The economy’s consumer parachute

Context

Investment, which has grown at an average annual rate of about 17 per cent over the past five years, has been the main factor lifting India’s average annual GDP growth to around 9 per cent over the same period. The slowdown now forecast for India’s GDP growth is mainly due to a fall-off in investment amid the global liquidity crunch, with banks unwilling to lend and companies unwilling to borrow at the prevailing high interest rates.

However, domestic consumption, which has been the biggest component of GDP with an average 67 per cent share over the past five years, will help to cushion the expected fall in economic growth.

India is a long-term consumption-driven economy, as its population is one billion-plus and the bulk of it is, as noted, now entering the working-age group.

Recent trends

Consumption growth has been accelerating in recent years, especially since the third quarter of FY2007-08.

Rising concerns about the effect of the global economic slowdown on India’s economy over the next year, and mounting evidence of a decline in domestic economic activity, are leading to anxiety on the consumption front as well. Falling asset prices, including those of housing and equities, and rising job insecurity, expectations that incomes will grow at a slower pace and stubbornly high interest rates will hurt consumption, especially in urban areas.

The latest data for the second quarter of FY2008-09 show a drop in overall private consumption growth to 5 per cent year on year from 8 per cent in the preceding quarter. However, consumption trends have been relatively stable in comparison with investment growth, which has been trending lower for the past two years.

More recent data on consumption patterns, such as retail sales, are hard to come by in India but the available numbers paint a mixed picture. The half-yearly Nielsen Consumer Confidence Index saw India’s reading fall to 114 in the second half of 2008 from 122. This is still the most optimistic score among the 52 countries surveyed, but it is clearly on a downward trend from a high of 137 in the second half of 2006. The results of a quarterly survey of 3,597 Indian companies released on 9 December 2008 by the recruiting firm Manpower indicated that hiring is likely to reach a three-and-a-half year low in January-March 2009. Meanwhile, car sales, an important indicator of consumer sentiment, dropped 19 per cent year on year in November 2008, the worst decline in eight years.

Industrial output growth, which staged a brief recovery in September 2008 thanks mainly to consumer goods (especially durables), fell 0.4 per cent year on year in October. The September boost could possibly have been due to inventory stockpiling ahead of India’s biggest festival season Diwali, which occurred in October. In fact, the “Business Standard” newspaper reported on 22 November that consumer electronics sales grew 30-35 per cent year on year in the festival season, helping to push up average sales growth for the year to 10 per cent from 7-8 per cent.

But another indicator, the ABN Amro Bank-sponsored Purchasing Managers’ Index (PMI), showed a sharp fall in manufacturing output in November 2008 to below 45.8. This is the first time since the 500 company-wide survey was introduced in 2005 that the PMI has fallen below 50, the inflection point for contracting manufacturing output.

Consumption boost from the fiscal stimulus

The government’s most recent fiscal measures to prime the economic pump, including the excise duty cut and additional spending announced earlier this month, come at a time when it had already been following an expansionary policy. The government presented a populist budget in February 2008, looking forward to national elections in 2009. As things turned out, that probably worked well for it. But if it had not already blown its fiscal deficit targets by a wide margin, it would have had greater headroom to take more immediate fiscal measures, such as cuts in direct taxes and retail fuel prices.

Here we analyse how some of the major fiscal stimuli introduced this year may affect domestic consumption:

1. Sixth Pay Commission: The revision of pay scales for government employees that takes place every decade came into effect from August 2008. Around 5 million central government employees received a minimum 21 per cent increase in their salary, costing the exchequer an additional Rs178 billion (US$3.6 billion) annually as well as Rs294 billion (US$6 billion) in back payments over the next two years.

   Our trusted source, market strategy consultant Rama Bijapurkar, points out that the revision of pay scales sanctioned by the Fifth Pay Commission led to a temporary spike in consumer demand by adding at least US$4 billion to the disposable income of state and central government employees. For example, car sales jumped 33 per cent in 1999, the year the pay hike was implemented. Automobile companies and consumer durables manufacturers are banking on this population segment helping to sustain sales this year, with some companies offering special discounts and schemes for government employees. The October rise in consumer electronics sales was partly attributed to the effect of the Sixth Pay Commission, which is also likely to help boost urban consumer demand from the third quarter of FY2008-09.

   Automobile sales growth, 1996-2007 (per cent)

   
2. Farm loan waiver: This populist step, announced in the February 2008 budget, obliges banks to write off bad debt incurred by farmers amounting to Rs716.8 billion (US$14.6 billion). Although the loan waiver does not put cash directly into the hands of farmers, it is likely to have a psychological effect, as they would be able to borrow again from banks without worrying over past payments due or borrowing from private moneylenders. However, any direct impact on rural consumer demand will be difficult to gauge, at least in the short term.
3. Excise duty cut: The government on 7 December 2008 cut the central value-added tax (Cenvat) by 4 per cent for all goods except petroleum products, amounting to a tax revenue loss of Rs87 billion (US$1.8 billion). The tax cut is expected to reduce prices of both final goods and raw materials. Companies in many sectors, including automobile manufacturers and tyre makers, steel producers and cement manufacturers, have lowered their product prices following this excise duty cut.
4. Fuel price cut: Following the collapse of global oil prices by more than US$100/bbl since their July 2008 peak, the Indian government finally cut the retail price of diesel and petrol by 6 per cent and 10 per cent respectively on 5 December 2008. This is still a small amount relative to the sharp decline in global, and therefore imported, oil prices because the government is trying to restore some of the losses that oil marketing companies made this year owing to a heavy fuel subsidy burden. However, further cuts in retail fuel prices are likely, with Oil Minister Murli Deora describing the recent reduction as an “interim measure”. Approximately 65 per cent of services in India are estimated to be dependent on petrol and diesel while freight and transport costs are estimated to account for 5 per cent of net sales for consumer goods manufacturing companies. Lower fuel prices should have a cascading effect on prices throughout the economy.
5. Agricultural subsidies: The government has also been doling out food and fertilizer subsidies (which protect farm incomes) for many years. Subsidy payments have not been reduced despite the apparent fiscal consolidation of recent years (see our report Healthier public finances for details). Many of the subsidies are also below-the-line items that are not reflected in the government’s budget. The Prime Minister’s Economic Advisory Council estimated in July 2008 that food, fertiliser and fuel subsidies account for around 4 per cent of GDP. Although the effect of these subsidies on stimulating consumption is debatable, the government will not cut them back.
   

   Budgeted subsidy payments, FY2003-09 (per cent of GDP)

   

The liquidity crunch

Another trusted source, Oxus Research and Investments’ Surjit S. Bhalla, argues that the government will need to take more direct steps, such as cuts in direct taxes and lowering interest rates further, in order to stimulate consumption. Industries across the economy have been pressing for a further relaxation in interest rates, as we have highlighted in our recent reports Vertigo in the real estate market and Credit crunch squeezes the infrastructure sector.

The automobile industry especially is in need of lower interest rates. Increasingly risk-averse banks have scaled back retail lending. Personal financing of cars and two-wheelers, which account for one-third of total retail loans, has become particularly difficult owing to a high non-performing asset (NPA) ratio for this sector. A July 2008 report by the credit rating firm Crisil said that gross NPAs for car and commercial vehicle loans increased to 2.3 per cent (as of 31 March 2007) from 0.9 per cent two years before. Meanwhile gross NPAs for housing loans, which make up more than half of all retail loans, rose to 2.2 per cent from 1.8 per cent over the same period. Because retail lending rates have continued to rise, Crisil projects gross NPAs for all retail loans to increase to 4 per cent by March 2009, up from 2.7 per cent as at 31 March 2007.

Although the RBI has cut its policy repo rate by 250 bp to 6.5 per cent since October 2008, commercial banks have yet to lower their prime lending rates (PLR) to match the extent of monetary easing. According to a fund manager who covers the automobile sector, even affiliated automobile financing companies such as TML Financial Services (Tata Motors) and Mahindra & Mahindra Financial Services are not lending at attractive rates to potential customers.

The good news is that retail credit penetration in India is low: the IMF estimated it to be just 10 per cent of GDP in 2005, compared with 27 per cent in emerging Asia and 58 per cent in developed markets. Furthermore, discretionary spending (on non-essential products or services) as a percentage of total income is also relatively low compared with other major economies. A May 2007 McKinsey report estimated that the expenditure on food, beverages and tobacco of an average Indian household was around 42 per cent of total income (although declining) in 2005, compared with 14.6 per cent in the US and 19.2 per cent in Brazil. Rural households spend an even greater proportion of their income on food.

Can rural consumers save the day?

India’s vast rural population, around 70 per cent of the total, is a beacon of hope amid signs of declining urban consumption. Rural consumption (including government spending) is estimated to account for a little over 60 per cent of total consumption. Approximately 50 per cent of rural GDP growth depends on farm growth. This has been relatively healthy so far: it was up 2.9 per cent in the first half of FY2008-09 compared with 4.5 per cent in the same period a year ago, but was better than the average 2.5 per cent growth over the past decade.

Prospects for the winter-sown “rabi” crop that is harvested in March-April also look good. The Centre for Monitoring Indian Economy (CMIE) has projected a bumper wheat crop for the coming season, and the area sown for all winter crops increased 12 per cent year on year in the week to 5 December 2008. A good harvest will also benefit the half of rural GDP that consists of manufacturing units and services, as farmers will spend more on buying fast-moving consumer goods, mobile phones and two-wheelers. An analysis of consumption expenditure over the past two decades shows that food as a proportion of spending – though still high at more than 50 per cent – has been declining while expenditure on various goods and services such as on durables, education and health has been rising.

A government-sponsored programme to build rural roads and to expand an employment guarantee programme (click here for our September 2007 report on The challenge of creating jobs for the rural poor) to the entire country is also providing alternative employment opportunities and additional incomes to the rural poor. Bijapurkar notes that even a one per cent improvement in the income brackets of rural India’s population means better living standards for six million people. The challenge is in reaching these widely scattered consumers, especially those with large incomes.

Some companies have made a success of tapping the small-budget rural market. The most talked about example is that of shampoo sachets, which now account for 70 per cent of India’s total shampoo market. A relatively small company named CavinKare began selling Rs0.50 (US$0.01) shampoo sachets in 1999 and has since grabbed 65 per cent of the rural market and a 20 per cent overall market share. Bigger rivals such as Hindustan Unilever have followed suit. Other examples abound, the most recent of which was the November 2008 announcement by PepsiCo India that it plans to start selling a nutritious food snack or beverage in rural and semi-urban areas for Rs1-Rs2 (US$0.02-US$0.04) in 18-24 months. It will use its large distribution network of one million outlets already in place across the country.

In view of the predominance of low-value items in the budgets of rural consumers and the challenges of penetrating this widespread market, the rural segment will not be able to offset the decline in urban consumption. But it will moderate the slowdown in overall growth and help India’s economy to remain one of the world’s fastest-expanding in this time of global economic uncertainty.

Trusted Judgement

Mass consumer markets are relatively safe.

Rama Bijapurkar, independent market strategy consultant and author of “Winning in the Indian Market - Understanding the Transformation of Consumer India”.

Consumer demand in India is not in the intensive care unit. The declining top line of consumer product companies does not mean that consumer demand is evaporating. The mass markets are relatively safe, as is rural India. One-third of total expenditure is accounted for by the bottom 60 per cent of the population while the top 20 per cent accounts for 40-45 per cent. Only 20 million people in India have invested in the stock market either directly or indirectly. Rural areas account for 64 per cent of India’s consumption expenditure even though per capita income is half that of urban areas because India’s rural population is 2.5 times the size of its urban population.

Most Indian workers are employed in the unorganized sector, so job losses in sectors such as IT (which are directly affected by the global financial crisis) will be small in comparison. Even in the organized sector, for the 1.7 million employees in the IT industry, there are 5-7 million government employees who have just received a hefty pay increase. But high-value items are taking a hit. Sectors such as automobiles are in a downturn. People are waiting and watching the situation. They are not replacing their cars as quickly or buying second homes. But even the upper end of the consumer market has not dried up: the pace will just be slower, with the replacement cycle lengthening.

If the sales growth rate of most consumer goods was 20-30 per cent, it will now come down to 15-20 per cent. Sales of consumer durables, which depend heavily on financing will not grow much and companies will have to cut prices. Consumer durables manufacturers will be more willing at this stage to maintain market share and volume rather than margin. Companies will not be able to command a brand premium as consumers are “down trading”, shifting to a lower-priced brand. For instance, consumers believe that there will be no effect on the appearance of their hair if they buy a bottle of shampoo for Rs70 (US$1.5) rather than Rs100 (US$2).

More fiscal and monetary policy action needed.

Surjit S. Bhalla, Managing Director of Oxus Research and Investments, a New Delhi-based economic research and asset management firm.

Asset price deflation will hurt urban consumer demand, but the positive news is that the rural front will be affected much less. That in turn will cushion the decline in overall GDP growth. India’s population is only 29 per cent urbanised, in contrast to China where urbanisation is 40 per cent. As India’s economy is also less dependent on exports, the decline in its GDP growth rate will be less than that of China.

In rural India, farm income will not be affected by the global crisis and non-farm income will also be less affected. It would be a mistake to extrapolate a collapse of urban incomes to the entire nation, and it would also be wrong to assume that rural incomes will be affected the same way as a result of wealth destruction in urban India. But rural India alone cannot save the economy; it will cushion the decline.

All the action taken so far on the policy front is not enough to boost consumption. More is needed from monetary policy (the repo rate should go down to 4 per cent), and on the fiscal side more tax cuts are needed (such as removing various surcharges in order to help bring down the overall tax rate by 3-4 per cent). If the investment slowdown were to continue, GDP growth could fall to 5 per cent for the second half of FY2008-09.

But the Indian economy is close to the bottom in terms of the growth cycle and should start recovering from the first quarter of FY2009-10. There have been severe price declines, particularly for oil. If inflation data for the past five months are seasonally adjusted, then the average rate is just 1.3 per cent. This implies that interest rates are too high and must come down further.

The Cenvat cut boosts purchasing power immediately. The Pay Commission also enhances the purchasing power of some consumers, but this accounts for only 0.5 per cent of GDP in the current fiscal year. Although it is fortuitous that the pay hikes are coming just when they are most needed, it is not enough to make a significant difference in overall consumer spending.

Wrap

Slowing demand from urban consumers will be a drag on India’s consumption growth, but not as much as in other major economies. We believe that steady rural consumption and fiscal sops including tax cuts and higher government salaries will help to keep overall consumption growth from falling too far. It is likely to settle down at around 6-6.5 per cent compared with an average 8 per cent in FY2006–2008, when GDP growth averaged 9 per cent. Most of the fiscal measures, such as the Pay Commission salary increase and the farm loan waiver, had been factored into consumption estimates before the effect of the global downturn was felt.

If, as Oxus Research and Investments’ Bhalla suggests, the government cuts tax rates and fuel prices further, there would be a direct impact on consumer purchasing power, providing a fillip to demand. These steps will probably be taken in the next few weeks: tax cuts are certainly a possibility by the government’s next budget announcement in February 2009. Government officials are making the right noises about taking further steps to ensure that economic growth does not slow down too sharply.

A further decline in interest rates is also necessary for discretionary consumption to pick up, especially in sectors such as automobiles and other consumer durables that are dependent on bank financing. Sectors such as food and clothing will probably remain relatively less affected given the high proportion of non-discretionary spending in total consumption expenditure. However, as our trusted source Bijapurkar highlights, companies across the board are likely to be affected by “downtrading” as consumers tighten their purse strings.

Value growth – or revenue increases through price hikes or sales of more expensive products – in urban areas will face challenges, but companies with large distribution networks can hope to offset some of the decline in urban sales through volume-driven growth in rural areas. However, because of the widely dispersed rural population, the small number of potential high-purchase consumers in rural areas and the dependence on the crop harvest, this market segment cannot itself boost overall consumption growth. Instead it can provide a soft landing for what appears to be an inevitable decline in India’s broader economic growth.

Relevant Companies

Name	Description
CavinKare	An unlisted Indian consumer goods company that makes personal care and food products.
Hindustan Unilever (HUVR:IN)	India’s largest consumer goods company. It manufactures home and personal care products as well as food and beverages.
Mahindra & Mahindra (MM:IN)	An automobile manufacturer with a range of products from commercial vehicles to passenger cars. It also makes farm equipment and automobile components.
Mahindra & Mahindra Financial Services (MMFS:IN)	A finance company that provides loans to buyers of Mahindra & Mahindra’s vehicles.
PepsiCo India	The Indian subsidiary of global beverages maker Pepsi Bottling Group (PBG:US).
Tata Motors (TTMT IN)	Manufactures and exports cars, sports utility vehicles, trucks and buses.