New Delhi: Ten days before the presentation of the Union budget, the government received a wake-up call on Monday from Moody’s Investors Service, which warned that India’s widening current account deficit and the spurt in its external debt exposed the country to the risk of a negative credit rating outlook.
Given these developments on the external sector, it is imperative for the finance minister to guarantee a return to the path of fiscal prudence, said the rating company, which now has a stable rating outlook on India’s Baa3 credit rating, the lowest investment grade.
A downgrade of the outlook to negative from stable would put the country’s rating on course for being cut to junk status. That may make it more expensive for Indian companies to raise funds overseas and hurt investment inflows into the country.
India’s current account deficit widened to a record 5.4% of gross domestic product (GDP) in the quarter ended 30 September, well above the accepted comfort level of 3%, exposing its vulnerability to external risks. The deficit widened mainly on account of a widening trade deficit as imports outpaced exports. Heavy imports of oil and gold contributed along with a slowdown in inward remittances from overseas Indians.
Moody’s, in a report released on Monday, said a loose fiscal policy fuels domestic inflation, which erodes the competitiveness of both export- and import-competing sectors, contributing to the widening of the trade gap.
“Trends in the first two factors are unlikely to turn significantly benign in 2013. Therefore, an improvement in India’s trade balance will require a shift to policies to enhance domestic competitiveness,” it said.
To be sure, despite decelerating economic growth, which is forecast to decline to a decade low of 5% in the current fiscal year, and being under pressure to generate resources to fund populist measures ahead of a raft of state polls leading up to the general election in 2014, finance minister P. Chidambaram has pledged to contain the fiscal deficit.
Chidambaram is committed to restricting the fiscal deficit to 5.3% of GDP this fiscal year and reducing it to 4.8% in the next.
These assumptions have come under threat after the Central Statistics Office projected that the economy would grow at 5% in 2012-13 and not 5.5-5.7% as expected earlier.
Moody’s, unlike rival rating agencies Standard and Poor’s (S&P) and Fitch, has so far maintained a stable credit outlook on India’s sovereign rating.
S&P had warned last year that there was a one-in-three chance of a sovereign rating downgrade to junk status if the “external position continues to deteriorate, growth prospects diminish, or progress on fiscal reforms remains slow in a weakened political setting”.
Fitch reiterated its negative outlook on India’s sovereign credit rating last month, citing concerns about slowing economic growth, persistent inflationary pressures and an uncertain fiscal outlook.
Moody’s said India’s monthly average trade deficit had risen from $13.5 billion in 2011 to $16 billion in 2012, up from an average of $9.5 billion a month between 2008 and 2010.
“These rising deficits are being financed by increased foreign-currency borrowing, raising India’s vulnerability to international financial volatility. Wider trade deficits can also weaken the currency, raising domestic prices of imported commodities, further fuelling India’s already high inflation rate,” it said.
Data released by the commerce ministry last week showed that India’s exports grew for the first time in nine months in January while imports touched a record high of $45.6 billion, leading to a $20 billion trade deficit.
The fiscal deficit is not out of bounds and can be controlled, said former Reserve Bank of India (RBI) governor Bimal Jalan.
“Oil prices are coming down and exports are recovering. What we need to do is to make exports part of our industrial policy to give it sufficient boost,” Jalan said.
Indira Rajaraman, a member of the 13th Finance Commission, said the government should be worried about the issues flagged by the rating agencies to the extent that they draw attention to the seriousness of the problems.
“Bringing down the fiscal and current account deficits (of the balance of payments) will need difficult decisions and agreement across the political spectrum,” she said.
Moody’s said India’s domestic policies partly explain why its current account deficit had exceeded that of many similarly-rated peers operating in the same global environment, even those that are equally reliant on energy imports.
India’s trade deficit touched $173.4 billion in the first 10 months of the fiscal year (April-January); oil imports cost $140.4 billion in the period.
Moody’s said the rise in the current account deficit has largely been funded by foreign currency debt.
“Consequently, India’s external debt has doubled since 2006 to about $365 billion in the third quarter of 2012. Still, India’s external debt to GDP ratio of 22% is relatively low compared to similarly rated countries,” it said, warning that if the current balance of payments trend persists, the country’s external liquidity position will eventually weaken.
The rising current account deficit and stubborn retail inflation are expected to curb the ability of the central bank to aggressively cut policy rates to support growth.
RBI governor D. Subbarao said last week that the country’s current account deficit may reach a record high in the current fiscal ending 31 March. “We are financing our current account deficit through increasingly volatile flows. Instead, we should ideally be getting as much foreign direct investment as possible to finance the current account deficit,” he said.
The central bank cut interest rates for the first time in nine months last month, but warned at the time that a lower current account deficit and easing inflation would be needed for it to make more reductions.
Reuters contributed to this story.