Monday, November 22, 2010

Capital formation

Capital formation is a concept used in macro-economics, 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 used in national accounts statistics, econometrics and macroeconomics. In that sense, it refers to a measure of the net additions to the (physical) capital stock of a country (or an economic sector) 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 financial 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.
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 “depreciation”), 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.