The near-term macro-outlook for India from Moody’s and S&P Are virtually identical. Why, then, is their medium-term assessment so starkly different?
By Sajjid Z Chinoy
How credit ratings agencies react to macroeconomic developments, and whether concerns about their actions are impacting the size of India’s fiscal response, has dominated India’s macro discourse in recent weeks. In the event, two of the three agencies revealed their hands. Both surprised, but in opposite directions.
Moody’s downgraded India to Baa3 (the lowest rung in the investment grade ladder) which was not unexpected. However, it directly moved to a “negative” (versus “stable” outlook) which constituted a negative surprise of sorts. Meanwhile, S&P and Fitch previously had India at BBB- (equivalent to Moody’s Baa3) with a “stable” outlook. The expectation was, given building macro pressures, these agencies could mark down the outlook to “negative”. Some even worried about the rating itself being downgraded. In the event, S&P surprised positively-re-affirming its rating and outlook.
Ratings differences across agencies are commonplace and ordinarily shouldn’t attract much scrutiny. But, here, minor quantitative differences are masking material qualitative differences in the outlook.
Moody’s offers a much more sobering assessment, noting, “India faces a prolonged period of slower growth relative to the country’s potential, rising debt, further weakening of debt affordability and persistent stress in parts of the financial system”. It, therefore, worries that “… mutually reinforcing downside risks from deeper stresses in the economy and financial system could lead to a more severe and prolonged erosion in fiscal strength”.
S&P, in contrast, retains a more constructive outlook, noting that while “India’s economy faces stark challenges in the near-term … we believe the country’s long-term outperformance will remain intact”. While acknowledging a panoply of near-term risks, S&P reiterates “… the economy’s long-term outperformance highlights its resilience. India’s wide range of structural trends, including healthy demographics and competitive unit labour costs, work in its favour”.
What is driving such different assessments? Different perceptions of how India will get through the Covid-19 crisis? Different views on how much fiscal space can and should be used to mitigate the shock? Different estimates on where public debt ends up? Different perceptions on external vulnerabilities?
Anything but. The near-term macro forecasts are virtually identical. Moody’s foresees growth contracting 4% in the crisis year and then rebounding 8.7% in 2021-22. S&P-with the more hopeful outlook-sees a deeper contraction of 5%, with growth rebounding 8.5% the year after. Consequently, the implicit level of output at the end of 2021-22 in S&P forecasts is actually 1.2% of GDP lower than that of Moody’s.
Similarly, the forecasted fiscal response is identical. Both ratings agencies see the general government fiscal deficit widen to 11% in the Covid-19 year and return to 8.5% in 2021-22. Consequently, debt/GDP in 2021-22 is also virtually identical with S&P forecasting it at 82.7% and Moody’s at 83.7%, much higher than the 72% of GDP going into Covid-19.
Finally, both agencies are equally sanguine about the external sector. Moody’s external vulnerability indicator in the Covid-19 year is projected to be the most benign in at least six years. On its part, S&P projects a current account deficit below 1% for GDP for three straight years.
If both agencies project India to emerge from Covid in similar shape-as reflected in their near-term forecasts-why are they so starkly different in their medium-term assessment? In a sentence, it is the different perceptions they harbour on India’s potential growth.
S&P, for instance, takes a more constructive view. Real GDP is pegged at 6.5% and 6.8% in FY23 and FY24. However, the GDP deflator is forecast at about 4.4% (which is surprisingly high since it has averaged just 3.4% over the last five years). Consequently, nominal GDP growth is pegged at 11.3% in the medium term, much higher than the realised outcome of 7.2% in 2019-20. To be sure, S&P’s more buoyant forecast is predicated on execution improvements to extant reforms (IBC, GST), implementation of recently announced reforms (agriculture, commercial coal mining), and the belief that political space for more reforms exist. Key to their outlook-and rating-however, is that nominal GDP growth returns to about 11.5%.
In contrast, Moody’s takes a less buoyant view on the medium-term, projecting nominal GDP growth at about 10% in the coming years with their tone suggesting risks are to the downside. Their primary concern remains a continued “credit crunch in India’s undercapitalised financial sector”, and for weaker growth to further worsen asset quality and reinforce the negative feedback loop between the real and financial economy.
When all is said and done, therefore, the difference between the two ratings agencies ultimately boils down to (ostensibly small?) differences in medium-term growth prospects. S&P projects medium-term growth at about 11.5 % while Moody’s at 10%. This may seem economically insignificant. In fact, it is not:
It is the difference between debt/GDP getting stuck at an elevated 84% (Moody’s) and debt/GDP declining every year after Covid-19 (S&P’s). Furthermore, if nominal GDP growth dips below 10%, debt/GDP begins to rise monotonically-as we have previously written on these pages. Small changes in growth have large impacts on debt sustainability.
More fundamentally, of course, the under-appreciated power of compounding means that small changes in steady-state growth rates have large impacts on per-capita incomes, the proportion of the poor being lifted out of poverty, tax buoyancy and fiscal health, and the financial sector over time.
In sum, the contrasting outlooks by the ratings agencies come down to their different perceptions of India’s potential growth, both going into and emerging out of Covid-19.
Much of the recent public debate in India has implicitly focused on what size of fiscal response may be acceptable to ratings agencies this year? Instead, as we have previously emphasised, ratings agencies would eventually care about medium-term debt sustainability which, in turn, hinges much more on trend growth than any one year’s fiscal impulse. The commentary of both ratings agencies underscores this crucial tenet. Fiscal capacity, and therefore ratings, are inextricably linked to growth potential and outcomes.
The important implication, therefore, is that the economic policy response to Covid-19 needs to be calibrated to the size of the economic shock India experiences. This is crucial in warding-off economic non-linearities (viable firms being forced to close down, financial sector freezing up, labour market stress getting amplified) that will hurt medium-term growth. The fiscal response, therefore, needs to be tailored to the size of the economic hit. Both ratings agencies forecast the fiscal deficit to widen to 11% of GDP in the Covid-19 year. But, there should be nothing sacrosanct about this forecast. If the size of the shock necessitates more fiscal support to hold the economy together in a crisis year and preserve trend growth, then more should be forthcoming. What is imperative, however, is the extra fiscal support comes with a clear and credible fiscal consolidation path for subsequent years, given India’s disadvantaged starting points.
Equally critical-both for the near and medium term-is nurturing the health of the financial sector. Growth will only be as strong as the financial sector is willing to fund. This will involve, (i) ensuring liquidity reaches the financial periphery, (ii) pre-emptively re-capitalising public sector banks for both resolution and growth capital given higher anticipated NPAs, (iii) altering the incentive structure to make public sector banks less risk averse, and (iv) dealing decisively with some of the persistent concerns surrounding NBFCs.
Finally, medium-term growth will depend crucially on the next wave of reforms. The recently announced agricultural reforms have the potential to unshackle a sector that has long been repressed. This should be complemented with, (i) aggressively selling assets on the public sector balance sheet (which itself will boost the economy’s allocative efficiency) to help finance the next wave of physical and social infrastructure (critical to jumpstarting growth post-Covid), and (ii) using the China supply-chain opportunity as a focal point to improve competitiveness on the ground, even in localised areas such as special export zones to start with.
All told, we must first strive to minimise any permanent economic damage from the pandemic, and then work to boost the economy’s underlying potential. Like many emerging markets, therefore, India has its work cut out.
The author is Chief India Economist, JP Morgan
Views are personal