New Delhi: Back in July, credit rating agency Fitch Ratings first indicated it found the state of India’s public finance bothersome. The local currency outlook was marked down to negative from stable while the outlook for foreign currency remained unchanged at stable. In an interview, James McCormack , managing director of Fitch’s Asia-Pacific sovereign ratings, spoke of the thinking behind that and also of the implications it has had for the economy. Edited excerpts:
Fitch changed its outlook to negative on India’s local currency in July. Can you take us through the steps that led to the change in the outlook?
The outlook revision was really the result of us taking a hard look at the Budget, the 2008-09 Budget. A couple of things stood out. Some of the off-Budget or below-the-line items, we felt, were flattering the headline a little bit. The improvement in public finances we have seen in India in the last few years have been supportive of the ratings, and have resulted in the rating being moved up a few years ago from sub-investment grade to investment grade. That was a big step. That previous change had been based in large part on our assessment of public finances getting substantially stronger over time and we felt the government had, at both the Central and state levels, concluded that improvements in public finances were supportive of medium-term growth and they saw the linkages between public finances and growth.
Downslide risk: Fitch’s James McCormack says India’s growth figure for the next year could slip below 6%. Ramesh Pathania / Mint
So when we looked at this year’s potential performance and we saw some backsliding on that, we became somewhat concerned for the medium term. So, we thought we will revise that outlook. If the deficit is considerably larger than it has been in recent years, that is obviously bad for debt dynamics. We felt we had to indicate that in the outlook.
Were you influenced by finance minister P. Chidambaram’s Budget speech where he actually said he would not be able to meet the revenue deficit target?
Not per se. We don’t want to necessarily measure the government against its own targets. We’ll measure the government against an objective peer comparison. So, we will compare India with other BBB-rated sovereigns.
Since July, we have had a supplementary budget presented in Parliament that gives a much better sense of additional expenditure. Does that trigger something?
The outlook hasn’t changed. To be honest, we are a little bit more interested in what we might see next year in terms of the Budget. This year...we are expecting a deterioration. We are definitely interested in where public finances go from here.
Are we looking at a one-off deterioration this year to be able to deal with higher oil prices, or are we talking about something more fundamental? That’s the question we are not yet in a position to answer. We have to got to think about that.
Most people have begun to mark down next year’s growth, which must affect the revenue part of public finances...
We have done the same. Let me say this about the growth outlook: We are not rating growth either. We don’t want to move countries’ ratings higher when they grow quickly and move them lower when they grow slowly. You are right, it has fiscal implications. If the fiscal situation is already stressed, which it is in India to some degree, that can add additional stresses and at times can highlight other fiscal weaknesses and lack of fiscal flexibility.
A number of countries in Asia, China being the most evident now..., are embarking on a large fiscal stimulus package. India is not in a position to do that. Public finances are not as flexible as those of China because previous deficits have built up a large debt stock which must be serviced. It can’t respond to cyclical needs in the same way that countries with a stronger public finance position can. So, growth matters. The number we (are) working with now for growth for the next year is 6%. The risks to that outlook are clearly to the downside. We could easily see growth slipping to below 6%.
If we look at the past fiscal performance and where the strengths have been, it has been on the revenue side. It hasn’t been through spending cuts. (There are) at least two reasons for that. One is stronger economic growth, raising tax revenue. Number two, there has actually been pretty significant improvement in tax administration. That shouldn’t go away, that will continue even through the downturn. That’s an important improvement for the medium term.
When we think about India’s public finances in the longer term, where are the needs for continued efforts? It is on the spending side. There’s some probably unpleasant and difficult political decisions that need to be made about spending priorities and how the government can continue to reduce the overall deficit or, in fact, keep it at a level of 3%, but provide public services that are needed to support growth and reduce poverty level.
The passage of the Fiscal Responsibility Bill had an impact on the assessment of rating agencies as it indicated multi-party support for fiscal rectitude. The law did provide the government of the day space to slip up, and they did. It is going to be very difficult to convince the people once again. How would you react to that?
Fiscal responsibility legislation cannot transform public finances but it does indicate there’s an issue authorities are taking seriously. The fact that it is there, in our view, is good.
Moving to foreign currency, what are the stress factors you see?
The stress factors are really on the capital account side. It is not necessarily the current account. The current account is going to be supported by the reduction in oil prices.
As that current account deficit gets smaller, the need for foreign capital shrinks as well, which is good because the availability of foreign capital is diminishing. But India needs foreign capital for domestic investment as well. So, there is a need for foreign direct investment, not such a great need for portfolio inflows.
What we are seeing in terms of international capital flows is revealing just how integrated India is into the global economy. Not on the trade flows side, but on the capital flows side and the reliance here on international capital flows, inflows particularly. That has been an important factor in supporting India’s growth in recent years.
When we think of capital flows to emerging markets, usually how those cycles work is inflows are gradual over a period of time and can become quite large. But when a reduction takes place, it is not gradual but sudden. It actually stops, capital flows stop very suddenly. That is what we seeing now.... The more open the economy is, the more reliant on flows, the greater the shock. India is going through a moderate external shock in terms of funding availability, inflows of capital, and that is going to affect growth.
So, it is not just a balance of payments issue. It is more of how that is going to affect growth. That is something we are concerned about from a growth perspective, not necessarily from a rating perspective. External fundamentals are still quite strong, reserve levels are still very high.