The role of "smart" capital in development

The role of “smart” capital in development

High investment rate is one of the cornerstones of sustainable catch-up. Based on data from the past 60 years, those countries that were high in investment during the catch-up period were able to get out of the middle income trap. In the successful catching-up Asian economies (Japan, South Korea, Singapore, and China), the investment rate exceeded 30 percent of GDP, while in European countries catching up it averaged nearly 25 percent (Chart 1). Investment plays an important catch-up role, as it not only directly raises GDP in the short run, but also contributes to potential long-term GDP growth through capital formation. At the same time, recent decades have made it clear that in addition to the level of investment, its structure is also important for economic development.

Investing in “smart” capital encourages economic catch-up. Investments by three asset classes[1] Investments in construction, machinery and intangible assets can be classified into a larger category (Fig. 2). Investments in ICT assets and intangible assets are called “smart” capital. ICT assets include computers and communications equipment, while intangible assets include research and development, mineral exploration, computer software and databases, licenses, know-how or entertainment assets, and literary and artistic works. ICT assets are classified as investments in machinery, while intangible assets are considered a separate category. In the remainder of the article, we examine digitization as the largest segment of “smart” investing. Empirical experience shows that advancing digitization through multiple channels will lead to higher economic growth during the transition. Much of the growth-enhancing effect already occurs during digital transformation, but transformation will continue to fuel growth in the coming years. Recent examples of Estonia and Lithuania show that the widespread use of digitization is contributing to their economic development.

Digital transformation will increase investment directly (through the gradual accumulation of ICT capital) and indirectly (as a result of higher rates of consumption), thus boosting GDP growth (Chart 3). Investment in ICT, like other developments, should be immediately recorded as gross fixed capital formation, and thus the increase in the value of GDP in the year of investment. In the long run, it contributes more to economic growth than investment in construction and machinery, as consumption of ICT capital is higher than a decline in non-ICT capital. Digital devices are getting obsolete faster, which requires more alternative investment. Over the past decade, countries with higher average changes in investment in intangible and ICT assets have also seen higher changes in depreciation rates. Together, these two factors increase the pace of GDP growth during change, thus supporting a catch-up.

Shifting capital structure improves productivity during digital transformation. Among the developed countries, productivity has improved most in the past two decades in economies where ICT capital has grown significantly. There is a positive relationship between work productivity and digitalization as measured by the European Commission’s Digital Economy and Society Index (DESI) (Fig. 4). Thus, digitization increases efficiency, improves production processes, and enables fast and flexible service to different customer needs.

The countries in which the growth of ICT capital played a greater role in the growth of the capital stock, witnessed a more significant development. According to OECD data, New Zealand, Sweden and Norway have experienced the largest increase in ICT capital stock over the past two decades, while the US’s GDP per capita has caught up by 6-12 percentage points. Meanwhile, the relative development of Italy and Japan decreased by 7-9 percentage points with less expansion of ICT capital. In European countries with a high investment rate (Ireland, Estonia, the Czech Republic, Sweden and Austria), intangible assets play an important role in investments, while in Hungary they account for 11% (Fig. 2).

The example of Estonia, which has recently been on a successful catch-up path, also reinforces the role of digitization and “smart” capital. The country’s achievements in the field of digitization, which are crucial to businesses, families and the public sector, have greatly contributed to boosting Estonian economic development. Estonia has a high degree of digitization of public services. With the support of the population, e-government has been gradually developed, as a result of which the vast majority of public services can now be managed via the Internet. Digital services also make it easier for businesses to get started and up and running. The growing advantage of Estonia in the world of startups compared to the Baltic countries can be explained by digitization. Innovation plays a major role in productivity. According to European innovation statistics, Estonia is the most successful in the Central and Eastern European region. The basis for the rapid transformation of technological reform lies in the openness of the population to digital technologies, which is also supported by a high level of education. The effectiveness of the digital skills of Estonia residents also exceeds the average value of the European Union member states and the values ​​of the region. The significant increase in the investment rate in the country between 2017 and 2020 was associated with investing in intangible assets. Digitizing the Estonian economy has helped it recover from the downturn caused by the coronavirus crisis with smaller real economic sacrifices. Thus, investing in “smart” capital can contribute not only to promoting development but also to increasing the resilience of the economy.

[1] Another category is biological resources, but their share is usually negligible compared to the other three asset groups.

The authors are employees of Magyar Nemzeti Bank.

Cover Photo: Getty Images

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