RBI’s high FX reserves should protect INR from any speculative attack. This creates the space for monetary and fiscal easing
By Indranil Sen Gupta & Aastha Gudwani
We have been cautioning investors about the rising risks of a sovereign downgrade. Moody’s has just cut India’s rating to Baa3 from Baa2 (while retaining negative outlook), on low growth and rising fiscal risks. We, however, see the current slowdown as cyclical driven by excessive RBI tightening in mid-2018; a real lending rate shock on falling core WPI inflation in 2019, and now, the global Covid-19 shock. The Centre’s fiscal deficit (6.3% of GDP FY21 forecast) breaching the long-run average by 180bp is surely justified with growth falling ~900bp below potential. So, can India fall below investment grade? Not really, due to three buffers. RBI’s high FX reserves should protect the rupee from any speculative attack. Second, the MoF will likely recapitalise PSBs through non-fiscal levers such as issuing recapitalisation bonds and/or using RBI’s $127bn revaluation reserves. Finally, a run of good harvests should cushion the Covid-19 shock.
Moody’s downgrades India on growth and fiscal risks: Moody’s has just cut India’s sovereign rating to Baa3 from Baa2 (both with negative outlook) bringing it to the lowest investment grade. This was driven by risks of a sustained period of relatively low growth, further deterioration in the fiscal position and stress in the financial sector. Its negative outlook reflects dominant, mutually-reinforcing, downside risks from deeper stresses in the economy and financial system that could further erode fiscal strength. S&P and Fitch Ratings currently rate India at BBB- with stable outlook, that also happens to be the lowest investment grade.
Slowdown cyclical: We see the current slowdown as cyclical, driven by 3 back-to-back shocks. Mid-2018 saw excessive RBI tightening. While nominal lending rates came off in 2019, on RBI easing, falling core WPI inflation led to a spike in real lending rates. 2020, of course, is seeing the global Covid-19 shock. While we expect GDP to contract by 2% in FY21, FY22 growth should rebound to 9%.
Fiscal stimulus key to support recovery: We continue to argue that fiscal stimulus is the need of the hour, notwithstanding Moody’s. While the Centre’s fiscal deficit, at our 6.3% of GDP FY21 forecast, will overshoot the long-run average by 180bp, this is surely justified with growth falling ~900bp below potential. It is the fall in growth, due to the Covid-19 shock, that is leading to a higher fiscal deficit than vice versa.
FX reserves, non-fiscal PSB recap, rains: High FX reserves. We highlight that RBI’s high FX reserves should protect INR from any speculative attack. This creates the space for monetary and fiscal easing. RBI is expectedly recouping FX reserves. Non-fiscal PSB recap: The MoF will likely recapitalise PSBs to de-stress the financial sector through non-fiscal levers—issuing recapitalisation bonds and/or using RBI’s $127bn revaluation reserves. Good harvests: After a bumper summer rabi harvest. We expect the winter kharif sowing to benefit from the Met’s forecast of 102% of normal south-west monsoons.
Edited excerpts from India Economic Watch, BofA Global Research, June 2.