Macroeconomic policy debates in the recent months have primarily focused on two issues: arresting inflation and reviving investment, both being growth positive. While inflation has abated, surprising on the downside, the worry on investment revival continues to linger.

Notwithstanding government’s efforts to clear large projects, highly leveraged corporate balance sheets, large impaired assets with banks, and limited fiscal space suggest that the capex cycle will take some time to turn around. However, most analysts remain optimistic; their one-year-ahead GDP growth forecast for FY16 exceed 6%. The underlying presumption is that domestic consumption demand will sustain to bridge the negative output gap. How realistic is this assumption?

We focus on rural demand which constitutes a dominant segment of private final consumption (PFC) that contributes nearly 60% to expenditure GDP. The significance of rural demand can be assessed from the last NSSO consumer expenditure survey round (July 2011–June 2012), according to which the monthly per-capita consumption expenditure in rural areas increased at a compound annual rate of 16.7% against 15.6% in urban centres over 2007-08 to 2011-12. But recent domestic and external developments suggest that this segment is set to weaken quite considerably as its key drivers face significant headwinds.

We reckon five such drivers that boosted rural income and expenditure: (i) high minimum support prices for agriculture goods, especially those of cereals, that changed the terms of trade in favour of farm sector; (ii) increased trade or net export of farm produce; (iii) government spending on rural infrastructure; (iv) remittances from non-farm employment, especially construction activities (housing, real estate and infrastructure) that drew labour from farms; and (v) welfare spending from schemes such as the MGNREGA. The combined effect of these drivers lifted rural consumption expenditure growth at a faster pace that contributed significantly to overall GDP growth. What has happened to these drivers in recent times and what is their likely trend going forward?

Minimum support prices (MSP)

MSPs were increased above 10% on average for wheat, paddy and coarse cereals during 2005-06 to 2012-13; for pulses, the raises were higher, in the15% region. This turned relative price movements in favour of the farm sector: Food prices increased nearly 2.6 times in 2013-14 over 2004-05 vis-à-vis manufacturing prices that rose only 51%. Not surprisingly, steep hikes in farm support prices were singled out as the main culprit causing high food inflation, perhaps with some justification. This prompted the government to not only moderate MSP hikes for major cereals crops like wheat and rice to 5% in 2013-14 and below 4% in 2014-15 but also asked states not to pay any bonuses as well. Further, as domestic prices converged toward international prices, it’s very unlikely that future hikes would be significant.

Agriculture exports

Farm incomes also gained from increased trade. In the last two years to 2013-14, farm export growth was 42% and 16%, respectively; over a longer period, India’s agricultural exports increased six-fold from 2003-04 to $42.6 billion in 2013-14, helped by the global commodity price boom. However, agriculture exports now face falling international prices of cotton, rubber, sugarcane, corn, foodgrains and so on; indeed, many international prices, e.g. cotton, wheat, are ruling lower than domestic prices. In conjunction with export restrictions placed at various points on several items to contain domestic food inflation, income gains from this source were subjected to uncertainty and are now falling with poor prospects ahead.

Government spending on rural infrastructure

Government spending on rural infrastructure played a not inconsiderable role in driving rural demand; this touched a peak of 0.9% of the GDP in 2008-09 and 2009-10 and stood at 0.5% in 2011-12. On average, about 30% of this spending was on rural roads, which has significant multiplier effects, followed by rural drinking water and sanitation, rural housing, irrigation and electrification that also generate further growth impulses. Fiscal compression is resulting in severe spending cuts that eventually devolve upon capital expenditure of which rural infrastructure has been a significant component; this decline follows fiscal consolidation that started in October-December 2012, indicating the tapering impulses to rural demand.

Non-farm employment

Non-farm incomes rose from job opportunities created mostly in the construction sector. The average annual growth of construction sector works out to 4.8% from 2010-11 until last year, while it grew a robust 10.8% in 2011-12. About 45% of rural households were engaged in the non-farm sector in 2011-12, an increase of nearly 20 million households from 2004-05 levels. However, construction activity has failed to pick up in any significant way. While the clearances of pending projects has so far not moved to the implementation or commencement stage, residential construction activity is still affected from a dampened property market where unsold inventory stocks are piled up. Overall growth of the construction segment, which fell to 1.1% and 1.6% in the two years to 2013-14, has shown feeble pickup in the first half of 2014-15; the segment’s growth is 4.7% over a 2.8% growth in the first half of 2013-14.

MGNREGA

Finally, rural incomes were also supplemented with employment under the MGNREGA, which provided an average 40-50 days of employment per year to about 25% of all rural households, as per the India Rural Development Report 2012-13. Spending cuts upon MGNREGA are significant in the year; a funds-squeeze is resulting in allocations far lower than the demand for number of workdays projected by various states under the social security scheme as per reports. Against a budget allocation of R34,000 crore (outlay for the scheme was R33,000 crore in 2013-14), an amount of R20,722.77 crore has been released to states and Union Territories and for MGNREGA as recently disclosed to the Standing Committee on Rural Development.

At a macro level, all these drivers have combined to slow down rural income growth, and therefore expenditures, as the marginal propensity to consume is relatively higher for this segment of the economy. That these drivers have weakened is evidenced by the sharp decline in rural wages. As analysed above, three of these drivers were policy-driven and are unlikely to be reversed given the fiscal constraints in the near future. The other two drivers were because of the fallout of lack of domestic investment activities and weakening global commodity prices. One does not see any quick reversal in these trends as well.

Therefore, it should be fair to presume rural expenditure slowdown should be significant going forward if these trends persist. One must also note that rural indebtedness is now on the rise, which could further dampen consumption demand. On the flip side though, falling inflation should increase real incomes and boost purchasing power. But will this be a significant offset to other effects in an environment of high inflationary expectations?