposals of valuables for a unit or sector.
"Total capital formation" in national accounting equals net fixed capital investment, plus the increase in the value of inventories held, plus lending to foreign countries, during an accounting period. Capital is said to be "formed" when savings are utilized for investment purposes, often investment in production.
In the US, statistical measures for capital formation were pioneered by Simon Kuznets in the 1930s and 1940s, and from the 1950s onwards the standard accounting system devised under the auspices of the United Nations to measure capital flows was adopted officially by the governments of most countries. International bodies such as the International Monetary Fund and the World Bank have been influential in revising the system.

Different interpretations

The use of the terms "capital formation" and "investment" can be somewhat confusing, partly because the concept of capital itself can be understood in different ways.
  • Firstly, capital formation is frequently thought of as a measure of total "investment", in the sense of that portion of capital actually used for investment purposes and not held as savings or consumed. But in fact, in national accounts, the concept of gross capital formation refers only to the accounting value of the "additions of non-financial produced assets to the capital stock less the disposals of these assets". "Investment" is a broader concept that includes investment in all kinds of capital assets, whether physical property or financial assets. In its statistical meaning, capital formation does not include financial assets such as stocks and securities.
  • Secondly, capital formation may be used synonymously with the notion of capital accumulation in the sense of a reinvestment of profits into capital assets. But "capital accumulation" is not normally an accounting concept in modern accounts, and contains the ambiguity that an amassment of wealth could occur either through a redistribution of capital assets from one person or institution to another, or through a net addition to the total stock of capital in existence. As regards capital accumulation, it can flourish, so that some people become wealthier, although society as a whole becomes poorer, and the net capital formation decreases. In other words, the gain could be a net total gain, or a gain at the expense of loss by others that cancels out the gain in aggregate.
  • Thirdly, gross capital formation is often used synonymously with gross fixed capital formation but strictly speaking this is an error because gross capital formation refers to more net asset gains than just fixed capital.
Capital formation measures were originally designed to provide a picture of investment and growth of the "real economy" in which goods and services are produced using tangible capital assets. The measures were intended to identify changes in the growth of physical wealth across time. However, the international growth of the financial sector has created many structural changes in the way that business investments occur, and in the way capital finance is really organized. This not only affects the definition of the measures, but also how economists interpret capital formation. The most recent alterations in national accounts standards mean that capital measures and many other measures are no longer fully comparable with the data of the past, except where the old data series have been revised to align them with the new concepts and definitions. US government statisticians have admitted frankly that "Unfortunately, the finance sector is one of the more poorly measured sectors in national accounts". The main reason is that national accounts were at first primarily designed to capture changes in tangible physical wealth, not financial wealth.

Gross and net capital formation

In economic statistics and accounts, capital formation can be valued gross, i.e., before deduction of consumption of fixed capital, or net, i.e., after deduction of "depreciation" write-offs.
  • The gross valuation method views "depreciation" as a portion of the new income or wealth earned or created by the enterprise, and hence as part of the formation of new capital by the enterprise.
  • The net valuation method views "depreciation" as the compensation for the cost of replacing fixed equipment used up or worn out, which must be deducted from the total investment volume to obtain a measure of the "real" value of investments; the depreciation write-off compensates and cancels out the loss in capital value of assets used due to wear & tear, obsolescence, etc.
Because of government tax-incentives and valuation issues, depreciation charged by businesses is rarely a true reflection of the loss in value of their capital stock. Hence, statisticians often revalue actual depreciation charges according to data about asset values and average service lives of assets, in order to obtain measures of true "economic depreciation".

Technical measurement issues

Capital formation is notoriously difficult to measure statistically, mainly because of the valuation problems involved in establishing what the value of capital assets is. When a fixed asset or inventory is bought, it may be reasonably clear what its market value is, namely the purchaser's price. But as soon as it is bought, its value may change, and it may change even before it is put to use. Things often become more complicated to measure when a new fixed asset is acquired within some kind of lease agreement. Finally, the rate at which the value of the fixed asset depreciates will affect the gross and net valuation of the asset, yet different methods are typically used to value what assets are worth and how fast they depreciate. Capital assets can for instance be valued at:
  • historic cost
  • current replacement cost
  • current sale or resale value
  • average market value
  • business value, assuming a certain profit yield
  • value for tax purposes,
  • value for insurance purposes
  • purchasing power parity value
  • scrap value.
A business owner may in fact not even know what his business is "worth" as a going concern, in terms of its current market value. The "book value" of a capital stock may differ greatly from its "market value", and another figure may apply for taxation purposes. The value of capital assets may also be overstated or understated using various legal constructions. For any significant business, how assets are valued makes a big difference to its earnings and thus the correct statement of asset values is a perpetually controversial subject.
During an accounting period, additions may be made to capital assets and capital assets are also disposed of; at the same time, physical assets also incur depreciation or Consumption of fixed capital. Also, price inflation may affect the value of the capital stock.
In national accounts, there are additional problems:
  • The sales/purchases of one enterprise can be the investment of another enterprise. Therefore, to obtain a measure of the total net capital formation, a system of grossing and netting of capital flows is required. Without this, double counting would occur.
  • Capital expenditure must be distinguished from intermediate expenditure and other operating expenditure, but the boundaries are sometimes difficult to draw.
  • There exists nowadays a large market in second-hand assets. In principle, statistical measures of gross fixed capital formation are supposed to refer to the net additions of newly produced fixed assets, which enlarge the total stock of fixed capital in the economy. But if a substantial trade occurs in fixed assets resold from one enterprise or one country to another, it may become difficult to know what the real net addition to the stock of fixed capital of a country actually is. A precise distinction between "new" and "used" assets becomes more difficult to draw. How to value used assets and their depreciation consistently becomes more problematic.
The general trend in accounting standards is for assets to be valued increasingly at "current market value", but this valuation is by no means absolutely clear and uncontroversial. It might be understood to mean the price of the asset if it was sold at a balance date, or the current replacement cost of the asset, or the average price of the asset type in the market at a certain date, etc.