Why consumption must slow down

GDP growth may get hurt too as a weaker currency and higher interest rates drag down consumption to bridge balance of payments deficit

Imagine a household that consumes Rs 100 but only earns Rs 80, and bridges the gap of Rs 20 by borrowing money or selling its assets. If for some reason its consumption grows to Rs 110 (say, for the purchase of a new cellphone or an increase in the price of some items), but income stays unchanged, unless it can get an additional Rs 10 of funding, the consumption is unsustainable. That, in essence, is the balance of payments deficit that India currently suffers: The excess of consumption over production, that is, the current account deficit (CAD) is now well in excess of the foreign capital inflows.

Credit Suisse currently estimates the deficit at $20 billion, but if the elevated monthly trade deficits of June and July were to persist, this number could double to $40 billion. Of the three moving parts -- consumption, production, and capital inflows -- only consumption is truly intrinsic and can be controlled by policymakers. Measures to boost exports and capital inflows are likely to have an impact only over the medium to long run.

How should one slow down consumption? There is no one perfect solution, and a mix of tools may be necessary. More than two-thirds of the increase in trade deficit over the past year has been due to crude oil, but if all $20 billion in import reduction was to be achieved by cutting oil imports (say, by raising taxes further on petrol and diesel), they would have to fall by more than 15 per cent, causing much collateral damage. Needless to say, this would be a politically risky move as well for the government. Another option is to slow down aggregate demand through higher interest rates or slower government spending: While this spreads the pain widely, and no one sector bears the bulk of the adjustment burden, this runs the risk of also slowing down sectors that are not necessarily driving the CAD expansion. A middle path between these two extremes is a weaker rupee, which attempts to spread the pain across all imports: If so, there would be 4 per cent drop for each. Local prices for most imported goods rise immediately if the currency weakens: Higher prices lower demand.

As the rupee has weakened, imported categories that form the bulk of India's imports like gold, stones, coal, metals, most fertilisers and agricultural commodities have seen increases in rupee-based prices. Among categories with large imports, only urea and old cellphone models have not seen price increases. For the most important category, crude oil, about a third of the demand that comes from plastics or industrial fuels, prices rise automatically. The remaining two-thirds is diesel, petrol, LPG and kerosene. The government has wisely allowed the impact of a weaker rupee to flow through to retail fuel prices: Higher prices at the pump become a headwind to demand growth for fuel as well as vehicle demand.

Illustration by Binay Sinha

With the rupee weakness persisting, the second-order effects are now showing up as product companies have started raising prices to pass through the increase in costs. Makers of cars, motorcycles, air-conditioners, televisions, and soaps and detergents have all announced hikes.

In a study of volume and price growth across consumption categories over the past decade-and-a-half, we found that 1 per cent increase in prices drives 1 per cent drop in volume growth, and vice versa. Cigarettes, for example, had 11 per cent price compound annual growth rate (CAGR) but no volume growth, while toothpaste had no price growth but 10 per cent-plus volume growth. The surge in volume growth reported by consumer companies after the GST rate cuts in November last year is partly explained by the lower prices that resulted. Using the same logic, the price hikes resulting from the rupee weakness are likely to slow volume growth.

This slowing of demand should drive the necessary correction in imports, and thence the balance of payments. Not much of substitution appears likely despite the improved competitiveness of domestic manufacturing after the currency weakness. As elaborated in earlier editions of this column, more than five-sixths of India's imports is due to a lack of availability (like crude oil, gold, metallurgical coal and copper), capability (cellphone, aircraft, defense equipment) or capacity (some chemicals; now steel may be headed this way again). That is, they are not substitutable, at least not in the near term.

A large part of India's export value-add also comes from categories like agriculture, textiles and leather, categories where global demand is not growing rapidly, and currency weakness can only help improve market shares, which generally take a while.

There are two key implications. The first is that with the reduction in demand driving the bulk of the adjustment, it may take a few quarters to bridge the $20-billion annualised deficit in the balance of payments, particularly as price transmission and behavioural changes take time. The second is that the adjustment would take a toll on economic growth.

In theory, a drop in consumption matched by a matching drop in imports should keep India's domestic output (as measured by GDP) intact. However, limiting the demand slowdown to only imported products is difficult, not only due to the difficulty in targeting demand for only those products that are imported but also as most end consumption items have both imported and locally produced components. Take for example a tube of toothpaste that uses plastic (where the starting raw material is imported crude oil): As higher prices slow down the demand for toothpaste, the locally produced inputs will also see a decline. 

While the year-on-year growth in GDP in the June quarter reached 8.2 per cent, it was on a low base, and the two-year compounded growth rate over the last five quarters is in a surprisingly narrow band of 6.8 to 7.0 per cent. The Indian economy is thus growing at the same pace that it has averaged over the past 25 years. But the worrying balance of payments deficit suggests that even this growth is becoming unsustainable, and the economy needs to slow down. Some structural adjustments may be necessary.

The writer is India Strategist for Credit Suisse