IMA Analysis

Monday June 1, 2020

Ratings Downgrade

Speaker:  Adit Jain,Editorial Director, IMA India June 2020

But still investment grade

When the Treasury presented the Finance Budget in February, it assumed the fiscal deficit for the previous year at 3.8% of GDP. As it happens the actual figure, the government now admits, is close to 4.2%. Revenues were estimated to grow at 4% in 2019-20 but they actually declined by 3.4%, with a tax collection shortfall of Rs 1.5 trillion. Going forward the budget expected, perhaps generously, that tax revenues in 2020-21 would rise by 12%, with corporation tax increasing by a more lavish 22%. Such prospects, which seemed incongruous even then, are now utterly out of context. The economy, which the budget assumed would grow by a nominal 10%, is more than likely to contract by anywhere between 5% and 10% in real terms. An appreciation of these facts, together with the recognition of a derailed financial system, stressed government finances and poor prospects for economic growth, are the basis for the downgrade by Moody’s and more worryingly, a negative outlook. Another demotion would classify Indian debt as basically investment unworthy or junk.

Whatever the reasons for Moody’s actions, the fact remains that India is staring at a period of prolonged slow growth. There is the risk of a further deterioration in the fiscal situation and stress in the financial economy. The fiscal deficit will jump, as would loan defaults within the banking system. India is poised for a troublesome period in the coming years and policy makers may find that solutions are difficult to implement and politically unpalatable. Three factors are likely to undermine the prospects of a sustained economic recovery, although some economists do believe that 2021 figures might surprise on the upside, because of a low base. First, persistently weak private sector investment, a trend that began a few years ago. Second, tepid job creation, now worsened with an upsurge in unemployment. And finally, a broken financial system with rising soured loans. The big worry is not that government debt will rise post Covid, but rather the notion that the debt burden will not reduce even well after things have begun to settle. India’s current debt-to-GDP ratio at 70% will escalate to 85% over the year and either increase further in later years or at best stabilise. On these scores, the debt figure is 30% higher than countries with a comparable rating in the same stage of development.

The equity and bond markets had possibly factored in the downgrade and consequently reactions were muted. The Reserve Bank, now generally on top of things, can be expected to step in to arrest volatility. 10-year bond yields closed at 5.82% no more than 3 basis points higher and the currency markets remained stable. The fact is markets do not react to absolute developments, simply to a mismatch of expectations and outcome. The Moody’s downgrade was anticipated and at least for now, India remains in the category of investment grade. Moreover, the participation of overseas investors in the country’s sovereign bond markets is minimal.

Still, Indian policy makers must not ignore the downgrade and should continue with reforms. Some decent steps were announced as a part of the rescue package, but more needs to be done. A national consensus must evolve with industry, trade unions, state administrations and civil society. The IMF forecasts for current year growth (at 1.9%) are wrong and will be revised considerably downwards when the next update is published. So, policy makers must work with more realistic scenarios in their assumptions and do what it takes to stem the slide. It is better to accept reality than be disappointed later with downward revisions.