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Next big spenders: India's middle class

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Throughout India's history, the vast majority of its people have lived in desperate poverty. As recently as 1985, more than 90 percent of Indians lived on less than a dollar a day. Yet India is poised to undergo a remarkable transformation. New research from the McKinsey Global Institute (MGI) shows that within a generation, the country will become a nation of upwardly mobile middle-class households, consuming goods ranging from high-end cars to designer clothing. In two decades the country will surpass Germany as the world's fifth largest consumer market.

The headlines of India's growth story are well known —after the country began reforming in the early 1990s, economic growth jumped to about 7 percent. It slowed in the late '90s but since 2002 has proceeded at a blistering pace, surpassed only by China among the world's large economies. Less well known is how this growth is reshaping the lifestyle of Indian families. MGI's research portrays a dramatic transformation that will touch Indians up and down the income pyramid, from the poorest rural farmer to the wealthiest IT entrepreneur. Companies that fail to understand the unique desires and tastes of the new Indian consumer will miss out on a half-billion-strong market that along with China ranks as one of the most important growth opportunities of the next two decades.

One of our most striking findings is how dramatically recent growth has reduced the numbers of the poorest Indians, a group we call the deprived. They earn less than 90,000 Indian rupees a year ($1,969 per household, or about a dollar per person per day), and include subsistence farmers and unskilled laborers who often struggle to find work. They can be found across India, from its isolated villages to its sprawling urban slums. Many depend on government-subsidized food to get enough calories each day. Since 1985, the ranks of the deprived have fallen from 93 percent to 54 percent of the population, as 103 million people moved out of desperate poverty and many millions more were born into less grim circumstances. When we factor in population growth, there are 431 million fewer deprived Indians today than there would have been had the poverty rate remained stuck at its earlier level, making India's economic reforms the most effective antipoverty program in its history. If growth continues at its recent pace, we expect a further 291 million people to move out of poverty over the next two decades. Most of these former poor will move into the class we call the aspirers, households earning between 90,000 and 200,000 rupees ($1,969-$4,376) per year. Aspirers are typically small shopkeepers, farmers with their own modest landholdings or semiskilled industrial and service workers. Their lives are not easy, but aspirers generally have enough food and might own items such as a small television, a propane stove and an electric rod for heating water. They spend about half of their income on basic necessities, and many of their other purchases are bought secondhand or in what Indians call the "informal economy." Over the next 20 years this group will shrink from 41 percent of the population to 36 percent, as many of them move up into the middle class.

The next two groups—seekers, earning between 200,000 and 500,000 rupees ($4,376- $10,941), and strivers, with incomes of between 500,000 and 1 million rupees ($10,941-$21,882)—will become India's huge new middle class. While their incomes would place them below the poverty line in the United States, things are much cheaper in India. When the local cost of living is taken into account, the income of the seekers and strivers looks more like $23,000 to $118,000, which is middle class by most developed-country standards. Seekers range from young college graduates to mid-level government officials, traders and business people. They enjoy a lifestyle that most of the world would recognize as middle class and typically own a television, a refrigerator, a mobile phone and perhaps even a scooter or a car. Although their budgets are stretched, they scrimp and save for their children's education and their own retirement.

Strivers, the upper end of the middle class, tend to be senior government officials, managers of large businesses, professionals and rich farmers. Successful and upwardly mobile, they are highly brand-conscious, buying the latest foreign-made cars and electronic gadgets. They are likely to have air conditioning, and can indulge in an annual vacation, usually somewhere in India.

The middle class currently numbers some 50 million people, but by 2025 will have expanded dramatically to 583 million people—some 41 percent of the population. These households will see their incomes balloon to 51.5 trillion rupees ($1.1 billion)—11 times the level of today and 58 percent of total Indian income.

The other major spending force in India's new consumer market will be our last segment—the global Indians, earning more than 1 million rupees ($21,882, or $118,000, taking into account the cost of living). These are senior corporate executives, large business owners, high-end professionals, politicians and big agricultural-land owners. Today there are just 1.2 million global Indian households accounting for some 2 trillion rupees in spending power. But a new breed of ferociously upwardly mobile Indians is emerging—young graduates of India's top colleges who can command large salaries from Indian and foreign multinationals. Their tastes are indistinguishable from those of prosperous young Westerners—many own high-end luxury cars and wear designer clothes, employ maids and full-time cooks, and regularly vacation abroad. By 2025, there will be 9.5 million Indians in this class and their spending power will hit 14.1 trillion rupees—20 percent of total Indian consumption.

As the seismic wave of income growth rolls across Indian society, the character of consumption will change dramatically over the next 20 years. A huge shift is underway from spending on necessities such as food and clothing to choice-based spending on categories such as household appliances and restaurants. Households that can afford discretionary consumption will grow from 8 million today to 94 million by 2025.

Long-established spending attitudes are already changing rapidly. Branded clothes are becoming de rigueur for the wealthiest Indians—Christian Dior, Louis Vuitton and Tommy Hilfiger already have a presence in the country. Gucci, Armani and Versace are on their way. For generations, Indians did their daily shopping at fresh-food markets and regarded packaged foods as "stale." However, just like their Western counterparts, a new generation of busy urban Indians is starting to appreciate the convenience and choice offered by packaged foods. Likewise, many Indians have traditionally viewed gold jewelry as a safer way to save than banks, but young Indians today are likely to see jewelry as a fashion statement, not a savings plan. They are also increasingly comfortable using credit cards —the share of Indians who carry plastic has quadrupled since 2001.

Of course, many of India's new consumers still have relatively modest means. Despite rapidly rising incomes, average spending will still lag behind countries such as Indonesia. Like China's, India's market will be based more on volume than on per capita spending. While luxury-goods makers may be able to sell to India's global consumers with little modification to their products, those selling to India's new middle class will need to be innovative to square the difference between the rising aspirations of consumers and their still-modest pocketbooks.

One such company is Tata Motors, India's leading auto manufacturer, which has announced its intention to introduce the world's first "one lakh" car. One lakh refers to the price, 100,000 rupees, or just $2,100. This will probably be the cheapest car in the world. Historically, a new car was out of reach of the vast majority of Indian households. But as incomes rise, car prices fall and financing becomes available to more people, a huge pool of pent-up demand will be released. In a tie-up with the State Bank of India, car manufacturer Maruti (majority-owned by Suzuki) is now offering customers the chance to buy one of its cars with lower monthly payments than if they were buying a motorbike. Over the next 20 years, we expect to see spending on cars growing by 12 percent per year. While more Indians will enjoy the freedom of their own transport, it's not hard to imagine the impact on the nation's environment and increasingly clogged roads. Affordability continues to be the hallmark of successful new consumer-product launches. In the household-products sector, an example of keen pricing is the $66 washing machine built by Videocon, the Indian consumer-electronics company. The Videocon washer was successful not just because it was cheap, but because its design was attuned to the needs of Indian families—for example, it will automatically finish a wash after one of India's frequent power outages—and it dropped costly standard features such as a drying cycle, which is unnecessary in India's hot climate.

Smart companies recognize that old consumer habits die hard. For generations, rural Indian families have either made their own clothes from bolts of cloth or had the local tailor make their garments relatively cheaply. Many remain suspicious of ready-to-wear clothes. Arvind Mills, India's leading denim manufacturer, overcame these misgivings by offering a "ready to stitch" jeans kit to local village tailors. It also distributed sewing-machine attachments for stitching the heavy denim and trained the tailors to use the kits. Within two months, more than a million of these Ruf 'n Tuf kits were sold.

India's shift to a consumer society will only accelerate as more people become "connected" via mobile phones, the Internet and TVs, and as advertising becomes a more prominent part of people's lives. Before India embarked on its program of economic reforms, the country had only 0.8 fixed telephones per 100 people, and virtually no mobile phones. While fixed-line penetration has almost tripled to 2.2 per 100 people, the real growth story has been in mobile, which has exploded and is expected to reach 211 million subscribers by the year-end. India's mobile market is currently growing even faster than China's, and we expect overall communications spending to continue to grow at a very rapid 13.4 percent per year over the next two decades. Other fast-growing categories will include transport, education and health care. It is testament to the determination of Indians to work for a more prosperous future that the highest priorities will be these "economically enabling" areas of spending that boost productivity and economic growth. Indeed, Indians will spend more of their disposable income on these categories than consumers in just about any other country. But the boost in private health-care spending, which we expect to double from 7 percent of all consumer spending today to 13 percent in 2025 (second only to the United States in percentage terms), also shows the weak underbelly of the nation's growth story. Despite the immense progress that India has made, the public sector—in particular, health, education and infrastructure such as roads and power—is in a desperate condition. Thus many Indians will spend their rising incomes to opt out of public services and go private unless those services improve.

While India's rising wealth will provide more resources to tackle these issues, its fast-growing population will stress its public services even further. India's success to date has been built on its human capital—a hardworking and increasingly educated population. If the country's growth is to continue, the reforms that have revolutionized its private sector will need to reach its notorious government bureaucracy as well. If this does occur, the dynamism of India's people will do the rest.

Farrell is director of the McKinsey Global Institute, McKinsey's economic research arm, where Beinhocker is a senior fellow.

This article originally ran in Businessweek.