India should not fear downgrade because of higher deficit as long as growth keeps moving up
In January, there is always a debate on whether or not to stay put on the path of the projected fiscal deficit. This year is no exception. However, the enormity of the situation is a little more, with the clamour for a continued public expenditure push and hence the possibility of deviating from the 3.5% target for FY17. As usual, the protagonists are out with a hammer and are convinced that such an action will obviously trigger a rating or outlook change for India. This is, however, not correct, and the rating histories of sovereign economies are full of examples where even with a higher fiscal deficit, a country has managed sometimes successive years of ratings upgrade.
Credit-rating agencies use a different criteria to determine the overall rating of a country. For example, S&P ratings are based on five factors—institutional effectiveness, economic structure and growth prospects, external liquidity and international investment position, fiscal flexibility and fiscal performance combined with debt burden, and monetary flexibility. Of these, growth considerations always take centre-stage, and if historical trends are to be believed, even take primacy over fiscal sustainability, no matter what rating agencies say. If this holds sacrosanct, India has every reason to believe a rating upgrade sooner than later, even with a higher deficit per se.
An analysis of rating of countries by S&P indicates that an increase in government borrowings by a country (thereby increasing its fiscal deficit) has not always been associated with a rating downgrade. Credit ratings of developed countries, including the US and Germany, have remained almost stable despite steep increases in their cash (a proxy for fiscal) deficits during 2009 (minus 10.3% of GDP) and 1995 (minus 7.9% of GDP), respectively.
Interestingly, there are instances where the fiscal situation has deteriorated but the rating has been upgraded. Indonesia’s foreign currency long-term credit rating was upgraded seven times between 2002 and 2011, irrespective of the increase in country’s cash deficit in 2003, 2007 and 2009. However, Indonesia experienced a healthy growth trajectory during this period and hence this should have been the primary reason for such rating upgrade. This also rejects the argument made by rating institutions that countries with low per-capita income do not generally experience rating upgrade quickly (Indonesia had a per-capita GDP of $1,066 in 2003 when its credit rating was upgraded and India’s GDP per-capita is now $1,596).
Similarly, Malaysia underwent an upgrade in its long-term credit rating in 1999 and 2002 owing to significant growth recovery during these years, albeit with higher deficits. In fact, Malaysia’s case defies logic, as the higher GDP growth in 1999 was mostly triggered by a negative base in 1998, but still it managed a rating upgrade that year.
In the current scenario, India is the fastest-growing economy in the world, with still a much improved fiscal position. India is doing well compared to its global peers at this juncture, when the economies the world over are reeling under recession. Higher inflation, which has been one of the issues facing the economy, has become benign, thereby having positive impact on country’s growth prospects. Meanwhile, India is also advancing in the ease of doing business ranking, suggesting a move towards a favourable investment destination.
No doubt, there has been a concern over meeting the fiscal target after implementation of the Seventh Pay Commission recommendations. In fact, the 10-year G-Sec yield hardened after the submission of the Pay Commission report. But it seems to have been overrated. Further, based on the recent RBI report Debt Management Strategy for India, it can be concluded that the current situation is not indeed worrisome. The report has analysed the debt profile of the central government with regard to cost, maturity and potential risk factors. Based on risk analysis containing metrics, including average time to maturity, analysis of the redemption profile, average time to re-fixing, and the percentage of outstanding debt maturing in next 12 months, it has been concluded that the government’s debt structure is relatively stable and the risks are low.
Consequently, with economic growth being the only mantra and even rating agencies like Fitch arguing about improved economic conditions recently, it logically boosts the prospects of India’s rating upgrade sooner than later. So, the government should not bother about any adverse fallouts of a higher deficit or the unwanted fear of rating downgrade, as long as it is able to push India’s growth to a decisively higher trajectory. In essence, there is no harm in setting a higher fiscal deficit target in FY17 as long as it finances productive expenditure.
Co-authored by Disha Kheterpal
The author is chief economic advisor, State Bank of India. Views are personal