International perceptions regarding India?s sovereign risk matter. They determine capital flows. And capital flows are important to bridge the current account gap, to fund investments and to bring in the FII flows that make Indian equity markets look sexy. If the sovereign risk is low then domestic companies find it easier, and cheaper, to raise capital from the international markets.

The most important institutions that determine a country?s credit-worthiness are the international credit rating agencies?principally, S&P and Moodys. Assessments of investment companies such as Goldman Sachs, JP Morgan, Morgan Stanley, etc. play an equally important role because they invest or make their clients invest in countries such as India.

These investment companies displayed exceptional speed in upgrading their perception regarding India immediately after elections. The flow of capital increased with corresponding speed. Within one week of the announcement of the results, over half a dozen international investment companies had expressed their confidence in India; within that same week FII flows shot up to over $1 billion. But, what will these investors do when the fiscal deficit turns out to be larger than is generally perceived to be comfortable? International rating agencies and investors abhor the GFD?particularly in emerging markets.

The fiscal deficit was 6.1 per cent of GDP in 2008-09. This was more than twice its level of 2.7 per cent in 2007-08. The FRBM had required the deficit to drop to three per cent by 2008-09. This is now a far cry. If we include the deficit of the states the GFD bloats to 8 per cent of GDP. What if the deficit rises further? Will the investors and commentators reverse their perceptions on India?

The fiscal deficit is considered evil essentially because it either causes inflation to rise if it is monetised or it causes interest rates to rise if it is funded by market borrowings. Thus, a high GFD/GDP causes high inflation and/or high interest rates. If the deficit is financed by market borrowings it also starves the private sector of funds. But these theoretical constructs do not have much support, prima facie, in the data. We use the simple correlation coefficient to measure the relation. The correlation coefficient ranges from -1 (which implies a perfect negative relation) to +1 (which implies a perfect positive relation), and 0 implies no relationship.

The correlation coefficient of GFD/GDP and inflation is close to 0. It is 0.09 with WPI and 0.11 with CPI(IW). The relation is no better with the Prime Lending Rate of banks (0.10).The simple six-year averages of these indicators over the three periods 1992-1997, 1998-2003 and 2004-2009 reflect this weak relationship aptly. The GFD/GDP ratio was the highest during 1998-2003 and during this time the inflation in WPI was the lowest.

Another fear regarding the deficit is that it starves the private sector of credit. As the government taps the financial markets to fund its programmes, it sucks away the liquidity from the markets and leaves less for the private sector. Algebraically, this is true. But, it is not a problem because there is apparently, plenty to meet everyone?s needs.

Figures released by CSO show that domestic savings shot up sharply to 38.6 per cent in 2008-09, from 37.7 per cent in 2007-08. Liquidity continues to remain healthy in 2009 as well. The RBI expects deposits with banks to increase by Rs.7.7 lakh crore during 2009-10. This will meet the entire market borrowing and non-food credit projected by the government and the RBI. In the past, large gaps between these two have been bridged from other sources of finance without impacting lending rates.

Thus, a GFD/GDP ratio in the range of 6-7 per cent (or 9-10 per cent if we include the state deficits) does not seem to be capable of causing any major movements in inflation or interest rates. There is headroom to expand the deficit, if there is a need to. It is unlikely that the upper limits of these bands will be breached in 2009-10. And, we do not have to test the limits of the weak relationships. For, beyond some limits, theory is expected to make its point.

For the moment it would be wiser for us to concentrate on the manner in which the resources available with the government will be put to use. The direction and quality of government spending is more important than the level of the deficit. I return to the original question: How will the international rating agencies and investors react to the deficit?

Most commentators will agree with the assessment of the investors?that the Indian electorate?s mandate was for a stable government and, given that the Left had been left out, the new government is expected to pursue reforms and dis-investments. Betting a few more dollars on the Indian equity markets thus did make sense. But, it is a lot more difficult to appreciate the quick up-scaling of their GDP forecasts within days of the election results by a handsome 1-1.5 percentage points.

My guess is that they would be benign to the deficit if the government packages an aggressive dis-investment programme and if the finance minister announces an easier FDI policy stance. But, they would be very punishing if the deficit is high and if there is no dis-investments and no ?reforms?. I wonder though, what they would do to their GDP forecasts in such a case.

?The writer heads the Centre for Monitoring Indian Economy