What now after the upgrade?

By upgrading so close to the business end of India's poll cycle, Moody's has made it tough for the NDA to abandon fiscal restraint

With Moody’s having upgraded India’s sovereign bond rating to Baa2 from Baa3 citing continued progress on economic and institutional reforms, it is worth noting that the last big upgrade that India was subject to was in January 2004 when Moody’s upgraded India from Ba1 to Baa3 thereby marking India’s re-entry into the investment grade category.

So, what are the benefits of this celebrated upgrade? Financial markets are meant to be efficient. Hence, well in advance of the upgrade, the 10-year government bond yield had fallen from 9 per cent three years ago to around 7 per cent now. In addition, given that FIIs’ debt ceilings have already been hit, it is not clear to us that the upgrade will lead to incremental bond inflows into India. In fact it is worth noting that the average 10-year G-Sec yield “rose” by 10bps in the 24 months following the upgrade of January 2004 when compared to the 24 months’ average 10-year G-Sec yield before the upgrade of January 2004.

However, there is no denying that there could be a further drop in the cost of debt capital in the overseas debt funding markets as Western fund houses and banks have greater willingness to lend to countries which are two notches above junk rather than just being one notch above junk.

LOOKING UP “No pause (on fiscal consolidation) but challenges arising from structural reforms... could change the glide path,” finance minister Arun Jaitley has said. It is unlikely that the Centre will retain fiscal consolidation in FY19

 

Furthermore, this cost of overseas debt funding could then result in capital-hungry Indian firms — especially lenders — being able to raise lower cost funding abroad. That reduction in the cost of capital — which could be as much as 100 basis points for the marginal cost of borrowing — in turn would allow Indian lenders to provide cheaper credit to their customers, thus potentially reducing the cost of capital across the economy.

Additionally, given that the proportion of debt held by Indian companies that are unable to meet their interest obligations has risen to a nine-year high, this upgrade could potentially allow stressed firms to access capital in the overseas market at lower rates.

Obviously, all of these positives become that much more likely if the two other major credit rating agencies, i.e. Fitch and S&P, follow Moody’s example. At present, both S&P and Fitch have assigned India the lowest investment grade rating with a stable outlook (Moody’s was the only one to have a “positive” outlook on India).

The risk of reversion to the mean

Whilst the NDA has done a commendable job of fiscal consolidation so far (with the budget deficit falling from 4.5 per cent of GDP in FY14 to 3.2 per cent in FY18), the chances of India’s fiscal position slipping this point appear higher at present than at any other stage of the Modi-led government’s tenure. This viewpoint rests on a range of reasons.

Firstly, the Modi government has recently announced a $30-bn public sector bank recap plan. Whilst the exact impact on the fiscal deficit can only be ascertained once the final structure of bond issuance is decided, it is clear that this will add to India’s fiscal burden directly or indirectly over FY18 and FY19. Secondly, if crude oil prices — which are up 40 per cent over the past two years —continue rising then the exchequer will be forced to cut excise rates further.

Thirdly, as per the medium-term fiscal policy statement tabled in Parliament on February 1, 2017, the government said that it would aim to hit a fiscal deficit of 3 per cent of GDP in FY19 from 3.2 per cent of GDP in FY18. However, the government has not yet resurrected the Fiscal Responsibility and Budget Management (FRBM) Act which would ensure the maintenance of fiscal discipline in the run-up to the general election of 2019.

Finally, it is worth noting that the fiscal maths for FY18 itself is looking fairly precarious and the only way the government can meet its fiscal deficit target for FY18 is by curtailing expenditure growth significantly in 2H FY18.

At a qualitative level, our discussions with those who are part of the political ecosystem suggest that the party is acutely aware that a rising proportion of the electorate is unhappy owing to: (1) the way and manner in which GST was implemented; and (2) the demonetisation decision that was undertaken a year ago. In fact, our own surveys suggest that small and medium businesses (SMEs) are reeling under distress due to disruptions such as demonetisation and GST. A pre-poll survey conducted by Lokniti-CSDS in Gujarat suggested that even as the BJP is set to retain control of the state, (1) 40 per cent of voters were of the view that GST was a bad move; (2) the Congress now leads BJP amongst the farmers of Gujarat; and (3) 49 per cent of voters were of the view that Prime Minister Modi had failed to bring about the “achhe din” (i.e. “good times”) that he had promised.

In light of the above factors and with the finance minister saying last week, “no pause (on fiscal consolidation) but challenges arising from structural reforms... could change the glide path”, we believe that it is unlikely that the government will continue with fiscal consolidation in FY19. It is worth noting that in a typical five-yearly election cycle in India, the final 18 months contain over a dozen Assembly elections before the climactic general election. Hence, unsurprisingly, the fiscal balance tends in India to deteriorate in the final 18 months prior to the general election. In fact, that brings us to the most heartening aspect of Moody’s long overdue upgrade — by upgrading so close to the business end of India’s election cycle, Moody’s has made it very difficult for the NDA to abandon fiscal restraint over the next 18 months.

Saurabh Mukherjea and Ritika Mankar-Mukherjee are CEO and senior economist respectively at Ambit Capital