Thirteen years after India became an investment grade economy, the country has finally managed to convince at least one of the three major rating agencies that it deserves to be upgraded.
On Friday, 17 November, Moody’s Investors Service upped India’s sovereign rating by one notch to Baa2 from Baa3. The outlook on the rating is stable. A series of policy decisions taken by the government over the last few years will ‘enhance’ India’s growth potential and expand its ‘large and stable’ financing base for government debt, Moody’s said in its release.
Ironically, the upgrade came at a time when the view on India’s short term fundamentals was souring.
Weakening economic growth, normalising inflation, and the risk of fiscal slippage have led many to question India’s near term outlook. While most accept the benefits of attempting to formalise the Indian economy, the worry has been that the Indian government is trying to do too much too soon. In the process, it may hurt the economy before helping it.
Moody’s accepts that growth in the near term will be weaker than expected. India’s economy will grow at 6.7 percent in the current year, and 7.5 percent next year, the rating agency forecasts.
The rating upgrade, however, is based on the long view on India.
According to the rating agency, structural reforms will lead to a higher potential growth rate for India over the medium to long run. It cites both administrative and institutional reforms to back its call.
First among these is the new Goods and Services Tax, which could help achieve a long desired widening of the tax base. This, in turn, could have a positive impact on the Indian government’s ability to generate more tax revenue.
India’s tax to GDP ratio currently stands at close to 11 percent, and is lower than a number of other emerging market economies.
Other key reforms cited by Moody’s includes the move towards direct benefit transfers, which the rating agency says is as an important move to promote ‘expenditure efficiency.’ It also expects the recent decision to recapitalise state owned banks to help remove bottlenecks to a revival in the investment cycle.
Institutional reforms, the benefits of which are intangible but critical for the development of the economy, have also been acknowledged. Here, Moody’s refers to adherence to the Fiscal Responsibility and Budget Management (FRBM) Act, and the move towards a committee based monetary policy framework. A flexible inflation-targeting framework has enhanced the ‘transparency and efficiency of monetary policy in India’, said Moody’s.
While Moody’s explains its view on the structural reforms in India at length, it does not do enough to explain whether its view on India’s fiscal and debt dynamics have changed.
For years now, one of the key concerns cited by rating agencies has been India’s relatively high debt-to-GDP ratio. India’s debt-to-GDP ratio stood at 68 percent in 2016, significantly higher than median of 44 percent for this rating category.
Critics of the rating methodology have long argued that it is not fair to compare India to the median, since there is wide variation within the group of countries. Italy, which is rated at the same level, has a debt-to-GDP ratio of 133 percent. Spain has a debt to GDP ratio of 98.7 percent.
It has also been argued that India has a captive financing base due to mandated bond holdings (statutory liquidity ratio) of Indian banks. Unlike other emerging economies, the Indian government’s foreign liabilities are limited and its external debt to GDP ratio is at a moderate 20 percent.
But on both these counts, there has been no change.
So has Moody’s acknowledged its mistake in using this metric on face value until now? It doesn’t say. What it does say is that it expects India’s debt burden to remain largely stable.
The debt burden will likely remain broadly stable in the next few years, before falling gradually, as nominal GDP growth continues and revenue-broadening and expenditure efficiency-enhancing measures take effect.Moody’s Press Release
Moody’s also fails to explain whether it expects a material change in India’s low per capita GDP – a second indicator which rating agencies had cited as a reason for keeping the country at a lower rating bucket.
In the Economic Survey released earlier in 2017, Chief Economic Adviser Arvind Subramanian had argued that using per capita GDP is incorrect since it's a ‘slow moving variable’. Subramanian argued that lower middle income countries experienced an average growth of 2.45 percent of GDP per capita between 1970 and 2015.
Subramanian hit out at rating agencies saying:
At this rate, the poorest of the lower middle income countries would take about 57 years to reach upper middle income status. So if this variable is really key to ratings, poorer countries might be provoked into saying, “Please don’t bother this year, come back to assess us after half a century.Economic Survey 2016-17
Did Moody’s buy into that argument? It doesn’t say.
The question now is whether Standard and Poor’s (S&P) and Fitch will also upgrade India’s sovereign rating. Historically, the two have been tougher to convince. Both have a stable outlook on their India sovereign rating, which suggests that they are at least two steps away from upgrading India.
A rating agency typically moves its rating outlook to positive before it actually changes a country’s rating. Given that, an immediate change in rating may not be on the anvil. Besides, both S&P and Fitch have flagged off near term risks facing central and state government finances and may choose to wait until data points to an improvement in those metrics before they alter their view.
For now, the impact of the Moody’s rating upgrade will be felt on the margin. Companies that borrow overseas may see financing costs drop. A pick up in foreign inflows into the bond markets would typically follow a rating upgrade, but in India’s case, foreign investor limits have been mostly used up (except in state government bonds).
But mostly, the impact of Moody’s rating upgrade will be on mood. The mood around India overseas. And the mood around economic reforms back home. Expect both to improve.
(This article has been published in arrangement with BloombergQuint. The author, Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.)
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