Why does a sovereign-rating upgrade continue to elude India?

India has been making presentations to these agencies for years, arguing that its rating does not reflect the strength of its economy and that it deserves an upgrade. Finance ministry officials made this case to the three agencies before this year’s union budget was presented, too.

Why does a sovereign-rating upgrade continue to elude India even though it has displayed macroeconomic stability and recorded the fastest GDP growth of any country during this phase of global uncertainty?

The rating agencies aren’t oblivious of India’s economic promise, of course. The latest note from Fitch makes it clear that India will be one of the fastest-growing Fitch-rated economies despite its expectation that the GDP growth rate will slow (on account of elevated inflation, high interest rates, subdued global demand and pandemic-induced, pent-up demand fading) from an estimated 7% in FY23 to 6% in FY24.

Fitch counts among India’s strengths its robust GDP growth outlook and resilient external finances. The growth outlook, it writes, looks promising after the improvements in corporate and bank balance sheets recorded in the past few years, which the government's infrastructure drive has done well to support. But India’s strengths, it explains, are offset by weak public finances. The elephant in the room is India’s deficits and debt levels, which are higher than those of its peers.

World Bank governance indicators and per-capita GDP figures don’t bring much comfort either. Fitch would like to see improvements in the low labour force participation rates. India's large domestic market makes it an attractive destination for foreign firms but the uneven reform implementation record may prevent this potential from being realised.

Long-term growth prospects matter because ratings rest chiefly on the ability of a country to repay its debt and narrow the fiscal deficit over the long term.

Fitch has said the general government deficit (excluding receipts raised from the divestment of government companies) for India is expected to fall to 8.8% of GDP in FY24 from 9.2% in FY23. Though less than the previous year’s, the 8.8% figure is still high. The central government remained committed in this year’s budget to its medium-term fiscal guidance and a deficit target of 4.5% of GDP by FY26. Fitch’s concern is that the budget provided few details on how this target will be achieved.

A commitment in the union budget does not cut much ice with rating agencies as the credibility of promises has eroded considerably. India’s Fiscal Responsibility and Budget Management (FRBM) Act has been in place since 2003. The trouble is that the targets for fiscal consolidation specified under it are routinely missed. This has happened in years of economic shocks such as the global financial crisis and covid-19 pandemic. But – and this is hard to ignore – it also happened in years when there were no global economic shocks.

For instance, on February 1, 2020, weeks before the pandemic began, the budget invoked the act’s ‘escape clause’ to get a 50-basis-points leeway in the fiscal deficit number for 2019-20. Against the target level fiscal deficit of 3.3% of gross domestic product (GDP) in 2019-20, the budget for that year presented a revised estimate of 3.8%, and instead of the earlier fiscal deficit projection of 3% for 2020-21, proposed a deficit of 3.5% of GDP. The growth in revenue collections was tepid, the budget speech said, explaining the slippage and seeking to use the escape clause.

Earlier, Parliament gave its approval in 2018 to delete from the FRBM Act the requirement of wiping out the revenue deficit. The revenue deficit broadly measures the amount of borrowings used for revenue expenditure, while fiscal deficit measures the overall borrowing to finance both revenue account deficit and capital account deficit. 

At the time, public finance experts had raised a red flag, arguing that doing away with revenue-deficit targeting and going ahead only with fiscal-deficit targeting would have serious implications for achieving the public-debt target. The decision to abandon the revenue-deficit target was also seen as inconsistent with the philosophy behind the FRBM Act, which was to force the government from switching from consumption to capital expenditure as the latter has a higher multiplier effect on GDP growth.

Indian economists arguing for a ratings upgrade tend to offer the argument that the country’s debt-to-GDP ratio is lower than that of many western countries. However, what matters from the point of view of sovereign ratings is the pace of debt reduction. David Beckworth of the Mercatus Center think tank has shown that in the US, the ratio of public debt to gross domestic product has plummeted by more than 20 percentage points from its pandemic peak. 

How does that compare with India? Fitch doesn’t expect India’s general government (centre, states and public sector enterprises) debt, estimated at 82.8% of GDP in FY23, to fall much even by FY28. India’s debt level, at over 80%, is much higher than the median number for BBB-rated economies – 55.4%.

Estimates by other economists are close to Fitch’s. Prachi Mishra, an IMF economist who previously worked at the RBI, has shown that India’s fiscal deficit, measured as a public-sector borrowing requirement (i.e., consolidating the centre, the states and their public-sector enterprises) has remained above 10% of GDP for the past several years. It hit a peak of over 14% of GDP during 2020-21. In terms of outstanding stock, sovereign debt-to-GDP increased by 20% after 2020 and is still nearly 85%.

Fitch estimates that even if India improves its record of missing fiscal deficit reduction targets, hitting 4.5% of GDP by FY26 would require accelerated consolidation of 0.7 percentage points a year in FY25 and FY26.

This is a tall order because interest rates are high and India’s tax-to-GDP ratio has remained stuck at less than 12% for years, a level that is lower than that of most comparable economies.

In FY23, a reduction of 0.3 percentage points was achieved. This year’s budget estimates another 0.5 percentage points reduction will be possible in FY24. The reason rating upgrades elude India is that the GDP growth does not translate into higher tax collections, as a result of which the pace of fiscal correction and debt reduction keeps missing targets.