Will The Pay Commission Hikes Boost Consumption?

The Seventh Pay Commission has recommended an overall 23.6% increase in salaries of central government employees and the pensions of the retired central government employees. The total cost of this increase in 2016-2017 has been estimated at Rs 1,02,100 crore (as can be seen from the following table).


Source: Seventh Pay Commission Report

This increase of Rs 1,02,100 crore has led several analysts and economists to conclude that a consumption boom is on its way. As analysts at Kotak Institutional Equities point out in a research note: “We expect automobiles, consumer durables and real estate sectors to benefit from the largesse. Although current demand conditions are somewhat subdued in both the sectors, the additional funds in the hands of central…government employees should be a positive for volume growth.”

The logic is very simple. If the recommendations of the Pay Commission are accepted the salaries of the central government employees will go up. The pensions of the retired central government employees will also go up. They are likely to spend this money and this spending will benefit the car, consumer durables (refrigerators, washing machines, television etc.) and the real estate companies. QED.

The truth might actually turn out to be a little more nuanced than this. There is no denying that there will be spending and that spending will benefit the economy, but the question is how much?

It is important here to consider those working for the central government and those who have retired from central government, separately. Let’s take the retired lot first. The increase in their case works out to Rs 33,700 crore (see above table). The Pay Commission report points out that as on January 1, 2014, the central government had a total of 51.96 lakh pensioners.

The increase of Rs 33,700 crore will be divided among these pensioners. This works out to Rs 64,858 on an average (Rs 33,700 crore divided by 51.96 lakh pensioners) or around Rs 5,505 per month (Rs 64,858 divided by 12). A portion of this will be taxed (I have no way of estimating how much, given that there is no way of estimating what is the average rate of income tax that India’s pensioners pay).

While this increase is substantial it is not substantial enough to make a huge impact on consumption. It will have an impact on consumer durables sales and two wheeler sales. But I don’t think this increase for pensioners will have an impact on sales of big ticket items like cars or homes for that matter. Also, it is worth mentioning here that pensioners are not as big spenders as those employed, anyway.

Those working for the central government will see a total increase of Rs 68,400 crore (Rs 1,02,100 crore minus Rs 33,700 crore of pensions). A portion of this increase in income will be taxed. Again, I have no way of estimating how much, given that I couldn’t find any data on what is the average rate of income tax that India’s central government employees pay. In fact, I could have used the average rate of income tax paid by individuals as a proxy, but I couldn’t find that number either. (Though the average rate of corporate income tax is available and is shared with every budget).

Assuming that the average rate of income tax paid by India’s central government employees is 10.3% (10% income tax + 3% education cess). This would leave around Rs 61,355 crore (Rs 68,400 crore minus 10.3% of Rs 68,400 crore) in the hands of the employees to spend.

The Pay Commission Report points out that there are currently 33.02 lakh central government employees. This means that Rs 61,355 crore will be shared among them. It works out to Rs 1,85,811 for the year (Rs 61,355 crore divided by 33.02 lakh employees), on an average. This works out to Rs 15,484 per month (Rs 1,85,811 divided by 12).

This is a substantial increase and will have an impact on consumption. It will lead to more two wheeler sales, more consumer durables sales and more car sales as well. But I still have my doubts whether this will lead to substantially more sales in real estate. Perhaps in smaller towns, yes.

Also, it is important to see how big this increase is with respect to the overall size of the economy. The increase of Rs 1,02,100 crore will work out to 0.65% of the gross domestic product (GDP) in 2016-2017.  In comparison, the awards of the Sixth Pay Commission had worked out to 0.77% of the GDP.

Some portion of this increase will be taxed away. Some portion will be saved. I guess it is fair to say that around half to two thirds of this increase will be spent and that works out to around 0.33-0.43% of the GDP. While that is a substantial number, it is not very big in the context of the overall economy.

Also, analysts and economists who have been talking about a huge revival in consumption have the Sixth Pay Commission experience in mind. As Crisil Research points out in a research note: “Sales of automobiles (two-wheelers and passenger vehicles) increased significantly (25-26%) while consumer durables saw a growth of 2.5-3% bps in fiscal 2010 and 2011 after the implementation of the Sixth Pay Commission report.”

The major reason for this big boost in consumption was that the increased payments to central government employees was made in 2009 and 2010, even though it had been due from 2006 onwards. This time the increase is due from January 2016. Even if the payments are made from April 1, 2016, onwards, the arrears will be minimal.

As the Seventh Pay Commission report points out: “The awards of the previous Pay Commissions, both V as well as the VI, involved payment of arrears…However, Seventh Central Pay Commission recommendations entail, at best, payments of marginal arrears.”

Given that central employees will not be receiving bulk payments in the form of arrears, the impact on consumption will not be as much as it was the last time around. Also, sales went up in 2009 and 2010 because of a cut in excise duty and a huge drop in interest rates. Both scenarios are unlikely as of now.

Crisil estimates that: “The Seventh Central Pay Commission to boost sales of passenger vehicles and two-wheelers by 4-5% incrementally in fiscal 2017…Consumer durables, too, are expected to see additional growth of 1-1.5% in volume, while there could be broad-based growth in televisions, washing machines and refrigerators.” And that sounds reasonable.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on SwarajyaMag.com on Nov 21, 2015

Short-term crude forecasts are, well, crude forecasts

oilVivek Kaul

The only function of economic forecasting is to make astrology look respectable.” – John Kenneth Galbraith

In response to yesterday’s column a journalist friend asked “where do you see the price of crude oil heading in the days to come?”. A perfectly innocent question which does not have an easy answer.
First and foremost it is important to understand why the price of crude oil has fallen in the recent past. One explanation lies in the fact that the demand for oil has not risen at the same pace as it had in the past.
As Satyajit Das author of
Extreme Money writes in a recent research note titled Reverse Oil Shock: Weak demand contributes perhaps 30-40 percent of the fall. In 2014, oil demand grew by around 500,000 barrels per day, below the 1.3 million barrels growth projected earlier, reflecting weak economic activity in Europe, Japan and emerging markets, especially China.”
At the same time this slow increase in demand has been met with an increase in the supply of oil. With high oil prices, other sources of oil like shale oil in the United States and oil from tar sands of Canada, have also become viable. As Das points out: “
Increased supply contributes 60-70 percent of the decline. In a pattern reminiscent of earlier price cycles, several years of high prices and strong demand has encouraged new sources of oil supply to be brought on stream, causing the price to adjust.”
The production of US shale oil has gone up by 4 million barrels per day since 2008. This has led to a situation where the United States produces 9 million barrels per day of crude oil, only around a million barrels lower than Saudi Arabia.
Also, oil from other traditional oil producing countries like Libya has also hit the market in the recent past. Libyan oil production increased by around 800,000 barrels per day after the “reopening export terminals following a truce agreed between tribal militias in the civil war”.
To add to all this has been the decision of the Saudi Arabia led Organization of the Petroleum Exporting Countries (OPEC) not to cut production with the fall in oil prices, as it has done in the past. It needs to be pointed out that Saudi Arabia has been a swing oil producer in the past, where it has either increased or decreased its production to ensure that global supply of crude oil equals its demand.
But that hasn’t happened this time around as Saudi Arabia hasn’t cut production. Why is that the case? On the previous occasions Saudi Arabia cut production it ensured that crude oil prices continued to remain high and in turn, benefited other countries.
As Das writes: “In the mid-1980s, Saudi Arabia cut its output by close to 75 percent to support weak prices. The Saudis suffered a loss of revenues and also market share. Other OPEC members and non-OPEC producers benefited from higher prices. In recent years, Saudi Arabia has regained market share, benefiting from the disruption to suppliers such as Iran, Iraq and Libya.” And given this, the Saudis are not in the mood to hand over their market share to other countries.
Hence, they would rather hold on to their market share than cut production and sustain a higher crude oil price. Also, shale oil is expensive to produce and by driving down the oil price Saudi Arabia is trying to make the entire shale oil business unviable.
Niels C. Jensen writes in The Absolute Return Letter for January 2015 titled Pie in the Sky: “In effect, OPEC is trying to destroy the economics of this industry, which admittedly requires quite high oil prices to remain profitable. Only 4% of total U.S. shale production breaks even at $80 or higher. A high percentage of the industry breaks even with an oil price in the $55-65 range.”
Brent crude oil is currently quoting at around $50 per barrel. If crude oil continues to sell at $50 per barrel or lower, it is for sure that US shale oil producers will go bankrupt in the days to come. As Jensen puts it: “OPEC (with Saudi Arabia in the driving seat) may exhaust itself and decide that enough is enough, or it may go for broke – in this case it would want U.S. shale producers to go bankrupt and exit the industry forever which, we note, is quite likely to happen, should the oil price stay at current levels or lower for any extended period of time.”
The trouble here is that this assumes that the United States will sit back and do nothing. But as history has shown the politics of oil is never so straightforward. As I had pointed out in yesterday’s column the shale oil companies have been major job creators in the United States.
As analyst Jawad Mian points out in the Stray Reflections newsletter for January 2015: “It is undeniable that the oil and gas sector has become a key driver of US economic activity…It has been responsible for about 30% of the 10 million national increase in jobs since the global financial crisis.” Oil companies have been major job creators in the states of Alaska, Texas, Pennsylvania, North Dakota, Colorado, West Virginia, Wyoming, Oklahoma and Montana.
Given this, chances are that the US political establishment will not sit back and watch if shale oil firms start shutting down. “
It is now a highly political chess game and, as I have learned over the years, when politics enter the frame, logic goes out the window,” writes Jensen.
At the same time the shale oil firms are politically very well connected in the United States. This can be made out from the way the shale oil firms are allowed to operate. As Jeremy Grantham writes
in the GMO Quarterly Newletter for the third quarter of 2014: “There are few if any constraints, for example, on what chemicals and in what amounts, can be pumped into a fracking well. Nor is the leakage of methane (natural gas) from the drilling and pipeline operations seriously monitored despite the fact that methane is over 86 times as potent a greenhouse gas, at a 20-year horizon, as CO2 is.”
This demonstrates the “the remarkable influence of the energy industry over the U.S. governmental process, if “process” is not too dignified a word,” writes Grantham. Grantham is one of the most well respected fund managers in the United States. And given what he says, the shale oil companies must already be working the United States government to do something about Saudi Arabia driving down the price of crude oil.
At the same time the US benefits from low oil price as well. “A number of U.S.-antagonistic countries around the world (think countries like Russia, Iran and Venezuela) will be seriously weakened as a result of lower oil prices, which will strengthen the position of the U.S. in global politics,” writes Jensen.
Low oil price also benefits the US consumers given that they have more money in their pocket to spend on other things. As Das explains: “
Lower oil prices increase disposable income. The average US motorist spends around US$3,000 per annum on gasoline. US households may save around US$500 to US$600 a year. If this money is spent then it will boost growth. There are also indirect channels such as transport costs. It also affects agriculture, which is four to five times as energy intensive as manufacturing.”
Given this, it will be interesting to see how the US political establishment reacts to a fall in crude oil prices and that will to some extent determine where oil prices head in 2015, even though it seems that they will continue to remain low in the short term.
Further it is worth remembering that the price elasticity of crude oil is low especially in the short run. This means even a small disruption in supply can lead to oil price shooting up rapidly. As Das puts it: “The structure of the oil market entails fine margins between demand and supply. The current oversupply is around 2 million barrels a day, less than 2 percent of global consumption…Key uncertainties include weather conditions, unanticipated supply disruptions and geo-political factors.”

The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning on Jan 13, 2015

Consumption story: Mr FM, it’s about low inflation, not low interest rates

The finance minister P Chidambaram keeps asking public sector banks to cut interest rates. The assumption here is that because interest rates are high people are not buying things. Once banks start cutting interest rates and people start buying things, businesses will grow and the economy will be back on track again. But that is not the correct way to look at the current economic scenario.
In fact, in a piece that I wrote yesterday I had quoted a paragraph written by investment newsletter writer and hedge fund manager John Mauldin. As Mauldin wrote “The belief is that it is demand that is the issue and that lower rates will stimulate increased demand (consumption), presumably by making loans cheaper for businesses and consumers. More leverage is needed! But current policy apparently fails to grasp that the problem is not the lack of consumption: it is the lack of income.”
Mauldin wrote this with respect to the American economy, but it is equally valid for the Indian economy as well. When politicians ask banks to cut interest rates they assume that people are not buying things because interest rates are high, and hence they will have to pay higher EMIs.
This is partially but not totally true.
This belief does not take into account what Mauldin calls “lack of income”. In India, inflation has been fairly high over the last few years, particularly food inflation. What this has meant is that people have had to spend a higher part of their income on meeting their regular expenditure. This has meant lower savings.
aIn fact, a recent survey carried out by Assocham, found that household savings rates have dropped by a huge 40% in the last three years. “Poor households are unable to maintain the consumption levels at current prices while middle income families find their purchasing power erode fast, thus having far less surplus money,” Assocham Secretary General D S Rawat said on the results of the survey.
In fact, government own data, which is a bit dated, points out towards this trend. The household savings declined from over 12% of GDP in 2007 to under 9% in 2011. It would be safe to say that the savings rate would have fallen further since then.
Getting back to the ASSOCHAM survey, 82% of the respondents felt that their salary increments last year were not in sync with the cost of living, which has gone by nearly 40-45%. Given this, these respondents felt that they had to cut down on their standard of living by at least 25%.
All in all, what this means is that the increase in income over the last few years hasn’t been able to keep pace with inflation. What has also not helped is the fact that interest rates on offer on various kinds of deposits have barely managed to keep pace with the rate of inflation. A
s the Economic Survey of the government for the year 2012-2013, released in February pointed out “High inflation reduces the return on other financial instruments.”
In this scenario, where savings have gone down and income hasn’t gone up enough to keep pace with high inflation, it is difficult to expect people to buy things. If car sales haven’t grown for while, it is simply because people do not have enough money going around and do not feel confident about the future. It also explains why the consumer durables sector is not doing well.
On the flip side the two wheeler sales have remained robust. This was simply because rural wage growth was robust over the last few years. It was 9.3% in 2012 and 13.4% in 2011, after adjusting for inflation. In August 2013, the rural wage growth moderated to -0.1%. It will be interesting to see where two wheeler sales go from here, given that a large number of two wheelers are bought in rural areas.
Given these reasons, for the consumption story to start all over again, it is important that inflation is brought under control. For that to happen, the high government spending which has been the major reason for inflation needs to be reined in. As economist Arvind Subramanian wrote in a recent column in the Business Standard “A pre-condition, of course, is that fiscal deficits (actual not accounting, current not future), and especially spending, need to be brought under greater control.”
Only once that happens, will the consumption story start looking up again. Till then, we will have to unfortunately hear,Chidambaram ask banks to cut interest rates, over and over again.

The article originally appeared on www.firstpost.com on November 21, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)