Forget ratings agencies, focus on fundamentals3 min read . Updated: 28 Dec 2016, 04:18 AM IST
While India has made significant progress, there is still plenty of scope for improvement
The Narendra Modi government is not very pleased with global credit rating agencies. Last week, a Reuters report showed that India aggressively pushed for a ratings upgrade with Moody’s Investors Service and criticized its methodology. The government of India was also critical of the view taken by S&P Global Ratings in November and economic affairs secretary Shaktikanta Das had then called for introspection among rating agencies.
India has implemented a number of reforms since the Modi government took charge in New Delhi and has been expecting an upgrade in credit ratings with an improvement in economic fundamentals. The fiscal and current account deficit has come down; India has formally adopted the inflation targeting framework for monetary policy and is today the fastest growing large economy in the world.
The macroeconomic fundamentals are now noticeably better than they were in 2013, when India was staring at a potential downgrade which would have then multiplied problems for policymakers and imposed enormous cost on the Indian economy. In fact, to a large extent, it was the fear of a downgrade in credit ratings that prompted the Manmohan Singh government to take corrective measures and decisively move on the fiscal consolidation path which was taken forward by the Modi government.
To be sure, a ratings upgrade will help India attract more capital from the rest of the world at comparatively lower rates and can boost growth prospects. A large number of institutional investors are mandated by regulations to invest in securities based on credit ratings. An upgrade will also help the government politically. It will be seen as an acknowledgment of the government’s handling of the economy. Despite the benefits, however, should the government be upset about ratings ? There are at least three reasons why the government should not worry about a ratings upgrade at the moment.
First, while India has made significant progress, there is still plenty of scope for improvement in macroeconomic fundamentals. For example, India has a genuine problem of higher fiscal deficit. The Fiscal Monitor of the International Monetary Fund shows that India has one of the highest general government budget deficits among comparable economies. Further, the Indian banking system is currently struggling with high non-performing assets. Since most of the bad loans are concentrated in public sector banks, the requirement for capital infusion is likely to put pressure on government finances in the short to medium term.
Also, while India has adopted the inflation targeting framework, markets and rating agencies may want to see the extent to which the central bank is successful in keeping inflation closer to the central point of the target. There was a view in the market that the central bank would perhaps be comfortable with inflation hovering around the upper limit of the given band. But Reserve Bank of India governor Urjit Patel has done well to clarify that securing the 4% target remains the central bank’s primary objective. However, some of the improvement in macroeconomic fundamentals could be tested if crude prices settle at a significantly higher level compared with the levels seen in the past two years.
Second, credit rating is not the only determinant of investment. More than rating agencies, policymakers should focus on convincing the market that India is becoming a better place to do business. For this, the government will need to implement reforms at a much faster pace without creating uncertainty in the policy environment. For instance, it does not help India’s case as an investment destination that even after a decade of deliberations, it’s still not certain when exactly the goods and services tax will be implemented.
Third, credit rating agencies are not popular for giving advance signals to investors. One of the biggest takeaways of the 2008 global financial crisis was that the ratings agencies were way behind the curve in recognizing risk. The Financial Crisis Inquiry Commission in the US, for example, said in its report: “This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms."
Therefore, instead of finding fault in the methodology of rating agencies, policymakers in India would do well to build on gains attained in recent years. India needs to convince markets more than ratings agencies by building a track record of running a balanced budget with low and stable inflation. If economic prospects improve further with the necessary policy support and investment picks up, ratings upgrades will follow.
Should India worry about a ratings upgrade at this stage? Tell us at firstname.lastname@example.org