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Are S&P and Fitch overreacting?

Business Standard 

Cyclical ups and downs are no basis for an investment downgrade but it is time to address the deterioration in domestic macros

Chandrajit Banerjee Chandrajit Banerjee
Director General, Confederation of Indian Industry

“The reports do not dwell on the extent to which India's slowdown is due to negative external conditions and wrongly suggest it is largely self-inflicted by policy makers”

It is widely known that political roadblocks have held back economic reforms and the Indian economy is slowing down. Indeed, the Confederation of Indian Industry has appealed to the political leadership to converge on issues of national importance. That these factors should lead to a downgrade of India’s credit rating, however, does not follow. A sovereign credit rating indicates a country’s creditworthiness and the risk associated with investing in the country. It is apparent that despite the recent setbacks to economic growth, there is hardly any likelihood that India will default on its loan repayments. For one, the government’s debt-to-GDP ratio has been fairly stable at 45 per cent and, second, its external liabilities constitute less than four per cent of its total outstanding debt. In fact, the recent rating actions by Standard and Poor’s (S&P) and Fitch were initiated by the rating agencies themselves. It is no wonder, then, that the government has reacted negatively and rejected the reports.

It seems that in view of the turmoil in the euro zone, rating agencies are being extra careful about those countries that run relatively high deficits. It is important to note that most developing countries, including the Brics countries (Brazil, Russia, India, China and South Africa), are going through a period of economic slowdown that has resulted in increasing budget deficits.

The reports by S&P and Fitch do not dwell on the extent to which India’s slowdown is due to negative developments in external conditions. I would attribute at least 80 per cent of the recent change in India’s economic outlook to the slowdown in exports and sudden increase in risk aversion among portfolio investors resulting in large capital outflows. Whereas the impression generated by the reports is that the downturn is largely self-inflicted by India’s policy makers.

The S&P report’s comments on how the separation of political power and executive leadership has been detrimental to economic policy-making are also off the mark. Such a system has worked well at times as is apparent from the excellent performance of the economy during the UPA-I regime. If the separation of power were a genuine handicap, then the agency should have downgraded the country much earlier in 2004 when this system was first put into place. The reason the government is finding it difficult to move forward with some economic reforms is that democratic processes can often be time consuming.

Despite these drawbacks, if one were to look at India’s rating as a broad indicator of the level of risk associated with investing in a country, I would think that the threat of a downgrade is not justified. India remains an attractive place to invest owing to its long-term growth potential. In fact, the data on foreign direct investment put out by the Reserve Bank of India show that inflows into India have actually increased from around $35 billion in 2010-11 to $47 billion in 2011-12. Despite the turmoil in financial markets and the outflow of capital led by portfolio investors, India has remained an attractive place to invest. External commercial borrowings by Indian companies have also remained robust during this period, indicating willingness of global banks to take on Indian debt.

Rating agencies have, historically, given little weight to the fact that developing countries are able to grow their GDP at a faster rate than they accumulate debt. The problems being faced by some of the developed countries are far more serious than those faced by India. Compared to the US, Japan and most European nations, India’s debt as a percentage of GDP is lower, while its growth rate is higher. Yet all these countries have a higher rating compared to India.

A credit rating should not change according to cyclical ups and downs in an economy but should reflect structural changes. I do not see any deterioration in structural indicators like the saving and investment rates or labour productivity. The investment rate, which has moderated on account of the cyclical downturn, remains at a relatively high level of 35 per cent. Without the problems of an ageing population, India’s saving rate is relatively high at over 30 per cent. A report throwing more light on such structural indicators would have been more interesting.

Rana KapoorRana Kapoor,
Managing Director and CEO, YES Bank

“The potential loss of investment grade status and its ramifications for an emerging economy like India, which is short of investment-related flows, should not be dismissed”

The year 2012-13 began with Standard & Poor’s (S&P) and Fitch raising a red flag over India’s sovereign credit rating. While the long-term rating was retained, both the international rating agencies revised their outlook on India from “stable” to “negative” on the back of rising concerns on twin deficits and slowing growth. The rating agencies see the prospects of India’s economic growth worsening amid greater vulnerabilities to global economic shocks.

From a technical perspective, S&P’s warning translates into a one-in-three chance of India losing its “investment grade” status within the next two years. The potential loss of investment grade status and its ramifications for an emerging economy like India, which is short of investment-related flows, should not be dismissed.

In the middle of a soft and uncertain global economic phase, the domestic macro fundamentals have witnessed sequential deterioration. Economic growth has moderated close to 6.5 per cent with inflation remaining elevated. Fiscal and trade deficits are gravitating away from normally accepted levels of sustainability. Most importantly, the deterioration in macros and business sentiment has coincided with the lack of adequate policy and reform actions.

The warnings from international rating agencies have evoked considerable emotional reactions from thought leaders and policy makers. In my opinion, introspection, followed by clear, vision-backed actions should take precedence over poignant refutation.

The deterioration in domestic macros should be analysed from two different perspectives to arrive at any strategic response.

The consumption-led fiscal deficit is one of the most important links in the domestic economic chain. The high level of fiscal deficit and excessive government expenditure has not only dampened the investment climate, but it has also contributed to the sticky structural nature of inflation. Moreover, higher deficits have led to a moderation in overall savings rate in the economy, thereby exerting pressure on the current account deficit.

With the fiscal deficit-to-GDP ratio slipping to 5.8 per cent in 2011-12 vis-à-vis the targeted level of 4.6 per cent, the onus of correction lies squarely with the government. It is comforting to see that the 2012-13 target for fiscal deficit has been set at a more realistic level of 5.1 per cent. Besides, the fiscal adjustment process is being backed by a higher budgeted allocation towards capital expenditure and a contraction in the subsidy bill.

The long-awaited upward adjustment in petrol price was a step in the right direction. The government has also displayed a renewed focus on infrastructure projects. However, more needs to be done in fuel price adjustments and revival reforms. Policy makers should use this “opportunity-in-adversity” and build on the momentum to introduce reforms in areas of foreign direct investment in retail and insurance, land and natural resources acquisition, direct tax code and goods and services tax. These reforms will help in de-bottlenecking the investment flows, contain supply side pressures on inflation, and increase the growth rate in a short time span.

The year 2012 appears challenging with a recession in the euro zone and a lackadaisical growth momentum in major economies like the US and China. The sentiment of global risk-aversion has also contributed in investment flows to India remaining subdued.

A relative outperformance by design and grit by Indian policy-makers to counter these adverse global factors would not only help in improving domestic macros, but also improve India’s image as a long-term investment destination.

There is little doubt that India’s economic fundamentals are structurally strong. High savings and investment ratios, low reliance on external debt, resilient banking and corporate balance sheets, and the second-largest consumer market in the world are key pillars of strength for the economy.

But clearly, as S&P and Fitch pointed out, the determination and the ability to undertake those remain hostage to compulsions of coalition politics. The good news is that the red flag raised by the international rating agencies appear to be a timely wake-up call for policy makers.

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First Published: Thu, June 21 2012. 00:12 IST