Moody’s boost to Modi: Should India really cheer?

The Narendra Modi government is celebrating the upgrade of India’s sovereign credit rating by Moody’s Investors Service. The new rating places India at Baa2, up a notch from Baa3. The outlook has also been raised from positive to stable, while other ratings including the one for short-term local currency have seen an upgrade by a notch each.

It is important to place Moody’s action in perspective and understand what this upgrade actually means. Also, what all should the government be wary about to maintain the newly acquired rating and even improve it further in the coming years?

India’s last upgrade by Moody’s was 13 years ago in 2004. And that was a far bigger development. That was when India re-entered the investment grade category on a rating scale devised by Moody’s, after a gap of six years. From June 19, 1998 (in the aftermath of India’s nuclear tests in Pokhran) to January 22, 2004 India remained classified in the non-investment or ‘junk’ category.

Things were not so bad in the 1980s. From January 28, 1988 to October 3, 1990, India had a credit rating of A-2, the highest investment grade rating it ever got. But on October 4, 1990, it was downgraded to Baa1 in the wake of India’s twin crisis of worsening balance of payments and fiscal indiscipline. On March 26, 1991, it was further downgraded two notches to Baa3, which was the last category of investment grade rating. On June 24, 1991, India plunged into the non-investment category at Ba2, a downgrade of two notches.

It was upgraded to investment grade at Baa3 on December 1, 1994 and remained there till early June 1998.

The investment grade under Moody’s rating scale has 10 notches (see table below), starting with Aaa, which has the smallest degree of risk, and ending with Baa3, which has a moderate credit risk. Till Thursday, India was at Baa3 and now it has moved up to Baa2.

Experts point out that the ten categories of rating under the investment grade are further classified under four broad groups. Aaa is ranked at the top with the smallest degree of risk. Aa1, Aa2 and Aa3 are categories that are meant for countries with a very low credit risk (China, for instance, is rated at Aa3) and A1, A2 and A3 are assigned to countries that are seen to be having a low credit risk. The fourth group consists of Baa1, Baa2 and Baa3, which are countries with a moderate credit risk.

What has happened now is that India’s rating has moved up only one notch within the investment grade category and it still remains within the last group that classifies countries with a moderate credit risk. In other words, India’s credit risk profile continues to be defined as moderate.

Why it took so long for India to move only one notch within the investment grade category with a moderate credit risk profile is a comment on the effectiveness of Moody’s rating methodology as also on the government’s ability to influence the rating agency to recognise the many policy developments that could have merited an earlier upgrade.

In the last 13 years, investment flows from abroad have seen a steady rise and Indian companies have been borrowing more from overseas markets, though it could be argued that the terms of these loans could have been better with a higher rating from Moody’s. Nevertheless, a rating of Baa3 has really not come in the way of either more foreign investment or higher foreign borrowing. So, is the celebration a little overdone?

The Modi government is in a celebratory mood perhaps because it has now succeeded in convincing Moody’s to improve India’s rating. It has been trying to get an upgrade in the last couple of years, but it has succeeded only now. The Manmohan Singh government too had tried, but did not succeed in securing an upgrade.

The immediate impact of India’s rating upgrade will be positive in terms of access to foreign loans at relatively easier terms. Investment flows into the country are also likely to increase. Indian companies looking for loans and capital on easier terms would certainly benefit. But its consequences for the government’s macroeconomic management may not be entirely positive.

One, the increased flow of foreign exchange into the country is likely to put further upward pressure to the exchange rate of the Indian rupee, which is already significantly overvalued. Exporters may not like further appreciation in the value of the Indian rupee, which went up on Friday after the decision on the rating upgrade became public.

Exports growth in the first seven months of the current financial year has been tepid and with an appreciating rupee the government’s task to promote exports will become even more challenging. Imports are also likely to see a surge with the appreciating rupee and this might not augur well for the country’s current account deficit that has already widened to over two per cent of gross domestic product (GDP).

Two, one of the factors that helped the rating upgrade for India was the government’s improved fiscal situation. In each of the last five years, the Union government has succeeded in reducing the fiscal deficit, though by a small margin. From 5.8 per cent of GDP in 2011-12, the Union government’s fiscal deficit declined to 3.5 per cent in 2016-17. The combined fiscal deficit of states and the Centre also has not yet gone out of control, though its progress at 6.4 per cent of GDP in 2016-17 gave the Moody’s some confidence in India’s ability to stay on the path of fiscal consolidation.

Therefore, the challenge of staying on the path of fiscal consolidation becomes even more pressing in the current year as also in the coming years. The fiscal deficit target of 3.2 per cent of GDP for 2017-18 is under stress, as non-tax revenues have declined and the pressure on the fisc has risen on account of additional expenditure on account of public sector bank recapitalisation and infrastructure spending. There is also a demand from influential sections within the government to relax the fiscal deficit reduction targets and give a pause to the implementation of the fiscal responsibility and prudent budget management practices to be stipulated under a proposed law.

Meeting the fiscal deficit target for the current year and laying out a road map for further fiscal consolidation in the coming years is of utmost importance if the Moody’s rating needs to be upgraded further. Worse, if there is any slippage in meeting the fiscal deficit target, the rating will be adversely affected. “A material deterioration in fiscal metrics and the outlook for general government fiscal consolidation would put negative pressure on the rating,” says Moody’s in its statement on Friday.

Three, the government has to be mindful about the health of the banking system. Moody’s has warned that “the rating could also face downward pressure if the health of the banking system deteriorated significantly”. The government has laid out a Rs 2.11 lakh crore plan for recapitalising the state-owned banks.

But its implementation in itself is not a panacea for the banking sector. Recapitalisation will help the banks to improve their capital adequacy and increase lending. But equally important will be early resolution of their stressed assets, strengthening their management systems so that past imprudent steps like lending to risky projects are not repeated and a revamped ownership structure that makes them more nimble-footed and free from political interferences.

If the health of the banking system does not improve in the next year or two, the risks of a downgrade may lurk once again.

Four, India’s rating is likely to come up for a downward review if its “external vulnerability increased sharply”. For India, oil prices are certainly a factor. India continues to be hugely dependent on imported oil, whose prices of late have begun to rise. If these prices rise and the government is not able to manage their consequences in the domestic economy through prudent pricing policies, then the newly acquired rating can be subjected to a review. The government has to be cautious on this front.

And finally, India’s rating can be sustained and indeed improved if the government continues to stay on the path of fiscal consolidation and bring its debt under control. Moody’s has noted that the combined debt of the governments has risen to 68 per cent of GDP, which is significantly higher than the median rate of 44 per cent for all countries classified under the Baa group. While there are many other positive countervailing factors in India’s case, but further growth in debt can be a cause for concern.

Similarly, stress on more institutional reforms and implementation of key pending reforms in the areas of land and labour laws could help Moody’s consider an upgrade for India. But given the current political situation, it is unlikely that the Modi government will like to spend its political capital for undertaking tough and unpopular reforms like those that will relax land acquisition rules and make labour laws more flexible.

For the present, the Modi government is content celebrating its rating upgrade by Moody’s. And why not? The ruling party at the Centre is fighting a crucial Assembly election in Gujarat, one of India’s foremost industrialised states. Less than three weeks ago, the World Bank released its 2018 Ease of Doing Business report that raised India’s rank in ease of doing business from 130 to 100, the highest jump that any country has seen so far in one year. And now, Moody’s upgrades India’s credit rating!

If elections could be won with the help of good economic news about India coming from international agencies like the World Bank or Moody’s, leaders of the Bharatiya Janata Party should consider themselves fortunate and the release of these reports quite timely.