When Standards and Poors revised its outlook on India’s BBB- long term sovereign credit rating to negative from stable in April of this year, the criticism it raised in India has not been surprising, given the inherent dangers of a potential downgrade and loss of the investment grade status for the Indian economy.
In its report on India the rating agency explained its move with lower GDP growth prospects, the risk of erosion in India’s external liquidity and fiscal flexibility, as well as “the risk that Indian authorities may be unable to react to economic shocks quickly and decisively enough to maintain its current creditworthiness”.
A return to high growth rates would depend on fiscal reform and improvements to India’s investment climate, the report noted.
At the end of the first quarter 2012 India’s GDP stood at 5.3 per cent down from 6.1 per cent in the previous quarter. Meanwhile the Indian rupee declined by 20 per cent against the dollar over the past year and business confidence has taken a hit.
At first glance one could conclude from S&P’s assessment that many of India’s problems are political.
The rating agency points specifically to a “policy paralysis”, the failure to implement announced reforms and a lack of reform willingness in general.
This has impacted business confidence as much as raised scepticism among local and foreign investors. Investor confidence was further hurt by both the reversal of a previous government decision to raise cap on foreign direct investment in multi-brand retail from26 per cent ownership to 49 per cent and the retrospective implementation of taxation on offshore transaction involving assets in India.
These types of decisions have led to a perception that does not bode well for India’s growth prospect and led to concerns that India’s market liberalisation since the 1990s could be undone by a change in economic policy. Even a failure to advance the liberalisation of markets in India would reduce India’s growth potential and hurt the country’s credit rating, according to S&P.
When India became the poorest country in 2007 to receive an investment grade rating, this was done on the basis of high economic growth rates and a high level of foreign exchange reserves. Poverty rates had declined and a total of 40 million people had been lifted out of poverty. Savings and investment rates had increased.
These rates are expected to come down amid a strain on public finances and lower corporate profitability, which in turn would result in lower GDP rates or a higher external deficit that makes the country more vulnerable to external shocks, the credit agency notes.
Decreasing foreign currency reserves and a widening current account deficit have already changed India’s external profile.
While this in itself is not serious enough to warrant a ratings downgrade, India’s policy response will determine whether such a move will be necessary in the future, according to S&P.
Although senior Indian politicians remain committed to market reform, the momentum for market liberalisation has stalled. Labour laws remain “rigid”, the land markets “heavily regulated and opaque” and “populist policy solutions may be tempting”.
Moreover, S&P argued, corruption scandals and allegations in major regulated sectors such as mining, telecommunications, oil and gas, and land acquisition, could lead to a backlash against liberalisation by a public that may confound market-oriented policies with favouritism.
Most importantly the framework for making economic policy has weakened in light of the division within the Congress party on economic issues and the division of roles between a politically powerful Congress party president and an appointed prime minister. The general election in 2014 further constrains the potential for reform to the second half this year and early 2013.
On a positive note, S&P states however, India is in better shape than it was in the 1990s for instance, given that many Indian firms are now globally competitive, global perceptions of India have improved markedly, India’s middle class is growing and the country’s improved infrastructure could spark economic activity in the future.
Critics to the ratings move by S&P (and Fitch Ratings) have not argued against the assessment of political roadblocks to reform but rather their implications for the credit rating, by pointing to the government’s fairly stable debt-to-GDP ratio at 45 per cent and low external liabilities of less than 4 per cent of its total outstanding debt .
Chandrajit Banerjee, the director general of the Confederation of Indian Industry, argues developing countries are held to a different standard than developed ones which arguably have bigger problems. “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,” he writes.
“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.”
Banerjee also notes that the division of power, crictised by the rating agencies, has been existence for some time and served India well in the past and structural indicators such as savings and investment rates, foreign direct investments or labour productivity remain high.
He maintains that despite the turmoil in financial markets and the outflow of capital led by portfolio investors, India has remained an attractive place to invest.