Despite Moody’s upgrade, India’s economic outlook remains tough

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On November 16, the global rating agency, Moody’s Investors Service, upgraded India’s sovereign rating to BAA2 -“Stable” (a medium investment-grade with moderate credit risk) from BAA3 – “Positive” (the lowest investment grade rating).

This was the first rating upgrade in 14 years.
Although it was greeted joyously as a vindication of the reform process, the upgrade did not have more than a fleeting impact on prices in a strong bull market. The stock market zoomed up for one session before correcting down on profit-booking. Government debt yields fell for one session before correcting back to around pre-upgrade levels.

Many observers expressed surprise at the timing of the upgrade. While the positives cited in Moody’s statement have been visible for a while, the potential negatives cited have also become more worrisome.

In its statement Moody’s said: “The decision to upgrade is underpinned by expectation that continued progress on economic and institutional reforms will, over time, enhance India’s high growth potential and its large and stable financing base for government debt, and will likely contribute to a gradual decline in general government debt over the medium term”.

Economic Gaps Remain

Moody’s expects “very gradual improvement in the government debt burden”. It assumes a weakening of growth in the near-term (due to GST and demonetization) and a rise in near-term public debt (to 69 per cent of GDP from 68 per cent). It believes that these effects will be transient. The rating could improve quickly if there’s “sizeable and sustained reduction in the general government debt burden.  The implementation of key pending reforms, including land and labor reforms”, could also trigger another rating hike.

The agency also listed several red signals: “A material deterioration in fiscal metrics and the outlook for general government fiscal consolidation would put negative pressure on the rating. The rating could also face downward pressure if the health of the banking system deteriorated significantly, or external vulnerability increased sharply. ”
The reduction of the fiscal deficit started two years ago, as crude prices dropped lower. Even the GST is into its second quarter. The upgrade could be considered tardy in those terms.

But all three potentially negative variables have gotten worse in the last six months.

The Fiscal Deficit will surely exceed the 3.2 per cent of GDP targeted in the 2017-18 Budget. Early glitches in the GST implementation may lead to a miss of tax collection targets. The government has also “front-loaded” expenditure and spent over 95 per cent of the targeted Fiscal Deficit by August 2017 in attempting to keep GDP growth falling off a cliff.  Non-Performing Loans in the banking system also continue to rise, albeit slowly. The RBI estimates NPLs will rise until March 2018 at least. However it could be argued that the new insolvency law and the RBI’s insistence that banks recognize NPLs, are signs of improvement. A massive recapitalization is also in progress.

On the external front, the Current Account has been impacted by rising crude prices and a sharp increase in imports, while exports remain weak. The trade deficit is up 60 per cent for April-October 2017 versus the same period in 2016. Exports have grown at 9 per cent, while imports have risen 23 per cent. The Current Account Deficit (CAD) was running at 2.4 per cent of GDP after the first quarter (April-June 2017) and it could stabilize at around 1.5 per cent of GDP for the entire fiscal. That is manageable given reserves are close to $400 billion but it’s much higher than the 0.6 per cent of GDP registered in 2016-17.

Prior to the rating upgrade, the World Bank’s ‘Ease of Doing Business’ ratings saw India jump 30 places in global rankings, from 130 to 100. The data for the survey was gathered prior to the GST roll out. The polling sample is also restricted to Delhi and Mumbai. So this may not accurately reflect changes in the business environment.

Of course, a sovereign rating upgrade has concrete positive effects apart from boosting sentiment. Better public finances make it easier for the government to borrow, overseas as well as domestically.
Domestic commercial debt also tends to be bench-marked to treasury yields with some quantum of premium, depending on the borrower’s balance-sheet. So commercial interest rates and bond yields also tend to reduce as treasury yields fall. The interest rates on Overseas Commercial borrowings by Indian corporates, in forex-denominations, or in rupees (“masala” bonds), are also likely to reduce as sovereign debt yields drop.

FPIs have enthusiastically bought government debt for several years, usually hitting their designated limits. In this fiscal, FPIs invested a net Rs 1.179 trillion in rupee debt between April-October. In addition, the ratings upgrade could lead to stronger FDI flows as it promises fiscal stability.

S&P and Fitch Ratings remain cold

The two other major rating agencies, S&P and Fitch Ratings have not followed Moody’s lead as yet. In October, S&P kept India’s rating unchanged at the lowest investment grade with a stable outlook. S&P said the fiscal position needed to improve, “For an upgrade, India would have to address its weak fiscal balance sheet and weak fiscal performance. India has one of the highest general government debt-to-GDP levels (68%) among emerging market sovereigns”. The average government debt to GDP ratio for Emerging Market nations is about 44 per cent.

Moody’s also pointed out that the reforms process is incomplete and work in progress. Land and labor reforms are both critical . Both sectors require proactive action by states, given India’s federal framework. Given the political sensitivity of these two areas, concrete action seems unlikely. Multiple state assembly elections are scheduled for the next 18 months, and a General Election due by May 2019.

Taken together, the jump in rankings and the ratings upgrade have certainly boosted investor sentiment. But the jump in the Ease of Business rankings was on a narrow sample and it may not reflect conditions post-GST. The Moody’s upgrade is belated recognition for two years of fiscal discipline. But it also seems to be betting on the assumption that the current deterioration in the fiscal situation is transient. Follow-up reforms – which are vital if things are to improve- could be held up as the country shifts into election campaign mode.

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