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India, which currently has the lowest investment grade, has sought an upgrade from rating agencies. While Moody's Investors Service has obliged by upgrading the outlook on sovereign ratings to stable from negative, it retained the sovereign ratings. As such Moody's action has fallen short of India's expectations.
The moot question remains whether there is really a case for sovereign rating upgrade given that the economy is yet to reach pre-pandemic level on many parameters, its fiscal deficit may continue to be in double digits as proportion of GDP and debt to GDP ratio may also be high for the second year in a row.
All the rating agencies have given India the lowest investment grade. While Fitch has assigned a negative outlook to its ratings, Standard & Poor's (S&P) and now Moody's have given it a stable outlook. This means the chances of downgrading India's rating to junk are higher with Fitch, while the two other agencies may not do so unless some drastic events take place. Also, S&P and Moody's may take some time--usually one year to one-and-a-half years--to think about upgrading the ratings, since the outlook isn't positive.
In fact, only last month Fitch Ratings had said that India continues to "lag way behind" in Covid vaccination and the negative outlook on sovereign rating signifies the rising debt-to-GDP ratio.
India had administered 900 million Covid-19 vaccines up until last week. A query to Fitch on whether it will change its position now elicited no response.
Let us examine whether or not there is a case of upgrade of sovereign India's ratings by these agencies:
High-frequency lead indicators:
Before Moody's action on the outlook of sovereign ratings for India, S&P had affirmed India's sovereign rating and outlook in July. Since then, quite a lot of important data has come. First of all, GDP for the first quarter was released on August 31. It showed that pre-pandemic levels were yet to be achieved by then. While the economy grew by a record 20.1 per cent in the first quarter of the current fiscal year, such expansion was on a massive contraction of 24.4 per cent in the corresponding three months of the previous fiscal year. GDP was still 9.2 per cent lower than in the first quarter of 2019-20, the pre-pandemic period.
But since then, high frequency indicators did tell us that economic growth is fast recovering to pre-pandemic levels. For instance, while industrial production was up 11.5 per cent in July, it was still short of the 2019 level of July, though only by 0.3 per cent. However, core sector output, which gives advance information on the index of industrial production (IIP), not only grew by 11.6 per cent in August, but was also up 3.9 per cent from the pre-Covid level of August 2019.
Meanwhile, IHS markit purchasing managers' index (PMI) for manufacturing rose in September over August, but was still lower than July figure (see chart). This could be because manufacturing activities had contracted in June, which gave a bump to the July figure.
PMI services dipped to 55.2 in September from 56.7 in August. However, services activity still grew the second fastest since February 2020. In the PMI lexicon, a reading above 50 shows expansion, anything below that means contraction.
To pu it in perspective, PMI in September declined from an 18-month high the previous month. The index in August had risen on the base of contraction, with PMI standing at 45.4 in July (PMI measures activities month-on-month).
Arun Singh, global chief economist at Dun and Bradstreet, said," High-frequency data has shown recovery and is gaining pace as containment measures have been scaled back. Dun & Bradstreet Commerce Disruption Tracker reveals that only 21 per cent of businesses in India remained disrupted as of August 20, compared to 49 per cent since May-end, when the second wave had peaked."
Even if lead parameters show that the economy is gradually recovering to pre-pandemic levels, it also means that the economy at best would be where it was two years ago and this does not give any comfort from the point of view of rating upgrade.
This has been clearly substantiated by S&P's recent commentary. It said while high-frequency indicators suggest a strong rebound during the July-September quarter after a steep contraction in activity in the previous three months on the back of a severe Covid-19 wave, macro indicators remained weak, though recovering.
Financial sector risks:
It is the receding risks from the financial sector that gave comfort to Moody's to upgrade the outlook. The rating agency said, "The decision to change the outlook reflects Moody's view that the downside risks from negative feedback between the real economy and financial system are receding. With higher capital cushions and greater liquidity, banks and non-bank financial institutions pose much lesser risk to the sovereign than Moody's previously anticipated."
However, RBI in its half-yearly Financial Stability report said while banks and other financial institutions have resilient capital and liquidity buffers, and balance sheet stress remains moderate despite the pandemic, close monitoring of MSME and retail credit portfolios is warranted alongside the need for banks to reinforce buffers, improve governance and remain vigilant in the context of global spillovers. The report was released in July when the country was under the grip of the second Covid wave.
As can be seen from the chart, gross non-performing assets of scheduled commercial banks declined to 7.5 per cent at end March, 2020-21 despite Covid-19, from 8.2 per cent a year ago. Bad debts as a proportion of total advances stood at the same level as was there on March 31, 2016. In absolute terms, bad debts declined by 5.9 per cent at the end of 2020-21 year-on-year, mainly due to a fall of 8.4 per cent in bad loans of public sector banks.
Non-banking financial companies (NBFCs) such as IL&FS and DHFL, which were earlier marked by crisis, saw their non-performing assets declining to 6.4 per cent at the end of 2020-21 from 6.8 per cent a year ago. It was, however, still higher than the levels since at least March 31, 2015, barring 2019-20 end.
Recently, the government created National Asset Reconstruction Company Ltd (NARCL), a bad bank, which is expected to turn around non-performing assets amounting to Rs two trillion.
Fiscal deficit:
After remaining in reasonable limits in two years of 2017-18 and 2018-19, the combined fiscal deficit of the Centre and the states rose significantly to 7.8 per cent of GDP in 2019-20 even though Covid had impacted the economy in the last week of the year only, when the national lockdown was announced for the first time. Next year, Covid had raised it to an estimated 14.2 per cent, even as the Centre's fiscal deficit did slightly better than revised estimates. While revised estimates had pegged it at 9.5 per cent of GDP, it actually fell to 9.2 per cent. However, much of the deficit was caused by Covid-induced lockdowns and the Centre's efforts on transparency in the subsidy regime. This year, it again might remain in double digits with the Centre's deficit itself pegged at 6.5 per cent of GDP. However, it may again fall a little bit, with the Centre's fiscal deficit as a proportion of the Budget Estimates falling to an 18-year low of 31.1 per cent in the first five months of the current financial year. The September GST figure of Rs 1.17 trillion gives a ray of hope towards that.
In fact, S&P in July this year had said that India's fiscal deficit is likely to remain high in fiscal 2022, at more than 11 per cent of GDP, amid the economy's nascent stabilization. India's fiscal performance is likely to have been affected by the severe Covid-19 situation in the first quarter of the fiscal year.
Debt-to-GDP ratio:
The country's debt worsened as the government brought in various schemes to help the vulnerable sections of society survive during 2020-21 and 2021-22. The debt is estimated to have touched 84.2 per cent of GDP in 2020-21 and is likely to have gone even beyond that as the state's budget estimates were incorporated in the calculations. In fact, the combined deficit of the Centre and the states had been high even before Covid hit the country. The charts show that the combined debt has already crossed 70 per cent in 2018-19 and 2019-20 from 61.9 per cent in 2017-18, which itself had come down from 68.8 per cent in 2016-17. The Centre's debt stood at 58.8 per cent of GDP in 2020-21. It fell slightly to 57.6 per cent in the first quarter of the current financial year.
The good thing is that the Centre included GST compensation to states in its calendar for overall borrowing which was kept unchanged at Rs 5.03 trillion in the second half of the current financial year even after incorporating borrowings for GST compensation to the states in that. After its February Budget announcement of Rs 12.05 trillion of gross market borrowing, in May, the government had said it may have to borrow an additional Rs 1.58 trillion from the market to meet the GST compensation shortfall.
However, market borrowings constitute a small fraction of the total debt of the Centre. For instance, it accounted for 6.1 per cent of total debt during the first quarter of the current financial year.
Another segment of the debt is external debt, which itself is still a smaller proportion of the total liabilities of the Centre than the market borrowings. For instance, it constituted 5.55 per cent of the total debt of the Centre during April-June, 2021-22.
External debt is very important to understand whether there could be a possibility of default, a prime concern for sovereign rating.
The exact nature of the external debt is not available for the first quarter of the current financial year, but if the entire 2020-21 is taken into account India's external debt, including that by the private sector, is not prone to default. Even in the pandemic year, the long-term debt constituted 82.3 per cent of the total, while the rest of 17.7 per cent was short-term in maturity.
Higher portions of short-term debt than long term-borrowings in the external debt can lead to external shocks as had happened in the time of the Southeast Asian crisis in late 1990s. In this respect, India is in a comfortable position.
Other debt vulnerability indicators also continued to be benign. The debt service ratio rose to 8.2 per cent during 2020-21 from 6.6 per cent during the previous year. This is mainly on account of, apart from lower current receipts, debt restructuring undertaken by leading non-financial corporations. The debt service payment obligations arising out of the stock of external debt as at end-March 2021 are projected to be moderate. A country’s debt-service ratio measures the amount of debt interest payments to the country’s export earnings.
Despite that, the country's overall debt remains high due to Covid-impacted higher borrowings by the Centre and the states. Together with the general fiscal deficit, it can come in the way of any upgrade of India's sovereign ratings. Yuvika Singhal, economist at QuantEco Research, said the sovereign rating upgrade is unlikely at the current fiscal deficit and debt levels.
Ranen Banerjee, leader of economic advisory services at PwC India, said the economic indicators coming back to pre-pandemic levels is a good sign for resilience of the economy. However, it may be a bit early before rating agencies could consider an upgrade as the projected deficit is still high at over six per cent and the debt stock has risen significantly post-Covid 19 outbreak, he said.
"We can expect a rating upgrade if the economy shows resilience and grows strongly in FY'23," Banerjee opined.
Inflation:
The rate of retail price rise was benign in 2017-18 and the next year. Consumer price index (CPI)-based inflation was a bit higher in 2016-17 and 2019-20. But Covid-affected supply shocks jacked it up over six per cent in 2020-21. However, the inflation rate was not available for April and May. While the average inflation rate was well beyond six per cent, the RBI's monetary policy committee may have taken comfort from the fact that imputed numbers for April and May were not taken into consideration, otherwise the rate would have crossed its mandate of keeping it up to six per cent. If it does not do so for the three consecutive quarters, it would have some explaining to do to the government. The rate was well above six per cent for six consecutive months starting June 2020-21, while peaking at 7.61 per cent in October. It remained well below six per cent for four months beginning December FY21. During the current fiscal year, inflation was above the mandatory six per cent in May and June, but fell below that in the next two months. However, rising fuel prices and the decision of the GST Council not to include petroleum in the reformed indirect tax system may spoil the party. One may have to look at how China's Evergrande crisis would affect metal prices, though they are on the upswing for now.
Reforms:
The government has already initiated a few economic reform that the rating agencies have taken cognizance of, such as reduction in corporate tax rates which came into effect from 2019-20. Even then, Moody's had lowered the ratings to lowest investment grade and retained the outlook on them to negative in June 2020 to reflect uncertainties caused by Covid-19.
More recently, the government amended the Income Tax Act to do away with a provision to tax overseas deals for acquiring assets in India with retrospective effect. This single move of bringing in retrospective amendments to the Act by then finance minister Pranab Mukherjee was solely responsible for shooing away many foreign investors. The move by the NDA government will go a long way to instill confidence among investors about stability of the tax regime.
Singh of Dun & Bradstreet said the Indian government is instituting an ongoing series of economic reforms to increase the efficiency of doing business with the global economy and to overcome the market limitations.
However, the rules for settling retrospective tax cases, particularly indemnifying the government, could be cumbersome and time-consuming for companies, experts said. They may struggle to come to terms with sweeping undertakings and declarations from the board and other shareholders, observed legal and tax experts.
Besides, the indemnity bond format brings all disputes under the jurisdiction of Indian courts. This could be another pain point for declarants, they say, adding a declarant may prefer his home jurisdiction or at least a neutral one.
The government also brought in three farm laws to enable farmers to sell their products outside the designated mandis. Though these laws were also brought in last year at the time of announcement of the Covid package and should have been taken note by the rating agencies, the political logjam over the measures to reform agriculture could not be removed. Rather the recent violence at Lakhimpur Kheri in Uttar Pradesh over the Acts which claimed lives of eight people may add fuel to the fire.
Recently the government also announced a telecom package to address the liquidity problems of the players in the sector. This included a four-year moratorium on payment of dues arising due to the Supreme Court’s September 1, 2020 judgment on adjusted gross revenue (AGR). Another four-year moratorium on payment of spectrum purchased in past auctions, barring the 2021 auction, is also likely to provide relief. However, it is too early to conclude whether the package will enable the sector to become more competitive or there will be only two main players left.
The other recent reform measures included production linked incentive (PLI) scheme for auto and textiles, pipeline of monetising assets. PLI for auto came close on the heels of Ford Motor Company deciding to wind up its business in India, though the reasons for this are mounting losses of the company. Three US auto companies have withdrawn their business from India in the last four years. Earlier, General Motors and Harley-Davidson have also left India. This is yet to be seen how PLI for auto would help reverse this trend and would enable more technology-driven vehicles to come to India. The earlier attempt to create manufacturing zones have not fructified.
In nutshell, the case for an upgrade by India may have to wait a bit longer till these reform measures make it easier for companies to operate, enable banks to deal with bad assets, create more manufacturing base in the country etc.
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