India’s sovereign rating fixation
The fifth-largest economy in the world has never been rated at the lowest level of investment grade in the history of sovereign credit ratings, noted the latest Economic Survey. It marshalled plenty of evidence to underscore that sovereign ratings do not capture India’s fundamentals. It has several factors in its favour. India has a history of zero default. India’s stock of foreign currency-denominated sovereign debt is very low. In fact, even non-government short-term debt is worth less than 20 per cent of foreign exchange reserves. Foreign exchange reserves worth over $580 billion provide added comfort and increase India’s ability to deal with external shocks. The fifth-largest economy has normally been rated AAA. China was another exception at this level.
To be sure, credit ratings depend on a variety of factors, including an element of subjectivity, and it is hard to claim that they always reflect the fundamentals. The ability of rating agencies to foresee risk was thoroughly exposed during the global financial crisis of 2007-08. They were again behind the curve a few years later when sovereign debt in Europe came under stress. Thus, the argument that credit rating agencies do not look at India objectively may well be correct. Interestingly, the 2016-17 Survey also highlighted the rating anomaly.
Should Indian policymakers be concerned about India’s existing sovereign rating?
Let’s consider the current economic situation. According to the revised estimates, presented in the Union Budget, the fiscal deficit at the Central level will expand to 9.5 per cent of gross domestic product (GDP) in the current fiscal year. The government aims to contain it at 6.8 per cent in 2021-22 and, according to the new glide path, the fiscal deficit will be brought down to 4.5 per cent of GDP by 2025-26. The earlier target of containing the Central fiscal deficit at 3 per cent of GDP is not being talked about anymore. Differently put, the combined fiscal deficit may remain above 7 per cent of GDP, at least till 2025-26.
Meanwhile, the public debt-gdp ratio is likely to go above 90 per cent in the current fiscal year and will remain elevated in the foreseeable future. The overall fiscal stance suggests a subtle change in policy thinking, with increased tolerance for deficit and debt, though it may partly be a result of the pandemic. But this could increase risks in the system. It is likely that the potential growth of the Indian economy has declined, partly because of the disruption caused by the pandemic.
As a result, despite having a favourable interest rate-growth differential, the public debt ratio might decline at a very slow pace. Notably, India’s general government debt increased from 67.4 per cent in 201112 to 73.8 per cent of GDP in 2019-20. Higher public debt will increase interest payments and affect growth-enhancing capital expenditure. For instance, the central government will be spending over 50 per cent of its tax revenue on interest payment in the next fiscal year. This is not to suggest that India can potentially default on any of its liability, but it is unlikely to be considered for a rating upgrade with the given macroeconomic backdrop.
In fact, a higher credit rating by itself will not improve the macroeconomic situation. It will only potentially increase the flow of foreign portfolio investment, particularly in debt. Global money managers are expected to invest in securities above a certain rating threshold. But does India need an increased flow of foreign debt capital? Perhaps not. As a matter of fact, excessive foreign flow in debt instruments could end up creating longer-term imbalances in the economy. The central bank has been mopping up the excess flow of foreign currency to avoid unnecessary appreciation in the rupee. Further increase in inflows could put upward pressure on the rupee and affect India’s external competitiveness. Continued intervention by the central bank will push up rupee liquidity, which could affect inflation outcomes. Foreign debt flows also tend to be more volatile.
That said, India must avoid the possibility of a downgrade. It will affect investor confidence and increase volatility in financial markets as happened in the past. Thus, the policy focus should be on strengthening macroeconomic stability and improving the longer-term growth outlook. The existing credit rating is not a constraint in this context. It is not stopping India from improving ease of doing business and attracting long-term investment. In terms of fiscal management, India tends to run a large general government deficit. It’s a real constraint for economic management and longer-term sustainable growth.
India’s tax-gdp ratio is not only low compared to other emerging and advanced economies, but has also not improved over the years. India needs a revised fiscal policy road map with measures to increase revenues. This will help India’s cause far more than a possible rating upgrade. Also, if China can grow at a rapid pace for an extended period with a relatively unfavourable credit rating, so can India. Thus, policymakers should not lose sleep over any rating discrimination. It’s not holding India back.