Rating upgrade was long overdue FINGER ON THE PULSE

Moody’s rating upgrade of India is a shot in the arm for the Narendra Modi government. The upgrade will help lower the cost of funds for Indian companies. It will increase foreign inflows into India as portfolio flows are linked to sovereign ratings. It will allow the government to be a little more relaxed about meeting its fiscal deficit target for this year.

Is an upgrade justified at this point? Not if you go by a range of today’s economic indicators. The current account deficit is well within control. But the combined fiscal deficit of the Centre and the states is poised to touch 7 per cent consequent to the bank recapitalisation package. Gross domestic product (GDP) growth is at its lowest in several quarters and there is uncertainty as to how soon it will recover and by how much. The banking system is in serious stress. Export growth has been unsatisfactory over a longish period.

Today’s indicators compare unfavourably with those in, say, 2005-06. That was a time when India’s growth was 9.6 per cent and every indicator was looking healthier. India’s rating was, nevertheless, one notch lower than the present rating of Baa2. What has caused a change of heart at Moody’s at a time when our indicators are not looking so good?

Moody’s says that, in upgrading India, it is being guided by future prospects, not the current indicators. There are two arguments that Moody’s makes. The first is about sustainability of India’s growth. It believes that the reforms carried out by the Modi government – demonetisation, goods and services tax (GST), bank recapitalisation, the monetary policy framework, Aadhaar, etc – have improved the potential for growth.

Moody’s expects India’s growth rate to improve from 6.7 per cent in 2017-18 to 7.5 per cent in 2018-19 and to stay at that level thereafter. It seems to suggest that, but for the reforms seen in the past three years, a high growth rate – say, of 7-7.5 per cent – would not be sustainable.

Really? India’s GDP growth averaged 7.5 per cent even in the highly stressed three year period 2015-17. In 2017-18, the growth rate is poised to fall below 7 per cent thanks to the short-term disruption caused by demonetisation and the GST. A rebound to a growth rate of over 7 per cent thereafter was thus very much on the cards even without many of the reforms that Moody’s cites. The recapitalisation of banks is, perhaps, the one push the economy needed to get back to a growth rate of over 7 per cent — and many don’t even perceive giving capital to public sector banks as a “reform”.

The other argument that Moody’s makes is about sustainability of debt, which is the long-term behaviour of the debt-to-GDP ratio. The crucial determinant of debt sustainability is the difference between the nominal growth rate and the nominal interest rate. The other determinant is the government’s primary deficit.

Measures such as demonetisation and the GST help contain the primary deficit by broadening the tax base and boosting tax revenues. So does Aadhaar by containing leakages in subsidies. The combination of growth, expansion in tax revenue, and expenditure control, Moody’s believes, will keep India’s debt-to-GDP ratio stable at about 68 per cent in the coming years. Over a long period, the ratio will fall.

This is, of course, true. But Moody’s need not have waited for so long to conclude that India’s debt dynamics are reassuring. Between 2007 and 2016, India’s debt-to- GDP ratio fell from 74 per cent to 68.5 per cent without any help from demonetisation, GST or Aadhaar. This is because the first of the two determinants of the debt-to-GDP ratio, the difference between the nominal growth rate and the nominal interest rate, has been extremely favourable in India.

The second determinant, the primary deficit, has been pretty adverse. India’s primary deficit averaged 3.2 per cent in the period 2007-16, which is much higher than that of nine emerging market peers. (Economic Survey, 2016-17). Yet, the first factor has been strong enough to overwhelm the second. Unless there was a major shock, India’s debt-toGDP ratio was poised to decline even without the recent reforms.

Moody’s still worries that India’s current debt-toGDP ratio of 68 per cent is way above the median ratio of 44 per cent for economies rated Baa. The comparison is flawed because it does not factor in differences in growth rates. India’s growth rate is much higher than that of most of its peers, so it can afford a higher debt-to-GDP ratio.

India’s recent reforms have certainly brightened the prospects of India growing at <i>beyond<p> the 7-7.5 per cent range. They have also ensured that even at a lower growth rate, the fiscal situation will be under better control. But a growth rate of over 7 per cent was always on. India’s capacity to service its debt was not in doubt even without the recent reforms. The rating upgrade should have happened long back.