India - Economy. Rough patch 2Q2013. Uphill ride for consumption. Institutional Equities

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1 Institutional Equities Rough patch 2Q213 Uphill ride for consumption

2 Ashutosh Datar (91 22) Abhijit R. Akella, CFA (91 22) Contents Executive summary...1 Uphill climb for consumption... 3 Farm price inflation to moderate... 7 Asset price inflation to cool off Government spending growth to decelerate Wage inflation pressures to subside... 42

3 Executive summary After 4 years of robust growth, we expect India s household consumption growth to decelerate sharply over the next 1-2 years. Sustained agri-commodity inflation, unprecedented asset price inflation, acceleration in government expenditure, and a sharp increase in wages due to a tight labour market have been the four key factors driving the uptick in household consumption in the past few years. We believe these four tailwinds are largely behind us. Furthermore, a few of these tailwinds such as asset price inflation and wage growth will likely turn into headwinds, weighing on consumption. Farm price inflation to moderate: A significant acceleration in agricultural growth (the overall farm income pie has doubled in the past five years) has been the biggest driver of rural prosperity in recent years. This was largely due to higher prices, although real growth was also above trend. However, the price inflation is unlikely to sustain because: Firstly, we expect significant moderation in the pace of increase in Minimum Support Prices (MSPs) after the passage of the food security bill. Secondly, inflation has already slowed significantly in non-foodgrain categories, reflecting a combination of slower demand and improved supply response. Accordingly, in our view, nominal agri GDP is likely to slow to 9-1 in the next few years from 14-15% in the past few years. Asset price inflation to cool off: Gold and land are the largest household assets in India. Prices of both these assets have increased sharply after the global financial crisis (12-13% Cagr in real terms over the past 3-4 years). In both these asset classes, anecdotal evidence shows that households have monetised the price increase either through outright sale in case of property or through mortgage in case of gold. Apart from the psychological impact, the price increase has thus also had a tangible impact on household wealth. With gold prices correcting, a big support for household finances has already waned. Similarly, anecdotal evidence suggests the pace of appreciation in property prices, at least in the metros, has moderated. Government spending growth to decelerate: Both central and state governments have seen a sharp acceleration in their revenue expenditure following the financial crisis (~18-19% Cagr in the past 4-5 years, from 12-13% previously), which has boosted aggregate demand. Expenditure growth for the central government has already moderated due to the need for fiscal consolidation, a trend likely to continue in FY14 and FY15. Expenditure growth of state governments, which was robust until now, will also decelerate in the next 1-2 years since their tax revenue is highly sensitive to nominal GDP growth, which is decelerating. Thus, state governments expenditure growth will moderate 4-5ppt in the next 1-2 years. Wage inflation pressures to subside: Finally, we believe strong wage growth in recent years was another key driver of consumption growth. This was largely due to robust economic growth engendering a tight labour market. The fragmented data on labour market suggests strong growth in employment over FY4-11, with unemployment rate at multi-year lows. Wage growth was generally in double digits and it was higher in rural areas, reflecting the loose fiscal policy. In the late 199s, a slowdown in growth resulted in higher unemployment and a sharp slowdown in wage growth. We believe a similar scenario is likely to unfold in the next few quarters. 1

4 Key Charts Agriculture growth has increased in lower productivity states but decreased in high productivity states High productivity states Low productivity states 6. Agri GDP Cagr (%) Medium productivity states FY95 FY1 5 FY6 12 Source: Planning Commission, CMIE, IIFL Research Gold price appreciation has been a big support to household finances Price inflation in farm sector has been near all time high in recent years (5yr Cagr) Agri GDP deflator median FY7 FY72 FY74 FY76 FY78 FY8 FY82 FY84 FY86 FY88 FY9 FY92 FY94 FY96 FY98 FY FY2 FY4 FY6 FY8 FY1 FY12 Property price in Gurgaon, on the outskirts of Delhi, has increased more than six times in the last decade (Rs tn) 7 6 Increase in value of gold stock (RHS) (% of GDP) 15% 12% 7 6 Gurgaon Residential Property price index 5 9% Value of household gold stock (LHS) FY98 FY99 FY FY1 FY2 FY3 FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14ii 6% 3% 3% 6% Source: World Gold Council, CMIE, IIFL Research. Note: Increase in value of gold stock is calculated as change in value of household gold stock at the start of the year due to change in Gold price during the year. State govt expenditure growth has remained robust even as central govt s expenditure growth has decelerated (YoY) Central government State governments Wage rate in the organised industrial sector has increased sharply in recent years (Rs) Emoluments per employee (LHS) (YoY %) Growth (RHS) 15, 25 12, 9, , 1 1 3, 5 FY9 FY1 FY11 FY12 FY1 FY2 FY3 FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 Source: CMIE, CSO, RBI, IIFL Research 2

5 Uphill climb for consumption The past few years have generally seen a robust uptick in household consumption growth with growth in rural areas outstripping growth in urban areas. Auto sales, for example, grew at 2 Cagr over FY9-12. Not surprisingly, consumption-oriented stocks have generally outperformed the broader market by a wide margin, reflecting both superior earnings delivery and valuation re-rating. In our view, the four key factors that drove acceleration in consumption are sustained farm price inflation, asset price reflation, fiscal stimulus, and high wage growth due to tight labour markets. However, support from each of these four factors is waning in varying degrees. Hence, we believe the recent trend of moderation in consumption is likely to continue and household consumption growth in the next 1-2 years will likely be significantly lower relative to the past few years. This will mean slower near-term economic growth; however, on the flipside, slower consumption should lead to decline in inflation as well as moderation in current account deficit, allowing RBI to cut interest rates. Thus, this is a necessary short-term adjustment for the eventual pickup in growth and the investment cycle. Household consumption has been robust in recent years Sharp increase in consumption: Household consumption in India accelerated sharply in the past few years. In recent years, growth rates have generally been higher across almost all categories of consumption, higher than in the high-growth years of Further, a key feature of this uptick in consumption is that growth rates in rural areas have generally been higher than in urban areas. This has happened despite the sharp moderation in overall GDP growth from more than 9% in FY11 to less than 7% in FY12 and further to ~5% in FY13. Figure 1: Two wheeler sales grew at > 2 Cagr in FY9 12 (Cagr) Domestic 2 wheeler sales 25% 2 15% 1 5% Figure 2: Passenger vehicle sales accelerated sharply (Cagr) Domestic passenger vehicle sales 25% 2 15% 1 5% FY3 6 FY6 9 FY9 12 FY3 6 FY6 9 FY9 12 Source: CEIC, IIFL Research Source: CEIC, IIFL Research 3

6 Figure 3: Tractor sales grew sharply over FY9 12 Figure 4: FMCG sales growth too was robust 25% Domestic tractor sales 2 FMCG sales growth 2 15% 15% 1 1 5% 5% FY3 6 FY6 9 FY9 12 FY3 6 FY6 9 FY9 12 Source: Industry, IIFL Research Source: CMIE, IIFL Research. Note: Aggregate for key large cap companies. Not surprisingly, consumption-oriented stocks generally outperformed the market by a wide margin. Thus, although the broader market has been largely flat over the past five years, auto and FMCG stocks have more than doubled, on an average. The stock performance reflects their superior earnings delivery as well as rerating in valuation due to expectations of continued superior earnings delivery. Consumption stocks have rerated and outperformed the broader market by a wide margin Figure 5: Consumption stocks outperformed the market by a wide margin CNX 5 Index CNX FMCG Index CNX Auto Index 4 (Indexed to 1 at Dec 26) Jan 6 Apr 6 Jul 6 Oct 6 Jan 7 Apr 7 Jul 7 Oct 7 Jan 8 Apr 8 Jul 8 Oct 8 Jan 9 Apr 9 Jul 9 Oct 9 Jan 1 Apr 1 Jul 1 Oct 1 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Apr 13 Source: NSE, IIFL Research However, many indicators of consumption have softened in the past few months, raising questions on the sustainability of the consumption momentum. Passenger vehicle sales have declined YoY over the past four months. Similarly, two-wheeler sales for which the rural markets were a key driver have declined YoY for two consecutive months. Further, FMCG sales growth (aggregate for key large cap companies) has slowed to a three-year low in CY12. Cement despatches (for which rural markets were a key driver) have similarly decelerated sharply in the past few months. 4

7 Figure 6: Domestic PV sales declined in recent months Figure 7: Cement production growth also decelerated sharply (YoY%, 3mma) 5 Domestic passenger vehicle sales (YoY%, 3mma) 15% Cement production % 9% 6% 3% 2 Jan 6 Jul 6 Dec 6 Jun 7 Nov 7 Apr 8 Oct 8 Mar 9 Aug 9 Feb 1 Jul 1 Dec 1 Jun 11 Nov 11 May 12 Oct 12 Mar 13 3% Jan 8 Jun 8 Nov 8 Apr 9 Aug 9 Jan 1 Jun 1 Oct 1 Mar 11 Aug 11 Dec 11 May 12 Sep 12 Feb 13 Source: CEIC, IIFL Research Source: CMIE, Industry, IIFL Research In our view, four principal factors have driven the sustained consumption momentum in the past few years: 1) Robust growth in the farm sector driven largely by higher prices; 2) Unprecedented asset price reflation; 3) fiscal stimulus, led by growth in both central and state government expenditure; and 4) strong wage growth due to tight labour markets. All these four tailwinds are fading in varying degrees. Thus, we believe that the recent trend of moderation in consumption is not just a blip but reflects a cyclical slowdown in consumption after a robust upcycle. Accordingly, we expect the consumption growth momentum to remain soft for the next couple of years. With consumption slowing and capex remaining weak, near-term GDP growth will remain sub 6% Slower near-term growth: A key result of the slowdown in consumption is slower near-term growth. The investment cycle remains sluggish and with consumption moderating, both the engines of the economy will see sluggish growth. Accordingly, we now expect GDP growth in FY14 to be a modest 5.4% as against our earlier expectation of 6%. The acceleration in GDP vis-à-vis FY13 is largely attributable to higher growth in agriculture, assuming a normal monsoon this year as against a deficient monsoon last year. GDP growth will thus remain sub 6% for the second consecutive year. Figure 8: Real GDP growth will remain near 1yr low for the 2 nd consecutive year (YoY%) 1. Real GDP growth FY1 FY2 FY3 FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14ii Source: CMIE, IIFL Research 5

8 Two key macro stress points will correct: Robust consumption demand in an environment of limited or no capacity creation was one of the key reasons why inflation and the current account deficit remained elevated despite the moderation in growth. However, with consumption demand expected to slow down sharply, we believe both inflation (especially CPI) and current account deficit will come off over the next few quarters. Accordingly, we expect CPI inflation to come off 2-3bps from its current level of more than 1 by the end of FY14. Similarly, we expect the current account deficit to moderate from ~5% in FY13 to ~3.5-4% in FY14. The recent decline in commodity prices, especially oil and gold will obviously also help lower both inflation and the current account deficit. The moderation in both inflation and current account deficit will allow the RBI to cut rates more aggressively than its current guidance suggests. Thus, we expect another 75bps of policy rate cuts through the course of FY14. Lower inflation, current account deficit and interest rates are necessary, though not sufficient by themselves, for an eventual recovery in growth rates. Thus from a medium-term perspective, we view this moderation in consumption as a necessary adjustment for the eventual recovery in the economy and the investment cycle. 6

9 Farm price inflation to moderate The biggest driver of rural prosperity in the past few years was the revival in the farm sector. Farm output growth increased sharply, rising above the long-term average. However, a sharp increase in prices was the real driver of this acceleration. This drove the fastest increase in farm incomes in almost two decades. On the flipside, there is no evidence of an across-the-board increase in farm productivity. Instead, what is visible is that, higher prices have made farming more profitable in the states with lower productivity even as farm output growth has decelerated in the more productive states such as Punjab and Haryana. However, in our view, this pace of increase in farm prices is unlikely to sustain. Firstly, with the imminent enactment of the food security bill, Government of India s (GoI s) focus will shift away from increasing MSPs to expanding coverage of the food security bill and containing subsidy. Secondly, non-foodgrain food inflation has already moderated sharply, reflecting a combination of increased supply response and lower demand. Although we do not expect farm inflation to return to its decadal lows of 2-3%, we believe it will certainly be lower than the double-digit inflation in the recent past. This will significantly reduce one of the key tailwinds for rural incomes and thus, rural consumption. Agricultural growth has been above average in the last few years, a sharp improvement from early 2s Sharp recovery in agricultural growth: Agricultural growth in India has been strong over the past few years despite the vagaries of monsoon (the 29 drought was the worst in more than three decades). During FY7-12, average real growth in the agricultural sector was 3.6% pa, significantly higher than the average five-year growth in the past four decades of 2.8%. In contrast, in the preceding decade, average real growth in agricultural GDP was a mere 2.3% pa. Thus, the past few years have seen near doubling of real agricultural output growth relative to the first half of last decade. The last time real agri growth was this high was in the mid- 199s (FY93-97). Figure 9: Real agriculture growth has been fairly strong in the past few years (5yr Cagr) (1.) FY7 FY72 FY74 FY76 FY78 FY8 FY82 FY84 FY86 FY88 FY9 FY92 FY94 FY96 FY98 FY FY2 FY4 FY6 FY8 FY1 FY12 Source: CMIE, IIFL Research Real agri GDP growth median Sharp reduction in variability of output: Along with acceleration in agricultural output growth, the sharp reduction in volatility of output has been another positive for the farm sector. Until the early 7

10 Volatility in Agri GDP growth has decelerated sharply, despite erratic monsoon 2s, farm output declined YoY for at least 3-4 years (sometimes even five) on an average every decade. This was largely due to vagaries of the monsoon. However, the past few years have seen the farm sector become far more resilient to weather fluctuations. In the last decade (FY3-12), farm output declined in only one year (in FY3). Given Central Statistical Organization s (CSO s) advance estimate of 1.8% growth in real agri GDP in FY13 (despite belownormal rainfall), this will be the first block of 1 years (FY4-13) during which farm output will not have declined even for a single year. Even a statistical measure of volatility such as the standard deviation suggests a sharp reduction in farm output variability: the rolling 1-year standard deviation of farm output growth is expected to decline to an all-time low in FY13. Figure 1: FY13 will be the first block of 1 years without a single year of output decline Agri GDP rolling 1yr number of years with ve growth FY61 FY65 FY69 FY73 FY77 FY81 FY85 FY89 FY93 FY97 FY1 FY5 FY9 FY13 Source: CMIE, IIFL Research Figure 11: Volatility in agri output is also at an all time low Agri GDP growth rolling 1yr standard deviation FY61 FY65 FY69 FY73 FY77 FY81 FY85 FY89 FY93 FY97 FY1 FY5 FY9 FY13 Source: CMIE, IIFL Research Historically, high volatility in agriculture has made farmers risk averse, impacting their consumption/savings behaviour. A few good years would inevitably lead to a year or two of sharply lower output and lower incomes. Hence, reduced volatility would have changed the farmer s mindset since he would expect good years to be followed not by bad years but just average years. FY1 is a good case in point: even though the year witnessed among the worst droughts since Independence, farm output actually grew modestly. Historically, such a bad monsoon would have led to high-single-digit decline in farm output. Capital productivity in the agriculture sector has declined However, capital productivity in agriculture has decreased significantly: Capital intensity of agriculture has increased significantly in the past few years. This is largely due to constant acreage of land, declining number of people involved in agriculture, a sharp rise in cost of farm labour, and increasingly erratic monsoons. The share of fixed capital formation in agricultural value added, which was stable in the first four decades post independence at around 8%, has more than doubled to 19% during the last decade. In absolute terms, fixed capital formation in agriculture grew at 7% Cagr in real terms during FY92-12, as against a mere 2% Cagr in the preceding 2 years. The bulk of the increased investment has come from the private sector and this reflects the significantly higher demand for farm equipment, which substitutes increasingly expensive farm labour. Tractor sales, for example, increased at 1 Cagr during FY2-12 as against just 4% Cagr during FY

11 Figure 12: Fixed investment in agriculture sector has increased Figure 13: Agriculture has become more mechanised 25% Gross fixed capital formation as % of agri GDP 6 Domestic tractor sales (') % % 1 FY52 FY57 FY62 FY67 FY72 FY77 FY82 FY87 FY92 FY97 FY2 FY7 FY12 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY FY1 FY2 FY3 FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 FY12 Source: CMIE, IIFL Research Source: Industry, IIFL Research However, the acceleration in real growth in agriculture has not kept pace with the increase in fixed capital investment. Thus, capital productivity of the sector has actually declined sharply. Incremental Capital Output Ratio (ICOR) for the sector increased from 3 in the 199s to 5 currently. Agricultural output growth should have been almost 8bps higher over the past decade than it actually was for capital productivity to have remained at the level of the 199s. Figure 14: Capital productivity in agriculture has decreased; ICOR has increased 8 Agriculture sector ICOR (1yr rolling) FY82 FY84 FY86 FY88 FY9 FY92 FY94 FY96 FY98 FY FY2 FY4 FY6 FY8 FY1 FY12 Source: CMIE, IIFL Research What this clearly brings out is that agriculture has hit the stage of diminishing returns to scale where significant increase in fixed capital investment is required for marginally higher growth. States with lower farm productivity are catching up with states like Punjab and Haryana, which have high productivity Catch-up behind the faster growth in agriculture GDP: Productivity catch-up rather than an increase in overall productivity has been a key driver of agricultural growth in the past few years. Thus, high productivity states such as Punjab and Haryana have actually seen slower growth in their farm sector whereas states with relatively lower productivity levels have seen significant acceleration. Thus, over the past five years, real agriculture GDP growth in states with low farm productivity such as Rajasthan and Madhya Pradesh has averaged more than 6% Cagr, which is twice as high as in Punjab and Haryana. 9

12 Figure 15: States with lower productivity have recorded higher real agri GDP growth Real agri GDP growth (FY7 12 Cagr) Punjab Haryana Rajasthan Madhya Pradesh Source: Planning Commission, CMIE, IIFL Research Figure 16: Agri growth has increased in lower productivity states but decreased in high productivity states High productivity states Low productivity states 6. Agri GDP Cagr (%) Medium productivity states FY95 FY1 5 FY6 12 Source: Planning Commission, CMIE, IIFL Research Overall, according to Planning Commission data, real agriculture growth in low-productivity states has grown at more than 5% Cagr during FY6-12, almost 2.5x the growth in high-productivity states. This is a major deviation from the preceding decade when agri GDP growth was largely similar across the high and low productivity states. Further, this has happened even as growth in highproductivity states actually declined during FY6-12 to 2% Cagr from 2.5% Cagr during FY1-5 and ~3% Cagr during FY95-. This suggests that the driver of faster growth in the farm sector was higher prices, which incentivized farmers in laggard states to capture the low hanging fruit with regard to productivity by making higher investments, and thereby catch up with states that are more productive. However, the structural problems facing the farm sector mean that the more productive states, which do not have lowhanging fruit, have seen their output growth continuing to decelerate. Figure 17: Foodgrain productivity in laggard states has increased sharply over the past 1 years Figure 18: and so has oilseeds productivity 35% 3 25% 2 15% FY1 FY11 Foodgrain yield relative to Punjab & Haryana FY1 FY11 Oilseeds yield relative to Punjab & Haryana 1 2 5% Madhya Pradesh Maharashtra Rajasthan Madhya Pradesh Maharashtra Rajasthan Source: Government of India, IIFL Research Source: Government of India, IIFL Research This trend of productivity catch-up can continue in the near term, as productivity differentials remain large, especially in foodgrains. However, this is at least partly contingent on continued strong price gains, making investments related to productivity improvements profitable. 1

13 The Planning Commission notes the following with regard to enhancing the productivity in the already high productive states like Punjab and Haryana: The variation in performance across States suggests that State-level responses and implementation play a very significant role in determining agricultural performance. However, to the extent that available technology limits potential growth, it will be difficult to maintain high growth rates where productivity has increased close to potential levels. This is relevant because the Eleventh Plan strategy gave much greater flexibility to States and focused more on yield gaps within existing technology, rather than emphasizing new technologies and supporting these. The growth acceleration since 25 has therefore been much stronger in states with lower productivity and less irrigation. This suggests that the strategy may be correcting the past relative neglect which caused rain-fed farming, covering over 6 per cent of arable land, to perform well below potential. Given our view that price inflation in the farm sector is likely to be lower in the next few years, the pace of this catch-up will slow. Thus, real agricultural GDP growth in the lower productivity states is likely to be commensurately slower. Sustained price inflation: Another factor favouring the rural economy has been strong price inflation in the farm sector, despite the strong volume (real) growth. Average prices of farm products increased a little more than 11% pa over the past five years, almost twice the rate of inflation in the preceding five-year period. Farm price inflation in the last few years was close to all-time high Figure 19: Price inflation in farm sector has been near all time highs in recent years (5yr Cagr) Agri GDP deflator median FY7 FY72 FY74 FY76 FY78 FY8 FY82 FY84 FY86 FY88 FY9 FY92 FY94 FY96 FY98 FY FY2 FY4 FY6 FY8 FY1 FY12 Source: CMIE, IIFL Research Price inflation in the farm sector in the past few years has been inline with inflation in early 199s and is among the highest rates of inflation in the past four decades. Further, price inflation has been broad based with prices of all categories of farm output increasing significantly in the past five years relative to the preceding five-year period. Of the key categories, the minimum increase in inflation was in pulses (part of the protein basket) at 27bps. 11

14 Figure 2: Price inflation has been higher across all categories Price inflation, WPI basis (Cagr) Cereals Pulses Fruits & Vegetables Milk Eggs, Meat Fibres Oil seeds Source: CMIE, IIFL Research Farm income pie doubled in the past five years: Owing to stronger real growth and significantly high price appreciation, the overall farm income pie doubled in the past five years, growing more than thrice as fast as in the early 2s, when the overall farm income pie grew at just 4-5% Cagr. Indeed, growth in the overall pie of farm incomes (distributed over landowners and farm labourers) in the past few years has been close to its all-time highs. The last time overall farm incomes rose at this pace was in the early 199s. Farm income pie has doubled in the last five years Figure 21: Farm income pie has doubled in the past five years (5yr Cagr) Nominal agri GDP growth median FY7 FY72 FY74 FY76 FY78 FY8 FY82 FY84 FY86 FY88 FY9 FY92 FY94 FY96 FY98 FY FY2 FY4 FY6 FY8 FY1 FY12 Source: CMIE, IIFL Research Reduction in the number of people dependent on agriculture: Agriculture is the dominant sector in India as far as employment is concerned, although the share of people dependent on agriculture has gradually declined due to faster growth in other sectors of the economy. This trend is not new. However, what stands out is that for the first time, the number of people employed in agriculture has declined in absolute terms. Between FY5 and FY1 (the latest year for which data is available), the number of people dependent on agriculture declined by almost 22m (almost ~8%). In contrast, in the preceding five years, the number of people dependent on agriculture actually increased by ~24m. Although, admittedly, the number for 29-1 is slightly skewed by the severe drought, the trend of decline in the number of people dependent on agriculture was established even as early as in FY8. 12

15 Figure 22: Number of people employed in agriculture is decreasing (m) Number of people employed in agriculture Source: NSSO, IIFL Research Labour productivity in agriculture has increased as people have shifted to more productive sectors of the economy The past few years had a potent combination of sharply higher farm income growth coupled with fewer people with whom to share the pie. Consequently, on a per-capita basis, the annual value added in agriculture (nominal terms) increased 22 during FY5-1 as against just 16% increase during FY-FY5, a big jump. This reduction in the number of people dependent on agriculture is again a multi-year trend since growth rates as well as labour productivity in agriculture are significantly lower than the rest of the economy. Figure 23: Labour productivity in agriculture is extremely low Labour productivity relative to agriculture (x) Industry Services Overall Source: NSSO, CMIE, IIFL Research The above factors explain the sharp uptick in farm incomes over the past few years. However, we believe that this pace is unlikely to sustain in the next few years. Price increase is a key driver of real growth: In the case of commodities like farm products, it is quite intuitive to expect a phase of high volume (real) growth to lead to lower prices, and a phase of low volume (real) growth to drive higher prices. Although this is indeed true in the short term, this does not seem to hold from a medium-term perspective in India in case of farm products, at least in the past three decades. 13

16 Figure 24: Price and volume growth in agriculture are highly correlated (5yr Cagr) Real Agri GDP growth (LHS) (5yr Cagr) FY8 FY82 FY84 FY86 Agri GDP deflator (1yr lead) (RHS) FY88 FY9 FY92 FY94 FY96 FY98 FY FY2 FY4 FY6 FY8 FY1 FY Source: CMIE, IIFL Research Real output growth actually tracks price increases suggesting the stimulus of price increase is necessary for volume growth As the chart above shows, volume growth and price growth have shown a strong positive correlation in the past three decades with price growth actually leading volume growth. Thus, the past few years have seen above average volume (real) growth as well as significantly higher price increases. Even in the early part of last decade, when real agri GDP growth was sub-2%, price increases were in the low single digits. This implies that support from strong price inflation, with a small lag, stimulates growth and is necessary for strong volume growth. Thus, if price inflation were to moderate for some reason, then it would also lead to moderation in volume growth, creating a double whammy for farm income growth. MSPs have been one of the key reasons for high farm price inflation: A key reason for the sharp uptick in farm prices in recent years, apart from higher economic growth and the consequent higher demand, was the distortion caused by sustained increase in MSPs fixed by the government. The government fixes MSPs for procuring foodgrains to be distributed among the poor under the public distribution system. As the chart below shows, MSPs have increased by 1-2 Cagr during the past six years as against a modest 3-4% increase in the preceding five-year period. MSP increases, driven largely by political considerations, have been one of the key reasons for high farm price inflation Figure 25: MSPs have increased sharply in recent years Minimum support price, Cagr FY2 7 FY % 12% 8% 4% Rice Wheat Jowar Bajra Moong Urad Gram Source: CMIE, RBI, IIFL Research 14

17 Although cost of farming has certainly increased in recent times, a large part of the increase in MSPs was driven by political rather than economic considerations. Thus, in the current Rabi season, the Committee on Agricultural Costs and Prices (CACP, the body that suggests MSPs to the government) recommended no change in MSP for wheat. Yet, the government has raised the wheat MSP by Rs65 per quintal. As the chart below shows, there is a close relationship between domestic market prices of paddy and wheat and their respective MSPs fixed by the government. Thus, higher MSPs have pushed up the domestic price of these crops. Figure 26: Domestic prices of paddy and wheat Figure 27: are closely correlated with their respective MSPs 1,6 1,4 1,2 (Rs/quintal) 2, 1,6 (Rs/quintal) 1, 8 6 Paddy prices 1,2 8 Wheat prices 4 2 Paddy MSP 4 Wheat MSP Apr 1 Apr 2 Apr 3 Apr 4 Apr 5 Apr 6 Apr 7 Apr 8 Apr 9 Apr 1 Apr 11 Apr 12 Apr 1 Apr 2 Apr 3 Apr 4 Apr 5 Apr 6 Apr 7 Apr 8 Apr 9 Apr 1 Apr 11 Apr 12 Source: RBI, IIFL Research The sustained increase in MSPs has caused distortions in the farm sector Source: RBI, IIFL Research However, we believe that this sharp increase in MSPs has caused distortions in the farm sector by sending the wrong price signals. Firstly, government intervention in the market, largely through purchases of rice and wheat, has become too dominant, with procurement in both these crops having increased to at least a two decade high. Government today buys 36% of total production of rice in the country and 3 of wheat production in the country. This by itself distorts the market. Figure 28: Procurement ratio for Rice and Wheat is at highest in at least 2 decades 4 35% 3 Procurement ratio Rice 25% 2 Wheat 15% 1 5% FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY FY1 FY2 FY3 FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 FY12 Source: RBI, CMIE, IIFL Research. Note: Procurement ratio is proportion of annual production procured by the government for distribution under the PDS. Secondly, while the ostensible reason for this large-scale procurement is to distribute it through the PDS, in reality this objective has not necessarily been achieved. Thus, stocks of rice and wheat with the Food Corporation of India have increased three times in the past five years. Current stock of rice and wheat with the FCI is 15

18 almost thrice the buffer stock norm (including the strategic reserve) and exceeds 1 year s requirement for full compliance with the proposed food security bill (5 kilos of foodgrain per individual per month for ~67% of the population). In absolute terms, the level of foodgrain stocks in the country with FCI amounts to over 5 kilos per individual. Foodgrain stocks with FCI have tripled in the last 5 years Thus, on the one hand the government pays higher and higher prices to farmers to procure grains but on the other hand, it just stores a large part of its procured grain in godowns, where a part of it simply rots due to deficient storage facilities. This forces the poor to either purchase grain from the market or cut their consumption as domestic prices go up. Therefore, the procurement program does not necessarily meet its purported objective. Figure 29: Foodgrain stocks have tripled in the past five years Stocks with FCI, as of December of every year 4 (million tonnes) 3 Rice Wheat Source: RBI, IIFL Research Sharp increase in MSPs has significantly moderated the long-term trend of diversification of crops away from cereals Thirdly, due to the sharp increase in support prices of foodgrains, largely rice and wheat, the pace of diversification in farm output has moderated significantly. The long-term trend in agriculture was a gradual shift in production away from subsistence-linked crops such as foodgrains to more commercial crops such as horticulture and oilseeds. Thus, in the 15 years from 1991 to 26, the share of foodgrains in the value of agricultural output declined 7ppt (~2.4ppt per block of five years). This shift broadly reflects the increasing commercialisation of agriculture. However, post the mid-2s, this trend has moderated sharply with the share of foodgrains in overall farm output declining less than 1ppt over FY6-11. This slowdown largely reflects a quadrupling of growth in cereals output to 16% during FY6-11 from 4% during FY1-6 and a sharp drop in oilseeds production growth to 18% during FY6-11 from 47% during FY1-6 (in absolute terms). 16

19 Figure 3: Pace of crop diversification away from foodgrains has moderated Foodgrains Others 68% 71% 73% 75% 76% 32% 29% 27% 25% 24% Mar 91 Mar 96 Mar 1 Mar 6 Mar 11 Source: CSO, IIFL Research The slower pace of increase in output of non-foodgrain crops created a demand-supply mismatch in those categories pushing up their prices. On the other hand, the higher production of foodgrains did not lower their prices due to the increase in the MSPs. Thus, the sharp increase in MSPs has been a major distortion and is partly responsible for the high food inflation seen in recent times. Farm profitability to remain depressed Farm economics were attractive during most of the upswing seen in the agricultural sector from Profit margins had improved sharply, driven by significant increases in MSPs and market prices, compared to which input costs did not increase commensurately. However, in the past few years, farm economics appears to have deteriorated, as price increases and MSP increases lagged increases in input costs, especially of labour and fertilisers, which had escalated sharply. The consequent pressure on margins adversely affected farmer sentiment, leading to a pullback in farm spending on agricultural inputs. Figure 31: Growth in farm profitability has slowed from heady levels (Rs) 25, Wheat profit per hectare (LHS) YoY % (RHS) 8 2, 15, 1, 5, Source: CACP, IIFL research 17

20 Figure 32: and is likely to remain subdued near term (Rs) 4, 35, 3, 25, 2, 15, 1, 5, Paddy profit per hectare (LHS) YoY % (RHS) Source: CACP, IIFL research For the kharif marketing year (October to September), the Indian government increased paddy MSPs by a substantial 15-16%, which helped revive profitability to some extent. For the marketing year (which will begin in October 213), the recommended MSP is up only Rs6 per quintal to Rs1,31. Assuming that input costs increase at a more modest pace (due to declining fertilizer prices and slower growth in labour costs), farmer profitability should remain stable, but well below the peaks seen during FY8-1, implying a more subdued increase in purchasing power. In the case of wheat, the MSP has been increased by a modest 5% to Rs1,35 (despite opposition from the CACP, which recommends MSPs to the government), following a more substantial increase in the previous year. As in the case of rice, profit margins are likely to remain well below their cyclical highs. Besides, there are substantial inventories of wheat (and rice) with the government, which could potentially pose a mediumterm risk to the profitability of foodgrain cultivation. Current foodgrain production already exceeds expected demand in FY17 Pace of increase in MSP likely to moderate significantly, as foodgrain production already exceeds expected demand in FY17: We believe that the pace of increase in MSPs is likely to moderate significantly over the next few years. According to the Planning Commission, India s current annual production of foodgrains of 257 million tonnes is equal to India s projected demand five years hence in FY17. Thus, purely from an economic perspective, there is little economic rationale for further increase in MSPs to stimulate foodgrain output. Figure 33: Foodgrain production already exceeds demand in FY12 million tonnes Projected demand Production FY17 FY21 FY12 Rice Wheat Coarse cereals Pulses Foodgrains Source: Planning Commission, IIFL Research 18

21 Once the food security bill is passed, there will be little incentive for the government to continue to increase MSPs at a doubledigit rate Even politically, we believe it is unlikely that MSPs will continue to increase in the double digits over the next few years. Firstly, many state elections and the general elections will end by 1H 214 (at the latest) and thus the political urge for a sharp increase in MSPs will no longer exist thereafter. Secondly, post elections, the government s emphasis on fiscal consolidation and thus expenditure management will continue at least for the initial few years. With the imminent implementation of the food security bill (which has across-the-board political support and is considered a populist measure), the government s food subsidy bill is expected to increase significantly. This suggests to us that the government will have even less incentive to increase MSPs significantly since this will have a direct bearing on its food subsidy bill. Consequently, we believe that MSP increases for foodgrains in the next few years will be significantly slower than the double-digit increases of the past few years. Non-foodgrain food inflation has already moderated sharply: Inflation in non-foodgrain items, and in particular the protein basket, has been a key driver of overall food inflation post the global financial crisis. Thus, non-foodgrain inflation averaged 15-2 during FY1 and FY11. However, this has now moderated quite sharply to single digits in the past nine months. The moderation in non-foodgrain inflation has happened across most categories. Figure 34: Non foodgrain food inflation has already moderated to single digits (YoY%, 3mma) 3 Primary food ex foodgrains 25% 2 15% 1 5% Jan 7 Jun 7 Oct 7 Feb 8 Jun 8 Oct 8 Feb 9 Jun 9 Oct 9 Mar 1 Jul 1 Nov 1 Mar 11 Jul 11 Nov 11 Mar 12 Jul 12 Nov 12 Mar 13 Source: CMIE, IIFL Research Non-foodgrain primary food inflation has already more than halved and is in single digits Thus, barring fish, most other categories have seen moderate lowto-mid-single digit (or, in some categories, even negative) inflation. A combination of improved supply response and slowing demand has driven this sharp decline in inflation. With overall consumption growth as well as wage inflation starting to moderate, this trend is likely to continue over the next few years. From a more mediumterm perspective, our expectation of lower growth in MSPs will imply that the pace of farm output diversification will pick up again resulting in slightly higher output growth in crops other than rice and wheat. This should also have a benign impact on price inflation in this category. 19

22 Figure 35: Inflation across categories quite consistent, driven by economic cycle 2 16% Foodgrains Fruits & vegetables Milk Eggs, meat & fish (5yr Cagr) 12% 8% 4% Source: IIFL Research From a longer-term perspective, prices of all categories of food have generally moved in sync suggesting a common driver Non-foodgrain crop prices in India are generally correlated with global prices Another point worth noting is that in the recent past, prices of some categories of food such as eggs, meat, fish or milk had increased sharply. However, historically, over the past 25 years, prices of all categories have largely moved in sync. This suggests that while there could be short-term factors that can cause significant divergence in prices of different categories of food, in the mediumterm all categories have the same driver. In our view, the main driver is the overall demand environment in the economy, with monsoons and MSPs also acting as influencers. Outlook for global soft commodity prices is weak: Prices of foodgrains in India generally do not correlate to global prices due to the impact of government-set MSPs and restrictions on international trade during periods of high volatility in global prices. Thus, when global soft commodity prices increased sharply in 28, India imposed export bans on rice and wheat, preventing the transmission of international prices to India. However, in case of most other crops (e.g., corn, soybean and cotton), where international trade is relatively free, domestic prices do seem to correlate with international prices. Figure 36: India s cotton prices correlate closely with international prices 5, 4, 3, 2, 1, (US$/MT) Cotton International Cotton Domestic 1Q 21 4Q 21 3Q 22 2Q 23 1Q 24 4Q 24 3Q 25 2Q 26 1Q 27 4Q 27 3Q 28 2Q 29 1Q 21 4Q 21 3Q 211 Source: CACP, IIFL Research Figure 37: and so do domestic soybean prices 7 6 (US$/MT) Soybean International Soybean Domestic 1 1Q 21 4Q 21 3Q 22 2Q 23 1Q 24 4Q 24 3Q 25 2Q 26 1Q 27 4Q 27 3Q 28 2Q 29 1Q 21 4Q 21 3Q 211 Source: CACP, IIFL Research 2

23 Agricultural exports have increased 6x over the past decade In large part, this higher correlation in some commercial crops reflects rising agricultural exports from India. Over the past decade (FY2-12), Indian agricultural exports have increased six times (2 Cagr). The biggest export category is meat and marine products with exports of ~US$6.4bn followed by cotton at US$4.5bn and guargum at US$3.4bn in FY12. Cotton exports, in particular, were negligible as late as FY6 (just US$6m) and guargum exports picked up only FY11 onwards (~US$25m in FY1), driven largely by its use in shale gas exploration in the US. Thus, clearly, exports have also played a big role in supporting farm incomes. Figure 38: Agri exports have tripled in the past five years Figure 39: Composition of agri exports (US$ bn) Agricultural exports Agriculture exports composition (FY12, US$ bn) Sugar and molasses, 1.9 Oil meals, 2.5 Tea, Coffee, Spices, 2.7 Guargum, 3.4 Others, FY2 FY3 FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 FY12 Raw cotton, 4.5 Rice, 5. Meat, marine products, 6.4 Source: CMIE, IIFL Research Near-term outlook for global soft commodity prices is weak Source: CMIE, IIFL Research In the next couple of years, global soft commodity prices are expected to decline after a spike in the last couple of years due to weather related disruptions in many parts of the world. In corn and soybean for example, the US Department of Agriculture (USDA) expects prices to drop ~2-3 next year. In case of guar gum, prices have already collapsed 67% over the past year after having increased almost tenfold in the preceding year. Thus, support from external markets is also likely to wane over the next 1-2 years. Figure 4: USDA crop price projections (as of February 213) Commodity Unit E P P P P Corn $/bushel Sorghum $/bushel Soybeans $/bushel Cotton $/pound Raw sugar Cents/lb Wheat $/bushel Rice $/cwt Source: USDA, IIFL Research. Note: Marketing years beginning September 1 for corn, sorghum and soybeans, August 1 for rice and upland cotton, October 1 for sugar, June 1 for wheat. Overall farm income pie will grow 9-1 over the next couple of years, significantly slower than the 14-15% growth in the last few years Thus, overall, although we do not believe that farm prices will collapse sharply as in the late 199s and early 2s (when farm price inflation averaged a mere 2-3% for a few years), nevertheless, they will decelerate from the double-digit levels of the past 4-5 years. Even if farm price inflation returns to the long-term median, it will still amount to a 3-4ppt moderation in price inflation. This, coupled with prospects for slower volume growth (given the link between volume and price growth) implies that overall farm income growth would decline by 4-5ppt over the next 1-2 years. 21

24 Asset price inflation to cool off Unprecedented asset price reflation has been another of the key drivers of domestic consumption in recent years. Gold and real estate are the two biggest assets for households in India, across all income strata. Prices of both these assets have increased sharply in the last decade, especially in the past 3-4 years, far outpacing inflation. Apart from the psychological wealth effect, households have increasingly monetised these assets through either outright sale in case of property or mortgage in case of gold. Thus, there has also been a direct tangible impact on consumption. However, both these tailwinds to consumption are likely to moderate and turn into headwinds in the next couple of years. Consequently, to the extent these factors have been drivers of consumption, the absence of their support will hurt consumption growth. Average Indian household owns ~75 grams of Gold Large pool of household gold stock: Appreciation in gold price has been one of the key drivers of consumption demand in the past few years. This is due to the large stock of gold held by Indian households. Although it is difficult to get a precise figure on household gold stocks in India, the World Gold Council had estimated the stocks at 18, tons a couple of years ago (~2, tons today, after adjusting for gold demand in the past two years). This number is probably an under-estimation because cumulative demand in the past 15 years is about 12, tons. Assuming current household gold stock of 2, tons, this translates into gold holding per household of 75 grams or Rs.21, (US$39). Figure 41: Household gold stocks are currently estimated at 2, tons or ~75gms per household (tons) 25, 2, 15, 1, 5, Estimated household gold stock in India FY96 FY97 FY98 FY99 FY FY1 FY2 FY3 FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 FY12 FY13 Source: World Gold Council, IIFL Research Figure 42: India s annual gold demand has increased post financial crisis (tons) 1,2 1, Annual gold demand in India FY97 FY98 FY99 FY FY1 FY2 FY3 FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 FY12 FY13ii Source: World Gold Council, IIFL Research Gold holdings in India are widespread across households of all income strata Another point worth noting is that, not only is holding of gold in India large in absolute terms, it is also widespread across households of all income strata. In relative terms, households in lower income strata have a larger part of their assets in gold, compared with households in higher income strata that have access to organised financial intermediation. Thus, in most cases, the wealth effect from an increase in gold price is higher for households in the lower income strata than in the higher income strata. 22

25 Gold prices have tripled in the last 5 years Gold price appreciation has been a big source of support to household balance sheets: In INR terms, the price of gold has increased from an average of Rs5/1gms during the late 199s and early 2s to an average of Rs3,/1gms in FY13, constituting an increase of 2 Cagr over the past decade. The sharpest increase, however, occurred in the past five years when domestic gold price tripled, translating into 25% Cagr. During a large part of this period, international gold prices were stable or declined. However, the ~2 depreciation in INR in FY12 and FY13 more than offset the decline in international prices. Another point worth noting is that sustained appreciation in gold price and thus the consequent wealth effect is a recent phenomenon, as the chart below shows. Figure 43: Gold prices have appreciated sharply especially in the past five years (Rs/1gms) 35, Average domestic gold price 3, 25, 2, 15, 1, 5, FY96 FY97 FY98 FY99 FY FY1 FY2 FY3 FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 FY12 FY13 Source: CMIE, IIFL Research Gold price appreciation is a recent phenomenon. Throughout late 199s and early 2s, gold price was largely stable in INR terms In contrast, despite being elevated, inflation has averaged around 7.5% Cagr over the past 1 years (translating into doubling of price level) and 1 Cagr over the past 5 years, translating into 6 increase in prices in the past five years. Thus, as an asset class, gold has considerably outperformed inflation. In real terms, gold has generated returns of 13% Cagr over the past 5 years (11% Cagr over the past decade). In contrast, between the mid-199s and mid 2s, gold price was largely stable in nominal terms, implying negative real returns. Gold as an asset class has clearly seen an unprecedented appreciation in recent years. In contrast, bank deposits as well as stocks have generated negative real returns in the past 4-5 years. Not surprisingly, household demand for gold has seen an uptick, amplifying the wealth effect. Thus, domestic gold demand has increased sharply in the past few years, averaging ~9 tons over FY1-13ii after averaging ~65 tons over FY2-9. That said, it is worth noting that although gold demand increased in recent years, it is only modestly (~1) higher than demand in the late 199s and early 2s when India s annual gold demand had averaged ~8 tons. 23

26 Figure 44: Gold price appreciation has been a big support to household finances (Rs tn) 7 6 Increase in value of gold stock (RHS) (% of GDP) 15% 12% 5 9% 4 6% 3 3% 2 1 FY98 FY99 FY FY1 FY2 FY3 FY4 Value of household gold stock (LHS) FY5 FY6 FY7 FY8 FY9 FY1 FY11 FY12 FY13 FY14ii 3% 6% Source: World Gold Council, CMIE, IIFL Research. Note: Increase in value of gold stock is calculated as change in value of household gold stock at the start of the year due to change in gold price during the year. Increase in value of household gold holdings has averaged ~9% of GDP in the last 5 years Our calculations suggest that the total increase in value of household gold stocks in the past five years is about US$1tn at the current exchange rate. A large part of the increase has been due to increase in price of gold. Annual increase in value of gold stocks (excluding the impact of additions in that year) has averaged 9% of GDP in the past five years from an average of just 1% in the preceding decade. To put this in perspective, the total fiscal stimulus by the central government in FY9 in response to the global financial crisis was 4-5% of GDP (through a combination of tax cuts and increase in expenditure). In contrast, appreciation in gold price is almost twice as large, that too for five consecutive years. Therefore, even assuming that just 1 of this wealth effect has flowed into consumption, it still amounts to 1% of GDP pa. Thus, pure appreciation in gold price has significantly boosted household balance sheets and therefore consumption in the past few years. Households have monetised gold stocks: The impact of gold price appreciation on household balance sheets is not just limited to psychological valuation gain. Households have increasingly resorted to monetising their gold holdings, largely by mortgaging gold. As an example, the loan book of two of the largest listed gold loan companies has increased more than 15 times in the past four years (as against an increase in gold price of just more than 2.5 times). Figure 45: Households have monetised their gold holdings by mortgaging them (Rs bn) Source: CMIE, IIFL Research Loan book of Muthoot and Manappuram FY8 FY9 FY1 FY11 FY12 24

27 Although it is difficult to track precisely where this monetised value of gold has been deployed, it is reasonable to estimate that at least part of it has been diverted to consumption. Thus, there has been both direct and indirect impact of this massive appreciation in gold price on household finances and as a corollary, on household consumption. Gold prices have corrected sharply in recent weeks and at current prices, FY14 will be the first year in over a decade when gold prices will have declined Gold price support to household balance sheets is likely to wane sharply: Although it is difficult to forecast gold prices, it does appear that most of the appreciation in gold prices is behind us. Firstly, despite the announcements of quantitative easing by the US last year and Bank of Japan this year gold prices have remained flat or have declined. These events have generally been associated with a sharp increase in gold prices in the recent past. From their peak in 211, gold prices have declined more than 2 in USD terms. Second, the global economy seems to be gradually on the mend with no significant stress points either in the US or in Europe. Thus, it appears unlikely that gold prices will register the sustained sharp rise seen in the past few years. Therefore, the most likely outcome seems to be stable gold prices in the near term. Figure 46: Gold prices have started to decline even in INR terms (YoY%, INR terms) Gold price change Jan 7 Apr 7 Jul 7 Oct 7 Jan 8 Apr 8 Jul 8 Oct 8 Jan 9 Apr 9 Jul 9 Oct 9 Jan 1 Apr 1 Jul 1 Oct 1 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Apr 13 Source: CMIE, IIFL Research Even domestically, gold prices have declined ~1 in the past few months. YoY too, gold prices declined in April, marking the first YoY decline in six years. If gold prices remain stable around the current level (~Rs28,/1 grams) as seems likely, FY14 will be the first year in over a decade in which gold prices will have declined YoY. Thus, from being a tailwind for household finances, gold will act as a headwind in FY14. Clearly, one of the key supports to household consumption will also wane. Land prices have similarly seen unprecedented appreciation: Along with gold, the other big driver of consumption through the wealth-effect has been the sharp increase in property/real estate prices in the past few years. In the case of gold, Indians are simply price takers and thus have had little influence over the gold prices (and as such have been fortuitous). However, in the case of property, domestic factors have driven the entire uptick. Land prices across India have generally doubled in the last 3-4 years Although there is no precise data on property prices across the country, anecdotal evidence suggests that property prices have generally doubled in the past 3-4 years on top of the sharp increase during the high-growth years of Thus, in major cities, 25

28 Land prices in many tier-ii and tier-iii cities have increased 7-8x in the last decade prices have generally increased 4-6 times over the past decade. However, the price increase has been sharper in tier-2 and tier-3 cities and anecdotal evidence suggests that prices in most tier-2 and tier-3 cities have increased 7-8 times over the past decade, even outperforming gold (which is up six times). In real terms, thus, property prices have generally increased at 14-15% Cagr over the past decade and at 11-12% Cagr over the past 3-4 years in most tier-2 and tier-3 cities. Even in major cities where price appreciation has been lower, in real terms, prices have increased at more than 1 Cagr. Figure 47: Property price in Mumbai has increased ~4x in the last decade Figure 48: Property price in Gurgaon, on the outskirts of Delhi, has increased more than six times in the last decade Mumbai Residential Property price Index Gurgaon Residential Property price index Source: Industry, IIFL Research Source: Industry, IIFL Research Land prices in Bihar Bihar Telegraph India 21 st May 212 ( 962.jsp#.UUFH2kpy2S) Selling fertile land may be anathema to farmers, but tillers in Bihta are parting with their plots without much complaint. The land price in this small town 4km west of Patna has skyrocketed in the past few years because of the construction of a number of projects in the area, including Indian Institute of Technology (IIT), National Institute of Technology (NIT), Employees State Insurance Corporation (ESIC) Hospital and others. Sources claimed that in a few years, Bihta would be to Patna what Gurgaon is to New Delhi. At present, a cottah (1,361sqft) of land is priced between Rs 1 and Rs 15 lakh. A few years ago, it was available for only Rs lakh. Netaji Subhas Institute of Technology registrar Krishnamurari told The Telegraph: When our engineering college was set up in 25, 11 acres of land was purchased for Rs 44 lakh approximately, at the rate of 4.4 lakh an acre. Now, the market rate of the same plot is about Rs 6.5 crore per acre. Biada (Bihar Industrial Area Development Authority) is selling land at Rs 45 lakh per acre. The lucrative land price is common knowledge. A tea stall owner at Bihta Bazaar, Saryu Singh, said: Most of the land near the road (Patna-Ara highway) has been sold or acquired by Biada. 26

29 Asked if farmers willingly sold the fertile plots, Singh said: Earlier, we had to sell around 1 bigha land (around 2 cottah) to get our daughters married. Now, we can raise the same money by selling only 1 cottah. The Statesman 6 th May 212 ( view=article&id=4955&catid=35&show=archive&year=212& month=5&day=7&itemid=66) What do underworld figures do with their ill-gotten gains these days? Apparently, at least in Bihar, many of the gangsters and underworld dons have been investing heavily in the now booming real estate business. Such has been the boom that the price of land has shot up more than four-fold in the past few years, with apartments mushrooming in every nook and corner across the state capital. Now that there is scarcity of land, promoters are approaching landowners and convincing them to build apartments on their land after dismantling their homesteads. With no regulation, construction is taking place haphazardly all over Patna, and with high demand, there has been an alarming rise in property rates. Apartment flats which barely a few years back were available for a maximum of Rs 6 to Rs 7 per square feet are now being sold at a minimum of Rs 4, to 8, per square feet. Home ownership in India is high, and thus the impact of property price appreciation on household finances is broad-based Home ownership in India is not low: Further, contrary to popular perception, home ownership in India is not low. According to the 211 census data, home ownership is close to 95% in the rural areas and it has increased to almost 7 in urban areas. It is easy to argue that quality of housing, especially in rural areas, is inferior, and so the high ownership rate especially in rural areas does not really matter. However, the fact is that in 211, only 2 of rural households lived in houses with roofs made of grass, bamboo, or wood. The number was 28% in 21. Similarly, more than 5 of rural households live in houses constructed with bricks, stone, and cement. This indicates the fact that most rural households own houses of reasonable quality and value. Figure 49: Home ownership rate is very high in rural India Figure 5: Home ownership rate has increased in urban India 94.6 Home ownership rate Rural (%) Home ownership rate Urban (%) Source: Census of India, IIFL Research Source: Census of India, IIFL Research Real estate is thus the single largest asset class for most households, even larger than gold and significantly larger than stocks or bank deposits. Significantly higher inflation-adjusted returns from this asset have had a favourable impact on household finances and have played an important role in the consumption boom in the past few years. As is the case with gold, anecdotal evidence suggests that individuals have monetised their homes/land by either mortgaging 27

30 their property (loans against property have grown sharply in urban areas) or through outright sale in rural and semi-urban areas. Thus, apart from the psychological wealth effect, there has also been a tangible impact of property price increases on household finances. Low real interest rates and deeply entrenched expectations of sustained price appreciation resulted in property price appreciation in the last few years Low real interest rates and entrenched expectations explain the recent property price appreciation: The uptick in property prices during is not surprising, given the strong economic activity during that period. However, the sharp increase in the past 3-4 years, when economic activity has moderated sharply, is counter-intuitive. In our view, two factors explain this sharp growth: 1) sustained, high inflation and low real interest rates despite a tight monetary policy from the RBI; and 2) deeply entrenched expectations of further increase in property prices due to lack of other avenues to deploy savings, other than gold. Therefore, as in the case of most asset classes where fund flows generally track trailing asset performance, more money has flowed into real estate, creating a virtuous cycle in the short run. However, as stock prices showed in 27-8, this virtuous cycle, led by expectations, cannot continue forever. Indeed property prices in India declined in the late 199s, indicating the existence of cyclicality. In any case, it is difficult to argue that the recent strong price appreciation can continue ad infinitum. Figure 51: Consumer inflation has remained around 9 1 in the past 4 5 years (YoY) 18% 16% 14% 12% 1 8% 6% 4% CPI Industrial Workers Jan 8 Apr 8 Jul 8 Oct 8 Dec 8 Mar 9 Jun 9 Aug 9 Nov 9 Feb 1 Apr 1 Jul 1 Oct 1 Jan 11 Mar 11 Jun 11 Sep 11 Nov 11 Feb 12 May 12 Jul 12 Oct 12 Jan 13 Mar 13 Source: CMIE, IIFL Research Figure 52: Real interest rates have generally been negative in the past 4 5 years (%) Real 1yr bank deposit rate wrt CPI IW Jan 5 Aug 5 Mar 6 Oct 6 May 7 Dec 7 Jul 8 Feb 9 Sep 9 Apr 1 Nov 1 Jun 11 Jan 12 Aug 12 Mar 13 Source: CMIE, IIFL Research Land prices in Kerala Times of India 7 th February 212 ( 7/kozhikode/ _1_land-price-land-mafia-land-brokers) KANNUR: The fate of Kannur airport is uncertain but the dream merchants are betting big on the real estate. Ever since the project was announced, land prices have hit the roof in Mattannur town and its adjacent rural areas. Kerala Land brokers have sprouted in the region and some have even formed their own associations, which are affiliated to major trade unions. Recently a 2.5-cent plot of land was sold for Rs 1.25 crore in Mattannur town. This has made the people selling the land demand unrealistic prices of Rs 35 lakh to Rs 5 lakh a cent in the town. 28

31 "Even if you are willing to pay the quoted price, you may not be able to get the land," said a real estate agent who is also a small-time Congress worker. "The land mafia has fixed the price and the land is in the hands of a few people including some political leaders." The high prices, according to him, are a creation of the real estate brokers. In Keezhallur panchayat including Moorkhanparamba where the airport is coming up, the land price was as low as Rs 3,-Rs 5, a cent till a few years ago. Now it has touched an unrealistic Rs 1.5 lakh. Even before the land acquisition process for airport began in 27-8, the price rose to Rs 25,. Till 4-5 few years back, the land price on the sides of the panchayat roads at Kotheri, Kara-Peravoor, Elampara and other nearby places which are around 5 km from the proposed airport land, the price was around Rs.1,-Rs 15, a cent. Now the prices have crossed Rs 1.25 lakh a cent. Figure 53: Expectations of further increase in house prices are moderating (% of respondents) House prices will increase more than current rate Sep 8 Dec 8 Mar 9 Jun 9 Sep 9 Dec 9 Mar 1 Jun 1 Sep 1 Dec 1 Mar 11 Jun 11 Sep 11 Dec 11 Mar 12 Jun 12 Sep 12 Dec 12 Mar 13 Source: RBI, IIFL Research Real interest rates will inch closer to zero as inflation moderates Expectations of further increase in property prices is moderating In our view, although it is difficult to forecast property prices, it is reasonable to hypothesise that in the next few years, the pace of appreciation in real terms will at least be significantly lower than in the past few years. We expect consumer inflation to decelerate sharply from more than 1 currently to ~7% (based on the new series of CPI) by the end of FY14ii, with further declines likely in FY15. Nominal interest rates are unlikely to fall by this magnitude. Thus, after almost four years of remaining negative, real interest rates will inch towards positive territory over the course of the next few quarters. Hence, an important supporting factor for the sharp property price appreciation in recent times is likely to wane. More importantly, anecdotal evidence points to moderation in the pace of increase in real estate prices, at least in the major metros. This is bound to impact expectations, which are already showing signs of weakening. Once expectations about future price appreciation change, fund flows will be impacted, albeit with a lag, which in turn will hurt prices. Thus, over the next few quarters, we expect this tailwind for household finances and therefore for consumption to at least wane if not turn into a headwind. 29

32 Land prices in Goa Times of India 17 th November 211 ( 17/goa/34948_1_curchorem-land-prices-real-estate) PANAJI: Battered by mining they may be, but the twin cities of Curchorem and Sanvordem are witnessing rising levels of prosperity-if the spurt in trade and commerce coupled by a surge in real estate prices is anything to go by. Goa Business analysts are unanimous in their view that trading of mineral ore in this mining belt has largely, if not singularly, given rise to the nouveau riche class of society here. And if real estate sales figures are a measure of prosperity, the mining belt is riding on the wave of this newly-acquired disposable money generated through the mining trade, legal or illegal." Mining trade generates a lot of black money. As real estate is the only source which can absorb a lot of black money, the increased demand for investment in real estate has led to this situation where there has been an almost 5 rise in property prices over the last 7-8 years," a leading chartered accountant from Curchorem told TOI. He added that 2-25 of this rise was "fictitious" largely due to the black money factor. Expectations of mega-developments around Mopa made the land there rise up in cost 1 times more. In contrast, the land prices in mining areas have gone up only four times. This could be because the pollution, traffic jams and hazards here have made residents migrate westwards or invest in properties elsewhere," Kakodkar said. Nevertheless, the increased demand for real estate in Curchorem and the consequent spiraling of its prices there can be illustrated from the following instance. While an office space in a centrally-located place in Curchorem was priced at 8, per sq m in 24, hardly seven years down the line, offices in the building located in the same area are now being offered at a pre-construction rate of 45, per sq m. Land prices in Karnataka Times of India 21 st January 213 ( 21/bangalore/ _1_price-rise-secondary-cities-dharwad) BANGALORE: Land and real estate prices have increased ten-fold over the past seven years in tier II cities across Karnataka. Karnataka The demand is clearly noticeable as the developers and buyers are showing interest now in secondary cities. The preferred cities are Mysore, Mangalore, Hubli-Dharwad, Belgaum, Gulbarga, Shimoga and Davanagere. Realtors say that in tier II cities, a two-bedroom apartment of 1, sq.ft. is not available for anything less than Rs 3 lakh. On the outskirts, the same apartment is available for Rs 25 lakh. Likewise, house rents too have become costlier by 8-9 times compared to what they were six to seven years ago. Interestingly, these cities with a population of nearly 1 lakh, have shown an increase despite the factors that range from political developments, recession, rising bank rates to shortage of construction materials that greatly affect the prospects of real estate business. 3

33 "Yes, the real estate business is on the upswing and we are expecting things to get only better in the coming years," said Ramesh Shahbad, a realtor in Hubli-Dharwad. V Govindaraju, a senior officer at the Stamps and Registration Department, attributed the land price rise in secondary cities to availability of facilities like educational institutions, hospitals, entertainment centres and shopping malls. The government has also taken initiatives to provide infrastructural facilities particularly roads and sanitation. 31

34 Government spending growth to decelerate The sharp increase in government expenditure, both central and state, has been another key driver of consumption in the economy. Growth in both central and state government expenditure accelerated 6-7ppt to ~18-19% Cagr in the past few years. Revenue expenditure, rather than capex, drove this uptick. In the case of the central government, the increase in expenditure resulted in higher deficit; but in the case of the state governments, tax buoyancy due to higher inflation kept the fiscal deficit in check. However, we expect a sharp deceleration in government expenditure growth to ~11-12% in the next couple of years. The central government has already embarked on the path of fiscal consolidation by cutting plan expenditure and thus its expenditure has grown by a modest 1 in FY12 and FY13. State governments will see their tax revenue growth come off as nominal GDP growth has slowed sharply. We expect aggregate government expenditure to grow in line with or marginally below nominal GDP growth over the next couple of years. Thus, another driver of aggregate demand and in turn consumption is likely to wane. Central government s expenditure accelerated 7ppt in the three years post the financial crisis Central government expenditure increased sharply after the financial crisis: The sharp upswing in central government expenditure following the financial crisis has been a key driver of aggregate demand in the past few years. Aggregate central government expenditure increased almost 7 in the three years during FY8-11. It grew at 19% Cagr in nominal terms, as against just 12% Cagr in the preceding ten-year period. Relative to nominal GDP, central government expenditure grew ~3ppt faster during FY8-11, after having grown slower than nominal GDP in the preceding ten-year period. Even in real terms, central government expenditure growth accelerated ~2ppt during the three years after the financial crisis, compared with the preceding decade. Figure 54: Central government expenditure has accelerated post financial crisis Central govt expenditure Nominal GDP Inflation (CPI IW) (Cagr) 11.8% 12.2% 19.3% 16.1% 1.6% 5.3% FY98 8 FY8 11 Source: RBI, CMIE, IIFL Research. Note: Includes off balance sheet items, excludes expenditure on acquiring RBI s stake in SBI in FY8, which was fiscal deficit neutral, and repayments to National Small Savings Fund in FY3 5. Quality of expenditure was weak: Not only was growth in government expenditure higher after the financial crisis, the quality of expenditure was also weak. Thus, almost the entire uptick in 32

35 expenditure was due to higher revenue expenditure rather than increased capital outlay. The central government s revenue expenditure grew at 19% Cagr during FY8-11 as against a growth of just 13% Cagr in the preceding ten-year period. Although growth in capital outlay also accelerated, the acceleration was a modest 2.5ppt. Relative to nominal GDP, central government s revenue expenditure averaged 15% of GDP during FY9-11 as against an average of ~12% in the preceding decade. Quality of expenditure was weak as revenue expenditure dominated the increase in total expenditure Figure 55: Central government revenue exp. has increased faster than nominal GDP Central govt revenue expenditure (% of nominal GDP) 18% 15% 12% 9% 6% FY96 FY97 FY98 FY99 FY FY1 FY2 FY3 FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 Source: RBI, CMIE, IIFL Research Subsidies, decadal pay revision and farm loan waiver were three important contributors of increase in expenditure This increase in government expenditure coincided with the global financial crisis when domestic growth decelerated sharply. Although a part of the higher expenditure growth reflects the fiscal stimulus to revive the economy, a large part of the uptick purely coincided with the crisis and had nothing to do with fiscal stimulus: subsidies, farm debt waiver, and pay commission arrears are just three examples. Aggregate central government expenditure on subsidies increased from an average of ~1.7% of GDP during FY5-8 to 2.8% of GDP during FY8-12. Similarly, employee expenditure increased from an average of 1.8% of GDP during FY5-8 to an average of 2.9% of GDP during FY9-11. The increase in employee expense reflects the decadal revision of civil servant salaries and the resultant payment of arrears in FY9 and FY1. Similarly, the farm loan waiver was again entirely a political decision rather than an economic decision. Figure 56: Subsidies have been a key driver of exp. growth Central govt subsidy exp Rs bn (LHS) % of GDP (RHS) 2,5 5% Figure 57: and salaries have been the other key driver Central govt employee expense Rs bn (LHS) % of GDP (RHS) 2, 3. 2, 4% 1,6 2.5% 1,5 3% 1,2 2. 1, 2% 8 1.5% 5 1% 4 1. FY FY1 FY2 FY3 FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 FY5 FY6 FY7 FY8 FY9 FY1 FY11.5% Source: CMIE, RBI, IIFL Research Source: CMIE, CSO, IIFL Research 33

36 Acceleration in government expenditure boosts aggregate demand in the economy, especially consumption demand, if expenditure growth largely comprises transfer payments from government to households. Thus, the sharp acceleration in government expenditure during FY8-11 was one of the factors supporting the strong uptick in household consumption expenditure in recent years. Central government s revenue growth slowed down sharply post the financial crisis Higher expenditure funded through higher deficit: With revenue growth decelerating sharply after the financial crisis, partly reflecting tax cuts as part of the fiscal stimulus, central government funded this higher expenditure growth through an increase in its fiscal deficit. Total revenue of the central government grew at a modest 8% Cagr over FY8-11, almost half the growth rate in the preceding ten years and more than half the growth rate in total government expenditure. Accordingly, fiscal deficit of the central government, after having averaged just 4% of GDP during FY4-8, increased sharply and averaged over 6% during FY9-11. It is worth noting that the central government s fiscal deficit in FY9 of ~8% at GDP was the highest in more than two decades. Figure 58: Central govt s revenue growth slowed sharply (Cagr) FY98 8 FY % 1.3% % Figure 59: resulting in a sharply higher fiscal deficit (% of GDP) Central government fiscal deficit 8% 6% 4% 2% Total revenue Net tax revenue Non tax revenue FY FY1 FY2 FY3 FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 Source: Govt of India, RBI, IIFL Research Central government s expenditure growth has slowed to ~1 in last two years and it will remain weak in the next 1-2 years as well Source: Govt of India, RBI, IIFL Research Central government expenditure has already slowed sharply: This sharp widening of the central government s deficit was clearly unsustainable and raised worries about a downgrade of India s sovereign rating to junk status. As a result, the central government has had to embark on a path of fiscal consolidation in the past two years. Central government s fiscal deficit has thus declined from 6.1% of GDP in FY11 to 5.2% in FY13RE. This is partly attributable to the sharp deceleration in expenditure growth to single digits, nearly half the growth rate of the preceding three-year growth. This has certainly been a drag on aggregate demand in the past couple of years. However, we believe this drag is likely to continue for a couple of years more as the central government s fiscal consolidation process is not yet complete. As against 9bps reduction in fiscal deficit in the past two years, the central government has committed to a 16bps reduction over the next three years (3.6% of GDP by FY16). With tax revenue unlikely to be buoyant at least in the near term due to continued sluggish growth (we expect GDP growth to remain at ~5.5% in FY14), a bulk of the adjustment will have to happen through slowdown in expenditure growth. 34

37 Figure 6: Central govt has committed to significant decline in fiscal deficit by FY16 (as % of GDP) Central government fiscal deficit FY12 FY13 FY14 FY15 FY16 Source: CMIE, RBI, GoI, IIFL Research Although the government has budgeted for acceleration in expenditure growth this year to 17%, we expect actual growth to be closer to 11-12% since revenue growth is likely to disappoint budget estimates. For example, the government has already cut subsidy on petroleum and fertiliser, which will translate into reduction in overall subsidy expenditure in absolute terms. Similarly, employee expenditure will now grow in single digits since only a part of the salaries of government employees is linked to inflation. Thus, central government expenditure, and in particular revenue expenditure is likely to grow in high single digits during FY This will imply a sharp ~9-1ppt moderation in expenditure growth compared with the FY8-11 period (expenditure growth will also be 2-3ppt slower than the FY98-8 period). This will have a negative impact on overall consumption momentum in the economy. State governments have also seen their expenditure growth accelerate 6ppt in the last few years State governments have been a bigger contributor to the fiscal stimulus: An under-appreciated fact about the fiscal stimulus post the financial crisis is the contribution of the state governments. Thus while the focus of fiscal stimulus has remained largely on the central government, state governments have been an equal, if not bigger, contributor to the fiscal stimulus. Growth in aggregate state government expenditure was similar to growth in central government expenditure at 18% Cagr during FY8-12 and significantly higher than the ~12% growth in the preceding four-year period. Growth in state government expenditure in this period was the highest in any block of four years since at least the early 199s. Accordingly, state government expenditure, after having significantly undershot nominal GDP growth during the high-growth years of FY4-8 (by ~3.5ppt), grew faster than nominal GDP growth during FY8-12 (by ~2ppt). Even in real terms, expenditure growth of the state governments was modestly higher during FY8-12 compared with the preceding four years. 35

38 Figure 61: State government expenditure has also accelerated post financial crisis (Cagr) 2 Aggregate state government expenditure Nominal GDP 16% 12% 8% 4% FY92 96 FY96 FY 4 FY4 8 FY8 12 Source: RBI, CMIE, IIFL Research State government expenditure in aggregate is larger than central government expenditure and thus has a bigger impact on the economy The reason why state government expenditure is important is that in aggregate it is larger than central government expenditure; thus, its impact on aggregate demand is higher. Further, as state governments have far lower interest expense (due to lower debt) and no defense expenditure, their spending has a more significant impact on the economy. As the pie charts below show, aggregate state government expenditure (excluding union territories of Delhi and Puducherry) is ~5% higher than central government expenditure (for FY12). However, excluding expenditure items such as defence capex and interest payments, which have little impact on domestic demand, state government expenditure is ~25% higher than central government expenditure. Figure 62: Central govt expenditure composition Central Govt FY12 Total exp: Rs13,44bn Figure 63: State govt expenditure composition State Govts FY12RE Total exp: Rs13,678bn Interest, 2,732 Defence capex, 661 Others, 9,651 Interest, 1,513 Others, 12,165 Source: RBI, Govt of India, IIFL Research Source: RBI, IIFL Research Further, unlike the central government expenditure, which saw a big uptick in FY9 (~4 growth) and then a moderation to ~1 in FY12, state government expenditure has accelerated to over 2 in FY12RE, offsetting the sluggish central government expenditure. Anecdotal evidence suggests that expenditure growth of state governments was ~2 even in FY13. Thus, the combined fiscal impulse has remained expansionary in FY12 and FY13, despite the sharp moderation in central government expenditure growth. 36

39 Unlike central government expenditure growth, which has moderated in FY12 and FY13, state governments expenditure growth has remained strong Figure 64: State govt expenditure growth has remained robust even as central govt s expenditure growth has decelerated (YoY) 5 4 Central government State governments FY9 FY1 FY11 FY12 Source: RBI, CMIE, Govt of India, IIFL Research Quality of state governments expenditure growth was weak due to faster growth in revenue expenditure and moderation in capex growth Quality of expenditure remains weak: Further, just as in the case of the central government, what stands out is the inferior quality of the expenditure growth. Although at a headline level, developmental expenditure of state governments has grown faster than non-developmental expenditure, overall expenditure growth has been consumption oriented (dominated by revenue expenditure) rather than capacity building (capex) oriented. Figure 65: Developmental expenditure of states has grown faster (Cagr) 25% 2 15% 1 5% Development Non development Figure 66: But expenditure growth was still driven by revenue rather than capital expenditure (Cagr) 2 15% 1 5% Revenue Capital FY92 96 FY96 FY 4 FY4 8 FY8 12 FY92 96 FY96 FY 4 FY4 8 FY8 12 Source: RBI, IIFL Research Source: RBI, IIFL Research Thus, revenue expenditure of state governments has grown at ~18% Cagr during FY8-12, as against just under 12% Cagr in the four preceding years. Capital expenditure growth has actually slowed modestly in the same period. State government revenue expenditure, relative to GDP, has risen to an eight-year high of 13% in FY12 and is now higher than the past twenty-year average. This is in contrast to the preceding 8 years when capital expenditure grew significantly faster than revenue expenditure. 37

40 Figure 67: Revenue exp. of state governments, relative to GDP, is at a decadal high 14% 13% State government revenue expenditure (% of nominal GDP) median 12% 11% 1 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY FY1 FY2 FY3 FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 FY12RE Source: RBI, CMIE, IIFL Research As is the case with the central government, a large part of the uptick in expenditure is due to the impact of the decadal revision of salaries of state government employees from FY9 onwards. Employee salaries, which account for ~1/3 rd of the revenue expenditure of state governments, have more than doubled during FY8-12, as against a 55% increase in the preceding four-year period. However, even excluding salaries and wages, expenditure growth of state governments has accelerated in the past few years. Despite faster growth in expenditure, aggregate state fiscal deficit remains contained at just over 2% Figure 68: State government fiscal deficit has remained contained Fiscal deficit (% GDP) Central govt State govt 8% 6% 4% 2% FY6 FY7 FY8 FY9 FY1 FY11 FY12 Source: RBI, CMIE, Govt of India, IIFL Research However, fiscal deficits of state governments, unlike the deficit of the central government, have not widened owing to the rapid expenditure growth. This is due to strong tax buoyancy seen in the states, contrary to the scenario at the centre. Robust growth in state tax revenue as state government revenue is driven by nominal rather than real growth: State governments have been able to sustain this robust growth in their expenditure because of strong tax buoyancy. Despite this sharp increase in state government expenditure, aggregate state fiscal deficit remains extremely modest at just more than 2% of GDP and close to the all-time low of 1.5% of GDP in FY8. Further, in aggregate, state governments are running balanced budgets on the revenue account as against a revenue deficit of more than 3% for the central government. 38

41 Figure 69: State s own tax revenue growth has modestly accelerated despite slower economic growth, post the financial crisis (Cagr) 24% State tax revenue Share in central taxes Nominal GDP 2 16% 12% 8% 4% FY96 FY 4 FY4 8 FY8 12 Source: RBI, IIFL Research Revenue growth of state governments has moderated only modestly in the past few years (16% Cagr during FY8-12RE as against 19% Cagr during FY4-8) despite slowdown in overall economic activity and sharp slowdown in central government s tax revenues (which account for ~25% of state government s revenues). This was largely because of a slight acceleration in the state governments own tax revenues which account for 5 of their total revenues states own tax revenues grew 18% Cagr during FY8-12 as against 17% in the preceding four-year period. State governments tax revenues is driven largely by nominal GDP growth due to dominance of indirect taxes Figure 7: State tax revenue growth is driven largely by nominal GDP growth 3 (YoY) 25% State tax revenue 2 15% 1 5% Nominal GDP growth FY1 FY2 FY3 FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 FY12 Source: RBI, CMIE, IIFL Research A key difference between tax revenues of central and state governments is that state tax revenue almost entirely comprises indirect taxes whereas central government s tax revenue includes a 5+ contribution from direct taxes. Indirect taxes, by definition, are sensitive to value of activity and not just volume. In contrast, the pace of real activity in the economy drives corporate profit, the largest component of direct taxes. Thus, it follows that state government tax revenue is driven largely by nominal GDP. As the chart above shows, tax revenue growth of states has had a strong 77% correlation to nominal GDP growth in the past 12 years. Consequently, as nominal GDP growth has remained stable at ~16% in the past few years (until FY12), not surprisingly, state government tax revenue has not decelerated at all in recent years. 39

42 Figure 71: Taxes from petroleum sector have increased sharply (YoY) 3 25% 2 15% Tax/Duties on crude oil & petroleum products Figure 72: due to a large increase in their prices Average price in major metros (Rs/litre) Petrol Diesel % FY8 FY9 FY1 FY11 FY12 FY13ii. FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 FY12 FY13 Source: PPAC, IIFL Research Petroleum sector has been a key contributor to state tax revenues due to advalorem levy Source: Bloomberg, IIFL Research Petroleum products have been another big source of revenue for the state governments. Unlike the central government, which levies a specific duty on petroleum products such as petrol and diesel, state governments levy an ad-valorem duty. Thus, the sharp increase in prices of petroleum products has boosted state governments tax revenue, as the chart above shows. Over FY1-13, the prices of petrol and diesel increased 55% and 38%, respectively, supplementing volume growth of ~7% Cagr. Accordingly, revenue from the petroleum sector increased at ~2 Cagr over the past 2-3 years. Revenue from the petroleum sector now contributes ~1 of total revenue and ~2 of tax revenue of the state governments. Tax revenue growth of states will decelerate sharply: However, strong growth in state tax collections and in general state revenue is unlikely to sustain. Firstly, nominal GDP growth decelerated sharply in FY13 to a multi-year low of ~12% and it is unlikely to pick up in FY14. Secondly, inflation in petroleum product prices has decelerated sharply. Petrol prices, which are deregulated, have declined in the past couple of months and diesel prices are unlikely to increase more than 4-5% this year, given the modest pace of monthly increase of ~Rs.5/per month. Demand growth for retail fuels has also decreased sharply and will likely be sub-5% in FY14. As a result, we expect tax revenue growth of states to decelerate sharply from 18% Cagr during FY8-12 to ~12-13% Cagr over the next couple of years. Figure 73: Taxes, which will see slower growth, constitute over 7 of state government s revenues State government revenue composition (FY12RE) Own non tax revenue 9% Share in central taxes 23% Own tax revenue 48% Grants from central govt 2 Source: RBI, IIFL Research 4

43 Tax revenue growth of state governments will slow sharply due to slowdown in nominal GDP growth and moderation in petroleum sector inflation Tax revenue growth of the central government is also likely to remain sluggish at 1-12% due to continued sluggish economic growth. This implies that share of state governments in central taxes will grow at a commensurate pace. Thus, we expect overall state revenue growth to decelerate sharply from ~16% Cagr during FY8-12 to ~12% Cagr over the next couple of years. This should result in correspondingly lower expenditure growth ceteris paribus. That said, state governments have a cushion because their fiscal deficit (at 2.3% of GDP in FY12RE) is lower than the upper limit of 3% of GDP mandated by the finance commission. This provides them the flexibility to increase their fiscal deficit moderately by running higher growth in expenditure in the face of decelerating revenue growth. However, this flexibility is limited. Thus, to contain fiscal deficit within 3%, assuming revenue growth of ~13% during FY12-15, expenditure growth still needs to moderate to ~14% from ~18% during FY8-12. In our view, overall state expenditure growth will moderate ~4-5ppt over the next few years, resulting in moderation in aggregate demand in the economy. 41

44 Wage inflation pressures to subside Faster GDP growth was another driver of the consumption boom in the past few years. Unlike in the 199s, acceleration in growth was broad based with faster uptick in growth in economically backward states. Thus, a vast swathe of the poorest people in the country saw rapid increase in incomes. Although this is the structural growth story of India and will likely continue in the medium-to-long term, there is a cyclical element to it that will see moderation in the next 1-2 years. The strong growth resulted in tightness in the labour market and was one of the key factors driving up wage rates, which have grown in double-digit terms over the past 7-8 years. However, the sharp slowdown in the economy will result in softness in the labour market and increase in unemployment rate, as was the case during FY-3 when economic activity last decelerated sharply. Thus, another tailwind for consumption will turn into a headwind in the near term. Acceleration in GDP growth in 2s was fairly broadbased Robust and broad based GDP growth: India s GDP growth has accelerated significantly in the last decade from an average of 5.5% throughout the 198s and 199s to an average of 7.5% Cagr over the past 12 years, constituting an acceleration of ~2ppt pa over a 12-year period. However, more noteworthy than the acceleration in growth is the broad-based nature of this uptick. For example, the traditional backward states of Bihar (including Jharkhand), Uttar Pradesh (including Uttarakhand), Madhya Pradesh (including Chhattisgarh), Rajasthan, and Orissa (monikered BIMAROU states), which have historically grown 1-2ppt slower than all-india growth, have actually grown faster than all-india growth in the past few years. Real GDP growth in these states has almost doubled from ~4% between the mid 199s and mid 2s to ~8% over the past decade, slightly faster than the all India GDP growth rate. Figure 74: Real GDP in the economically backward states has grown faster than all India growth in recent years (Real GDP Cagr) 5.7% 6.8% 2.9% BIMAROU 5.3% All India 8.9% 7.9% 8.2% 7.1% Figure 75: Even in per capita terms real GDP growth in backward states has been faster (Real per capita GDP Cagr) 3.3% 4.7% 3.3% BIMAROU 5.9% 7.3% All India 6.1% 5.2%.1% FY94 98 FY98 3 FY3 8 FY8 13 Source: CMIE, CSO, IIFL Research FY94 98 FY98 3 FY3 8 FY8 13 Source: CMIE, CSO, IIFL Research The traditionally backward states saw their GDP growth nearly double to 8% in the last ten years from the preceding ten-year period This, coupled with a sharp slowdown in population growth (from ~2% pa to just 1.6% pa in the last decade), has meant an even sharper acceleration in per capita incomes. All-India real per-capita GDP has increased at 5.7% Cagr over the past 12 years as against an average growth of 3.5% in the 198s and 199s. Average household incomes have doubled over the past 12 years in real 42

45 terms. Further, with population growth in the economically backward states having slowed more sharply than all-india population growth, even in per-capita terms, these states have seen faster real GDP. Thus, between FY3 and FY13, real per capita GDP in these economically backward states grew at 6% Cagr. In contrast, in the five years during FY98-3, real per-capita incomes in these states were largely unchanged. Figure 76: Population growth in the economically backward states has slowed sharply Decadal population growth Economically backward states (BIMAROU) 1.8% 2.1% 2.3% 2.3% 2.3% 1.9% Source: Census of India, IIFL Research India s per-capita GDP is inline with sub-saharan Africa s, but is growing significantly faster To put this in perspective, in per-capita GDP terms, India still ranks among the poorest countries in the world with per capita GDP of just around US$15 (FY12), broadly the same as in sub-saharan Africa. The backward BIMAROU states have per capita GDP almost 4 lower than the sub-saharan African average. However, per capita GDP growth in India has been more than thrice as fast as in sub- Saharan Africa, with the poorer states registering even faster growth. Therefore, if income growth for people living in such poverty has grown rapidly, it should come as no surprise that consumption in India has grown significantly over the past few years. Figure 77: India s per capita GDP is comparable to sub Saharan Africa s (US$) 2, 1,5 1, 5 Sub saharan Africa Source: World Bank, IIFL Research Per capita GDP All India Economically backward states Figure 78: India s per capita GDP is growing over 3x as fast as sub Saharan Africa s 7% 6% 5% 4% 3% 2% 1% Per capita GDP growth (26 11 Cagr) Sub Saharan Africa Source: World Bank, IIFL Research India This effectively is the classic and well-known structural India consumption story. Even if growth in India moderates to about 6-7% over the next decade, per capita incomes in real terms will still grow at ~5%, which will be more than 3x as fast as the growth rate in 43

46 sub-saharan Africa. India s per capita real GDP growth rate will even be faster than in South Asia, where income levels are much higher. However, while this tailwind is structural, it has a cyclical component as well. The cyclical component is turning into a headwind and will remain so over the next 1-2 years. Faster growth resulted in a tight labour market and pushed up wage rates Strong growth drove sharp increase in wage rates: Although data on labour market in India is patchy, the available data does suggest significant tightness in the job market until FY1-11 because of 5-6 years of ~9% GDP growth. Data from surveys done by the National Sample Survey Organisation (NSSO) suggests that structural unemployment rate in the economy in FY1 (latest period for which data is available) at 2.5% was at a multi-year low, implying an extremely tight labour market. Figure 79: Overall unemployment rate has trended down over the past few years Unemployment rate 4. Principal status Principal + subsidiary status % 2.6% 2.2% 2.7% 2.3% 3.1% 2.3% 3.1% 2.8% 2.2% % Source: NSSO, IIFL Research Similarly, the industrial sector has seen a big jump in employment levels. Employment in organised industries, after having remained largely flat between FY1 and FY5, increased more than 5 in the six years until FY11, the latest period for which data is available. Organised industrial sector saw 5 increase in employees between FY5-11 Figure 8: Number of employees in organised industry increased 5 over FY5 11 (mn) Number of employees in organised industry FY1 FY2 FY3 FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 Source: CSO, CMIE, IIFL Research Labour laws in India are rigid and are considered a major constraint for growth of the organised industrial sector. However, the fact is that majority of the employment in the country is in the unorganised sector for which labour laws are not very relevant. This makes the labour market extremely flexible and wage rates are in effect a direct 44

47 Wage growth picked up sharply post the financial crisis and was higher in rural areas than urban areas reflection of the state of the labour market. A sharp rise in wages would indicate a tight labour market, while a drop in wages would indicate a soft labour market. The limited hard data available on wage rates suggests that they rose rapidly in the past few years both in the organised and unorganised sectors. In the organised industrial sector, for example, average employee compensation increased in the double-digits over FY8-11 as against a ~5% increase during FY2-7. Further, wage growth was generally higher in rural areas, especially towards the end of the last decade, due to the impact of expansionary fiscal policies like NREGA and higher food inflation. Figure 81: Wage rate has increased sharply in recent years (Rs) Emoluments per employee (LHS) (YoY %) Growth (RHS) 15, 25 12, 9, 2 15 Figure 82: especially in rural areas (Cagr) Urban areas Rural areas 15% Organised Industrial sector wage growth 12% 9% 6, 1 6% 3, 5 3% FY1 FY2 FY3 FY4 FY5 FY6 FY7 FY8 FY9 FY1 FY11 FY2 5 FY5 8 FY8 11 Source: CSO, IIFL Research. Note: Calculated as total employee emoluments during the year divided by number of employees at the end of the year. Source: CSO, IIFL Research. Note left hand chart plots emoluments per employee while above chart only pertains to wages per worker and thus is not directly comparable to left hand chart. Rural unskilled wages have grown at 15-2 Cagr in the last few years as against 5% growth during Wages of unskilled labour in rural areas, for example, have grown at 15-2 Cagr during as against the preceding 5-6 year average of just 5% increase. These data points also corroborate our view that the labour market was extremely tight towards the end of the last decade. However, this tightness is largely cyclical and it reflects the backdrop of strong cyclical upswing in economic growth, which has already started to reverse. Figure 83: Rural wages have increased at a 2 Cagr in past four years Rural unskilled wage growth (male) 25 (YoY%) (5) Jan 2 Nov 2 Sep 3 Source: RBI, IIFL Research Jul 4 May 5 Mar 6 Jan 7 Nominal terms Nov 7 Sep 8 Jul 9 May 1 Real terms Slower growth will hurt the labour market: India s economic growth has slowed significantly in the past two years. From 9% in FY11, GDP growth slipped to just 5% in FY13 and according to our estimate, growth will recover only marginally in FY14ii to ~5.5%. Mar 11 Jan 12 Nov 12 45

48 From an average growth of ~8.6% during FY4-11, GDP growth will thus have slowed sharply by ~3bps to an average of around 5.5% during FY12-14ii. This is bound to impact the labour market both in terms of wage growth and the general employment level. During the last downturn in the late 199s, employment in organised manufacturing sector declined 1 Figure 84: Manufacturing sector had shed employees during the last downturn (mn) Number of employees in organised manufacturing sector FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY FY1 FY2 Source: CSO, IIFL Research. Note: Figure 8 plots employees in total organized Industrial sector while above chart plots only employees in the manufacturing sub sector for which longer data history is available. In the last downturn, when GDP growth slowed from 6.7% during FY94- to 4.6% during FY-3, the labour market experienced significant softness. For example, the number of employees in the organised manufacturing sector decreased by 1 over FY98-2. Similarly, NSSO s sample survey data suggests that the overall structural unemployment rate increased from 2.7% over to 3.1% over Not surprisingly, with softness in the labour market, wage growth also slowed significantly. Figure 85: Nominal wage rates broadly correlate to changes in unemployment rate 2 Nominal wage growth (Cagr) (LHS) Change in structural unemployment (ppt, RHS).5% 15%.2% 1.1% 5%.4% to to to % Source: NSSO, CMIE, IIFL Research Although inflation also moderated in that period, nominal wage growth decelerated more than the decline in inflation resulting in a wage growth decline even in real terms. Thus, all India average real wage growth decelerated from 3.6% pa during to to near during to Real wage growth again grew at ~3.5% during 24-5 to 29-1 and we expect wage growth to decelerate similarly, reflecting the sharp decline in the pace of economic activity. 46

49 Real wage growth had decelerated to near during the last economic downturn in the late 199s and early 2s Figure 86: During FY 5, when economic growth was weak, real wage growth was weak too 3.6% Real wage growth (Cagr) 3.4%.4% to to to 29 1 Source: NSSO, CMIE, IIFL Research Already, anecdotal evidence suggests that the labour market has started to soften significantly, especially in urban areas. For example, the information technology sector, the largest recruiter of skilled engineers in India, has not had to raise entry-level salaries for three years in a row. This suggests noticeable softening in the entrylevel job market. Constant nominal wages for three years has meant a significant decline (~25%) in real wages. Anecdotal evidence also suggests that wage growth in other sectors in urban India has not kept pace with inflation in the past 2-3 years, given the downturn in a host of sectors such as construction, engineering, and financial services. Labour market has already softened in urban areas, where wage growth has lagged inflation for a couple of years in many industries Although wage growth in rural areas remains relatively resilient, it is showing signs of moderation. Nominal wage growth for unskilled labour has moderated from more than 2 in 211 and early 212 to ~17% in early 213. This will moderate further as food inflation starts to moderate, assuming a normal monsoon. Further, given the fungible nature of the labour market, especially in less-skilled jobs, divergence in wage rate between rural and urban areas cannot sustain for long. We expect overall wage growth in rural areas to moderate significantly over the next few quarters both in nominal and real terms. This will also negatively impact consumption. 47

50 Notes 48

51 Published in 213, India Infoline Ltd 213 This research report was prepared by India Infoline Limited s Institutional Equities Research Desk ( IIFL ), a company authorized to engage in securities activities in India. IIFL is not a registered broker-dealer in the United States and, therefore, is not subject to U.S. rules regarding the preparation of research reports and the independence of research analysts. This research report is provided for distribution to major U.S. institutional investors in reliance on the exemption from registration provided by Rule 15a-6 of the U.S. Securities Exchange Act of 1934, as amended (the Exchange Act ). Any U.S. recipient of this research report wishing to effect any transaction to buy or sell securities or related financial instruments based on the information provided in this research report should do so only through IIFL Capital Inc ( IIFLCAP ), a registered broker dealer in the United States. 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