India on two propellers

Tax cuts and the impending civil service pay hikes could put a lot of money in people’s pockets, and spur consumption

Cafe Economics | Niranjan Rajadhyaksha

Equity markets usually hold a mirror to the real economy around them, other than during mad episodes of irrational exuberance. A quick look at the Bombay Stock Exchange’s benchmark index thus tells us a lot about how the Indian economy has changed over the past five years.

The 30-share Sensex is weighted by market capitalization, or how investors value the entire company on a given day. On Monday, there were only two pure-play consumer stocks included in the index—ITC Ltd and Hindustan Unilever Ltd. Their joint weight in the index was 6.85%. Five years ago, the situation was remarkably different. There were four consumer stocks in the Sensex—ITC Ltd, Hindustan Lever Ltd, Nestle India Ltd and Colgate Palmolive India Ltd. They jointly made up 22.75% of the index.

The trend in capital goods is a sharp contrast. Five years ago, the two capital goods companies in the index—Bharat Heavy Electricals Ltd (Bhel) and Larsen and Toubro Ltd—had a 3.72% weightage. On Monday, despite the sell-off in the two stocks over the past fortnight, the two heavy industry heavyweights made up 8.59% of the Sensex.

There have been several other changes in the benchmark index as well, but let’s focus on this one change for now—the changing balance between consumer and capital goods stocks. This change tells us something about how the Indian economy has evolved in recent years.

There has been a splendid investment boom over the past five years, as savings and investment rates have soared. The investment rate has shot up from 25.2% of gross domestic product (GDP) in 2002-03 to 35.9% in 2006-07. This sharp rise in investment spending has increased the demand for the machines that companies such as Bhel and Larsen and Toubro crank out every day from their factories. Consumption, too, has been growing. We Indians have not stopped using soap or smoking cigarettes, stuff that the consumer goods majors sell to us. But the relative importance of investment has increased and that of consumption has declined over the past five years.

The finance ministry’s new Economic Survey provides the numbers. During the five years of the 9th Plan, three quarters of the economic growth India clocked in those years came from government and private consumption. Investment contributed the other quarter. In the 10th Plan, the two were evenly balanced. Both were almost equally responsible for pushing the economy forward. But in the past few years, investment has been the more important engine. This year, consumption will contribute 52% of economic growth while investment will contribute 55.2%. (The trade deficit will account for the rest.)

Ever since the investment boom of the mid-1990s ended, the Indian economy resembled a plane flying with one engine. Consumption spending was by far the main propeller of economic growth. It held up the economy. The second engine started whirring around 2004. That’s one reason why the balance between consumer and capital goods stocks changed in the stock market over the past five years.

Is this about to change? In his new Budget announced last month, the finance minister has cut the effective rates of income tax. This is likely to put thousands of extra crores in the hands of taxpayers. P. Chidambaram told the Times of India in a post-Budget interview that he would like beneficiaries to save half their extra money and spend the other half.

Then there the impending civil service pay hikes once the recommendations of the 6th Pay Commission are accepted later this year. The annual hike in the Union government’s salary bill could be around Rs20,000 crore, or 0.4% of GDP. The state governments will have to match this payout to satisfy their own staff. Add another Rs20,000 crore. And what if there is a backlog of arrears to be paid? More spending?

In short, the tax cuts and the civil service pay hikes could prove to be an impetus to consumption spending in the coming year or two.

And what about investment? It is likely to steam ahead, but there is another low-probability possibility. There are some early signs of an investment slowdown. “The share of fixed capital formation in GDP has fallen from 33% in the first two quarters of 2007-08 to 31.6% in the third quarter. While not of great concern (it is in the range of this share in 2006-07), the drop needs to be monitored to see if a trend emerges,” say Axis Bank economists Saugata Bhattacharya and Rituparna Banerjee in a recent note.

Could India be headed for a consumption surge and an investment slowdown, mirroring the combination we saw in the late 1990s after there was a similar mix of tax cuts, civil service pay hikes and an investment slowdown?

It’s too early to tell. But if something like this does happen, watch how those consumer goods stocks could perform.