International credit rating agency Standard and Poor’s (S&P) downward revision of India’s long-term sovereign outlook had been widely predicted after the interim budget showed the fiscal deficit had ballooned. Perhaps more important is the rating agency’s threat of a downgrade. S&P minces no words in this regard, clearly saying that they “will be looking for indications that the next government will take renewed measures to rein in public finances. Continued loose fiscal policy or policy setbacks on monetary, financial and economic fronts that lower India’s medium-term growth prospects would result in a downgrade. On the other hand, if the government begins materially narrowing the public sector’s deficits again, the ratings may stabilize at the current level”.
A downgrade will mean that some funds, which have mandates to park their money only in investment-grade paper, could well withdraw money, leading to further pressure on the markets. It could also affect the prospect of new inflows as well as increase the cost of overseas borrowings for firms, though current prospects for the latter are already very tough.
Also See India: Adequate Forex Reserves (Graphic)
The government will, therefore, have to make a choice: Should it continue with the fiscal stimulus and risk a ratings downgrade, or should it keep the rating agencies happy and forget about a stimulus? On Tuesday, the government indicated which way it would choose, by reducing excise duties.
There’s one line in the S&P report that should be reason for comfort. That line states that “despite continued dislocation of international capital markets, confidence in India is bolstered by international reserves equal to 374% of short-term external debt”. The accompanying chart shows the result of a recent Citigroup Inc. study of forex reserve coverage ratios for Asian countries.
As seen from the chart, India’s external reserves are 2.19 times the total external financing requirements and 1.17 times the total external financing requirements plus mobile capital (or foreign holdings of stocks and bonds).
In any case, the rating agencies have been rather slow on the uptake, since government bond yields have been hardening for quite some time. Also, as A. Prasanna, senior economist with ICICI Securities Ltd, said, “It’s the strength of the dollar that matters for the rupee, rather than the S&P change in outlook.”
A similar case can be made for international bond yields as well. In today’s markets, what matters is a return of risk appetite, rather than any change at the margin in ratings. Moreover, it’s very likely that the more risk-averse funds have already fled emerging markets, so a downgrade may not make a big difference. Prasanna says that in the current state of the economy, a fiscal stimulus is necessary, albeit one that ensures the money is spent on things we need, such as infrastructure.
At present, with bank loans contracting and demand falling, a higher fiscal deficit may not really crowd out private sector investment and could indeed serve as a catalyst for private investment. It’s during a recovery that the deficit needs to be scaled back. But S&P’s change in outlook does alert the government to the fact that it is coming up against the limits to borrowing. That is also seen, of course, from the high yields and the devolvements at the government’s bond auctions on Tuesday.
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Graphics by Ahmed Raza Khan / Mint