Ultimate consumption bump | Value Research The Seventh Pay Commission may set the tone for higher salaries in the country, thus sparking consumption
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Ultimate consumption bump

The Seventh Pay Commission may set the tone for higher salaries in the country, thus sparking consumption

The Seventh Pay Commision is to submit its report by end August. After likely extension by a couple of months, its report may be delivered by end October and will be due for implementation in January 2016. This exercise of setting salary scales for central government employees is perhaps the largest of its kind in the world. The impact is far-reaching. Central government salaries are used as a benchmark for salary scales for state employees as well as public-sector companies. This changes fiscal numbers substantially. One estimate puts the salary bill for the central government, state governments and railways at $160 billion - over 8 per cent of the GDP.

Fiscal impact
Pay commissions are constituted once in ten years. However, before we assume that government employees are left stranded in the interregnum, dearness-allowance adjustments made every six months take care of price increases. Typically, every pay commission uses base salary and inflation increments accumulated over years as a new base and adds a dollop of increment to it. This increment can vary; the Sixth Pay Commission recommended an average increase of 35 per cent in salary levels.

Several commissions have attempted to suggest that increments should be coupled with performance incentives. This has never been accepted. Attempts to create performance benchmarks for government employees are by themselves contentious; and where implemented, end up at a level where almost everyone qualifies. At present, wage bill of the central government is 2.8 per cent of the GDP. States employ significantly larger number of people and their wage bills amount to 5.5 per cent of the GDP. In addition, there is another approximately 1 per cent that is spent by local bodies. In effect, direct salaries paid by governments amount to 9.3 per cent of the GDP.

Assuming the next pay commission will recommend the same level of increment as the last one did, i.e, 35 per cent, this would mean an overall impact of ~3 per cent of the GDP once the system has adjusted. This will put a serious pressure on government financials and fiscal deficits. The central government - which will be the first off the block to implement the next pay commission - will be faced with an incremental spend of almost 1 per cent of the GDP. When coupled with the increased transfer to states mandated by the finance commission, the fiscal consolidation promised over the next couple of years seems to be at risk.

Ultimate consumption bump

Demand multiplier
There is however a silver lining to this additional spend. Private-investment expenditure is not growing and will likely remain subdued till capacity utilisation increases. The government is focused on increasing capital spend on railways, roads and defence. Increase in employee salaries will present a fillip to consumption-driven sectors.

The previous pay commission was implemented in 2008 in a vastly different context. Due to a delay in implementation (it was due in 2006), payments were made with a retrospective effect, increasing the disposable incomes in employee hands by significantly more than the reported increase. This led to a sustained increase in consumption demand for a few years. Sales of cars and two wheelers surged and remained above trend for over two years. The global financial meltdown had led to loose fiscal policies and the government offered fiscal incentives to corporates to sustain growth. Sustained demand and loose policies led to entrenched inflation - the effects of which we are fighting till recently.

Ultimate consumption bump

Will history repeat?
There are many factors which can lead to a different outcome this time. The policies of RBI are fairly tight. We are witnessing high real interest rates after many years of negative real rates. The government has reduced its spend by economising on subsidies and attempting to reduce its fiscal deficit. Also, the pay commission report is likely to be implemented on time, so the effect of accumulated payments of 'backlog' pay will not be present.

Despite this, the effect of the report will still be high. A 30 per cent increase in salary bill represents $50 billion of additional disposable income. In addition, there is a likelihood of increase in loan eligibility for housing and vehicles. All this can provide a significant upside to consumer discretionary spend.

The market is already factoring this in. Maruti's high valuations but sustained attractiveness to investors can be put down to increase in demand for its cars expected at least in part from this source. However, there will be other beneficiaries. The estimated number of government employees earning over ₹1 lakh per month will likely go up by 500 per cent. That itself should create a market for residential real estate and kick-start the demand cycle for cement, paints, tiles, furniture, etc.

Market participants have been looking for higher earnings growth for corporate India. Thus far, it has proved elusive. With salary increases just round the corner, for once, expectations of better earnings in the next fiscal may not be belied.

Anand Tandon is an independent analyst.

This column appeared in the September 2015 Issue of Wealth Insight.

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