India's consumption evolution

While just 5 per cent of the country's population can be classified as middle class today, this will grow to over 40 per cent by 2025.

India is poised for a dramatic expansion of domestic consumption that will make the country one of the largest consumer markets in the world. However, many voices in the country have expressed concern that this explosion of spending power will compromise India's ability to invest for the future. New research by the McKinsey Global Institute (MGI) finds that these fears are misplaced.

If overall economic growth remains on a long-term path of 7 to 8 per cent, as most economists expect, then consumption will soar. We estimate that real consumption will grow from Rs 17 trillion today to Rs 70 trillion by 2025, a fourfold increase. This will vault India into the premier league among the world's consumer markets. Today its consumer market ranks 12th. By 2015 it will be almost as large as Italy's. By 2025, India's market will be the fifth largest in the world, surpassing Germany. In short, we believe that India has now entered a virtuous long-term cycle in which rising incomes lead to increasing consumption which, in turn, creates more business opportunities and employment, further fuelling GDP and income growth.

Our results show that a significant expansion in consumption is not dependent on an equally significant decline in savings. There are three major factors driving increased consumption, by far the most important being rising incomes which we estimate will account for 80 per cent of the total growth over the next two decades. The second driver will be population growth which we find will account for a further 16 per cent of the overall rise in consumption.

The third factor will be savings but developments on this front will play a relatively minor role. We expect India's household savings rate to peak and gradually decline from its current level of 28 per cent of disposable income to 22 per cent in 2025 as India's demographics become more youthful. However, this change will account for just 4 per cent of future consumption growth. Even if household savings were to remain flat, consumption would still grow substantially.

The primary driver of India's growth as a consumer economy will thus be increasing incomes. Our analysis shows that average real household disposable income is set to grow from Rs 113,744 in 2005 to Rs 318,896 by 2025, a compound annual growth rate of 5.3 per cent. This is much more rapid than the 3.6 per cent annual growth of the past 20 years and, with the exception of China, much quicker than income growth in other major markets.

Income growth is, in turn, dependent on sustaining overall economic growth in the years ahead. We are optimistic on this front because of the substantial scope for Indian businesses to increase their productivity, the growing openness and competitiveness of the Indian economy and favourable demographic trends. Our income estimate assumes real compound GDP growth of 7.3 per cent a year from 2006 to 2025, an acceleration from the 6 per cent growth of the previous two decades but in line with most estimates of India's long-run sustainable growth path.

India's economic reforms and the increased growth that has resulted have already proved to be the most successful anti-poverty programme in India's history. In 1985, 93 per cent of the population had an annual household income of less than Rs 90,000""an income bracket we categorise as deprived. By 2005, this had dropped by about two-fifths to 54 per cent of the population. By 2025, we see the deprived segment shrinking even further to only 22 per cent of the total population.

Rising incomes will also create a sizeable and largely urban middle class. We define the middle class as spanning real annual household disposable incomes of Rs 200,000 to Rs 1,000,000. In 2005, the Indian middle class was still relatively small with 50 million people or some 5 per cent of the population. However, if India achieves the growth we assume, its middle class will swell to 583 million people or 41 per cent of the population. In addition, households with real earnings of more than Rs 1,000,000 a year, which we refer to as global, will comprise nearly 2 per cent of the population but earn almost a quarter of its income.

Widespread concern that India does not save enough and that investment will suffer if consumption becomes the driving force of the economy is not warranted, in our view. Negative comparisons about India's level of savings are usually made against China whose gross national savings rate has risen from 33.6 per cent in 1985 to 50.4 per cent in 2005""arguably too high a rate and driven by inefficiencies in China's financial sector. Against other high-saving countries such as South Korea and Japan, India's savings rate is actually relatively high.

The issue with Indian savings is not the trade-off with consumption but rather, the composition and total level of Indian national savings. National savings are made up of three sources: households, businesses and government. Indian households are among the most frugal in the world, saving even more than their Chinese counterparts. The slight decline in their savings rate that we predict would merely bring them closer to levels seen in other fast-growing economies.

But India's businesses and government save far less than they should and this leaves the country's national savings skewed and heavily dependent on households. While India's services-driven economy has not been as capital-hungry as China's manufacturing-based one and household savings have been sufficient for the required investments so far, rectifying this imbalance offers the key to accelerating India's growth rate in future.

There are three issues that need to be addressed in order to rebalance the composition of Indian savings. First, as other MGI work has shown, reforming India's financial system will be critical to making the allocation of capital in India more efficient, increasing the depth of its capital markets and raising real returns in the economy, thus encouraging capital formation. Poor capital allocation coupled with India's heavy regulation of many industries continues to discourage the formation of medium- and large-sized enterprises. This leaves much of India's capital inefficiently tied up in small-scale, informal businesses and classified as household savings. Both the financial system and regulations on industry need to be reformed over time.

Second, the Indian government needs to play its part in maintaining fiscal responsibility and growing its own contribution to net national savings.

Finally, it will be important to acknowledge that FDI can also play a growing role in supplying India with investment capital and should be encouraged. While FDI is still modest relative to the size of India's economy (and dwarfed by the flows of FDI going to China and other parts of Asia), it has increased almost 18-fold from $315 million in 1992 to about $15 billion in 2006. We expect FDI to continue to increase significantly, especially if the regulatory and business environment continues to evolve in directions that welcome it.

Growth in Indian incomes and consumption will deliver substantial societal benefits with further declines in poverty and the growth of a large middle class. The good news for the long-term health of the economy is that India's growth as a consumer superpower doesn't depend on Indians saving less but rather on high overall growth continuing to translate into rising incomes. However, this positive outcome does depend on Indian businesses making their contribution by saving more and the government being fiscally responsible while continuing to reform the economy to ensure that India has sufficient capital to invest in its future growth.

Subbu Narayanswamy is a partner based in McKinsey & Company's Mumbai office and co-leader of McKinsey's consumer practice in India and Adil Zainulbhai is Managing Director "" India, McKinsey & Company