Will monsoon revive rural demand?

The rain gods, after two consecutive dry spells, have finally obliged. The monsoon is likely to be normal with a bumper agricultural output expected this year. However, the moot point is: Is this enough to turn around the fortunes of the rural economy? Though the Street certainly believes so, I have my doubts. The Street’s exuberance, perhaps, emanates from the strong rural recovery seen in FY11 and FY12 post a drought in FY10. In my view, this time around as well, a normal monsoon will undoubtedly help, but the macroeconomic context is pivotal for a full-blown rural recovery. I believe two key benevolent factors had aided the rural boom during the United Progressive Alliance (UPA)-2 regime, which unfortunately are missing this time around.

The rural boom commenced during UPA-1 and accelerated during the UPA-2 regime, while decelerating sharply over the past two years. The rural boom persisted, irrespective of the monsoon outcome, from 2006 to 2013. One of the primary reasons for this was the strong wealth effect, which more than compensated for the temporary income shortfalls (in poor monsoon years). Some may argue that rise in house prices, when used for residential purposes, should not materially impact consumption as the increase in net worth is only on paper. I disagree. Increase in net worth (even if it’s only on paper) does result in higher financial security, which in turn enables households to channelize a higher proportion of income towards consumption. There is ample literature on how wealth effects have boosted consumption in Western countries. This effect is likely to be even more pronounced in emerging economies such as India given low income levels. So, what drove the sharp spurt in wealth?

Wealth in the rural economy is predominantly concentrated in gold and property, with the latter cornering the lion’s share. Agriculture land prices rose manifold even in places where land productivity was not that high. The spillover effect of a sharp rise in urban land prices tends to affect rural areas and, moreover, rampant corruption further fuels the fire. Given that a lot of physical market transactions are executed in cash, property markets are an easy destination for black money. Farmers who dealt in thousands and lakhs were dealing in crores. This led to a sharp rise in the consumption of discretionary items.

However, over the past two years, the Narendra Modi government has cracked the whip on black money. This, in turn, has squeezed property prices in rural areas as well as liquidity, which is likely to persist for at least the next two to three years, thus adversely impacting rural sentiments.

Apart from the wealth effect, rural sentiments were strongly supported by income growth from 2005 to 2013. The income boom was primarily spearheaded by government policies, with global factors also providing support. First, benign government policies unfolded in the form of minimum support price (MSP), food stock management, farm loan waivers, spending in rural areas in schemes such as the Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS).

Over FY06-14, the compound annual growth rate for MSP was a robust 11% (2% in the previous five years). To ensure effective transmission of MSP hikes, the government procured very high stocks. In fact, even in a drought year (2009), the UPA government added more to its already overflowing food pile to ensure limited food supplies in markets, which in turn triggered a price rise. Though this resulted in high inflation, it boosted agri incomes despite the output shortfall. Additionally, there was a sharp ramp-up in government spending in rural areas as well. A bulk of this was in the form of entitlements such as farm loan waivers, food subsidy and MGNREGS. The cumulative result of all these measures was growth in rural incomes hovering in the teens for six consecutive years, irrespective of the monsoon outcome.

However, the Modi government has ushered in a regime change in rural India. The government’s modus operandi to boost rural incomes targets a productivity jump via higher spending on irrigation and agriculture rather than through sops like higher MSPs or subsidies. While these measures undoubtedly entail long-term benefits, the near-term impact is likely to be muted.

Second, even global factors had aided farm incomes dramatically during the FY06-14 period. Indian farmers made full use of the boom in international prices starting FY06. While international prices stabilized over FY11-14, rupee depreciation during this period compensated for the stagnating US dollar prices. The result was India’s net agri surplus jumping to 9% of agri gross domestic product in FY14 from 4% in FY06.

In contrast, over the past two years, global prices have caused ample pain. International food prices have plummeted on the back of a strong dollar. The problem was further compounded by persistent rupee appreciation relative to agri peers such as Europe, Brazil and Ukraine, resulting in Indian farmers being priced out in many agri commodities. Going ahead as well, global food prices are likely to remain subdued, given the excess global food stocks. This will be a drag on farm incomes.

Therefore, a normal monsoon will undoubtedly aid in alleviating rural distress. But, it is unlikely to spark a V-shape recovery, aka FY11, given subdued international food prices, eroding wealth effect and government policies, which are focused on eradicating black money. Hence, given the sharp rally in rural-oriented stocks, there is room for disappointment and perhaps caution is warranted in this space.

Vikas Khemani is president and chief executive officer, Edelweiss Securities.

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