India’s Achilles heel on ratings is its parlous state of fiscal affairs and the risk of a sharp deterioration of government debt to potentially ~75-80% of GDP.
By Sonal Varma & Aurodeep Nandi
As the Covid-19 pandemic and the associated lockdowns have started to bite into growth and derail fiscal discipline, countries are increasingly facing the additional risk of having to contend with sovereign rating downgrades. India has a sovereign rating of BBB- with a ‘stable’ outlook from S&P and Fitch, a grade above the junk category. Moody’s rates it at the equivalent of one notch above, at Baa2, it changed India’s outlook to ‘negative’ last November.
Why a downgrade or outlook change looms
Growth: India is currently under lockdown, with a partial relaxation announced for ~60% of economy in ‘green zone’ districts—aimed at the rural areas. This is likely to cost ~7.5% of GDP. Even afterwards, the economy will likely struggle to normalise, as companies will have to deal with labour, raw materials and demand shortages, as social distancing is enforced.
As an aftershock, India’s existing triple balance sheet crisis is potentially morphing into a quadruple one, roping in households. As corporate profits are hit and bankruptcies rise, there will be an inevitable impact on wages, jobs and consumption. This, in turn, could snowball into renewed stress for the banking sector. Meanwhile, rising credit risk premia means that excess liquidity does not guarantee a chase towards high-yielding risky assets as return of capital becomes more important than return on capital. Excess liquidity will continue to find itself drawn to stronger balance sheet entities, making for incredibly rough terrain for the weaker entities.
Given these direct and indirect effects, the real GDP growth will fall to -0.5% y-o-y in 2020 (vs. 5.3% in 2019). Quarterly growth profile envisages growth of 3.2% in Q1-2020 (Jan-Mar), before falling to -6.1% in Q2, -0.5% in Q3 and mildly recovering to 1.4% in Q4.
Fiscal risks: FY21 promises to be a year of stiff fiscal headwinds, and the targeted central government’s fiscal deficit of 3.5% looks increasingly ambitious. There are three key factors that will drive fiscal slippage in the coming year. First, the target is heavily reliant on an aggressive target for disinvestment (~1%) and non-tax revenues. In light of the current market conditions and growth headwinds, the government will struggle to find support from these sources of revenue.
Second, with real GDP growth likely to contract -0.4% y-o-y in FY21 and nominal GDP growth of 1.5% in FY21 vs the budgeted 10% will arithmetically bloat the fiscal deficit ratio, but it also implies very low tax buoyancy. Third, compared with the estimated output loss, the fiscal package has been barely 0.8% of GDP so far.
More fiscal stimulus may follow—the next tranche of measures will look to address cash-flow challenges faced by small and medium-sized enterprises and other hard-hit industries (aviation, hotels, tourism, etc). Given the sudden shock, the government may temporarily suspend the FRBM legislation and will push the fiscal deficit beyond the 0.5% that the current fiscal rules allow.
Fiscal deficit will rise to ~5.1% of GDP in FY21, with considerable upside risk, depending on the quantum of forthcoming fiscal support. With states’ budgets combined, the consolidated fiscal deficit will expand to ~9.5-10%, close to record highs in the recent past. Additionally, lower nominal GDP growth, along with rising contingent liabilities (support to banking sector) are likely to materially raise the public debt-to-GDP ratio.
External risks muted: The sharp correction in crude oil prices globally is likely to play an outsized role in keeping the CAD in FY21 under check. India’s exports and its invisible surplus are likely to be modest in FY21. On the capital account side, an outflow of portfolio investment and a moderation in net FDI inflows by ~$10bn from FY20 levels is expected. Overall, the CAD may sharply narrow to 0.6% in FY21 vs -1.1% (FY20).
How will rating agencies react?
Moody’s: The outbreak threatens to further unravel the optimistic assumptions underlying Moody’s upgrade. Moody’s is likely to downgrade India’s rating from Baa2 ‘negative’ to Baa3 ‘stable’. It may wait to get a better handle on the government’s fiscal plans to make a more complete assessment of the growth and fiscal impact. It will also most probably be closely monitoring developments on financial stability, with banks and shadow banks facing first bout of liquidity pressures.
Standard & Poor’s: Prior to Covid-19, S&P had cautioned in December that “if this recovery does not materialise, and it becomes clear that India’s structural growth has significantly deteriorated, we could lower the rating”. It expects GDP growth of 1.8% in FY21 before rising to 7.5% in FY22.
While a rise in debt to 75% of GDP will most probably trigger a change in fiscal ratings, in absolute terms, the band is more tolerant at 60-80% (compared with Moody’s 65-70%). For S&P to consider a downgrade, just fiscal deterioration may not be enough of a trigger. Rather, it would need to be convinced that the ongoing economic pain has structural legs and involves changes to institutional factors like the risk to social cohesion, diminished capacity of institutions, weak labour market or evidence of tapering in reform momentum. At the current stage, an outlook change by S&P is a risk, but not imminent.
Fitch Ratings: Last week, Fitch revised down its India’s GDP growth forecast in FY21 to 0.8%, expecting a decline in consumer spending growth and contraction in investment. Based on the risk factors that it outlined in December, the first case of “material” slippage in the fiscal deficit and debt sustainability has most likely materialised, and any negative rating action looking forward will hinge on this. Fitch now projects public debt to GDP to rise to over 77% of GDP in FY21, up from its previous forecast of 71%, and the ratio to remain on an upward track in FY22. Given its assessment of debt sustainability and poor fiscal track record, the likelihood of an outlook change to “negative” is elevated.
Should Moody’s ratings come in-line with others (even with a negative outlook), it will have only a small and short-lived negative impact on INR. Any outflows associated with a downgrade alone could also be modest. The bigger risk stems from S&P and Fitch, where India is rated BBB- and stable. If India’s outlook is moved to negative, then the next step is a potential downgrade. However, there are mitigating factors. Overall, the ratings risk is more medium-term, especially if the economic recovery and fiscal prudence path are pushed out. In the near term, risk sentiment, capital flows &oil prices are significant drivers.
A ratings downgrade to sub-investment grade could dent prospects for India bond inflows in the medium term; in the near-term, we believe domestic factors including fiscal slippage and RBI support for issuance are key.
Co-authored with Craig Chan and Dushyant Padmanabhan, NSL
Edited excerpts from Nomura’s Asia Insights report, dated April 29, 2020.