‘India’s economy is at an inflexion point’

The Indian economy is diversified, reasonably well-balanced and resilient, but the government’s “populist inclinations” run the risk of limiting these strengths, says Moody’s Investor Services vice-president and senior analyst Aninda S Mitra.

In an interview to DNA on the phone from Singapore, Mitra noted that India’s sovereign ratings have come under pressure and that the rating agency would be looking at the upcoming Budget for signs of a commitment to fiscal prudence and structural reforms. Excerpts:

In your report, you have not explicitly flagged the risk of a sovereign rating downgrade. Is there a risk of a downgrade going forward?
Yes, there is. The ratings have come under pressure, and they remain highly contingent on this newly elected government’s ability to push ahead with some combination of fiscal deficit reduction or disinvestments and/or more structural reforms that change the medium-term outlook for the country. I can’t say that one or the other is absolutely necessary for the credit rating, but some combination of all the above.

When is the earliest that the ratings might be reviewed?
The rating is not ‘under review’: it’s constantly under surveillance for developments — and if something terribly good or bad happens, we take ratings actions. In India’s case, developments are unfolding on an ongoing basis. There’s no one trigger point that would be considered crucial to the rating. Generally speaking, the kinds of things we would be watchful about are the long-term trends in the government’s debt ratios, the way in which it is financed — if we think it could potentially crowd out medium-term credit or private investment, we would be more concerned. And lastly, the medium-term growth potential of the country. If that starts to suffer because of external shocks or because of poorly managed domestic policies, then that’s the third thing that could lead us to take a more negative view.

Would you be looking at the upcoming budget to give you a sense of the policy orientation and a signal of how the macroeconomic management is faring?
Possibly, yes.  If you’ve been following the news flow, you will get clues to a certain level of concern from the RBI that fiscal consolidation needs to be reinstated. On the other hand, there’s also some talk from within the ministry of finance about a sense of prudence in the fiscal framework, but there’s also a perception...that the stimulus need to continue. What will ultimately come out of the budget, only the government knows. We would have to wait to at least see the kind of policy shift, if any, that takes place in the aftermath of the budget, and whether or not that is being accompanied by a broader move towards medium-term structural reforms or countercyclical policies in the fiscal framework.  It’s not as simple as: ‘The expenditure goes up — boom — you get downgraded’.

Will you be looking for a renewed commitment to the Fiscal Responsibility and Budget Management process?
We’ll be looking for some broad mix of either deficit reduction and/or more structural reforms and/or steps that will hold out the reassurance that the medium-term fundamentals of the economy are not affected on a long-term basis.

Alongside that, yes, of course, we will be looking to see if the budget is consistent or not with what one would expect to see from the second phase of the FRBM as is to be announced in October by the 13th Finance Commission. In terms of what the FRBM should look like... there’s talk about getting the subsidies above the line, of putting in stricter countercyclical spending measures, and of creating some sort of a body to accumulate proceeds from disinvestment and use that more countercyclically....We will be looking at how consistent a full budget is going to be with some of these measures.

Should the new government perhaps be given a bit more elbow room, given that GDP projections are being revised upwards?
When you talk about space, there are two kinds of spaces. You have what is clearly a low and diminishing fiscal space, but a new-found, considerably greater political space to do things as the government deems fit.  We’re trying to assess how the credit fundamentals of the economy fall between these two spaces. And that’s why we thought it would be appropriate to wait until after the elections to provide a deeper assessment of where we would like to see the policy mix evolve towards. Having seen that the government has a lot more political space, I think it would be appropriate to wait until after the budget to get a sense of what the long-term trajectory of the debt might be, how it’s going to be financed, and what the long-term potential of the Indian economy is going to look like.

In your report, you’ve said, “The susceptibility of the country’s sovereign ratings to financial or political event risks — that could result in a sudden deterioration in its debt-servicing ability — is low.” Where else does the risk come from?
There are two types of unforeseen risks. One would be contingent liabilities — for instance, if a big state-owned company needs a bailout. That would affect the budget. That’s the kind of contingent liabilities that are possible but may not have a huge impact. That’s something we look at in terms of the fiscal strength of the government. But there are other low-probability risks that could have an enormous impact - like the collapse of the banking system or something of that sort.

That is something we look at as an ‘unknown unknown’, if you will. But the susceptibility to completely unknown shocks is very low because the extent of leverage outside of the government sector is quite low. If you look at the debt-equity of private companies, it’s not high. That’s what why we say the risk of a financial meltdown is quite low. And in terms of political shocks — for instance, a massive terrorist strike — India has already been tested. We didn’t see widespread political instability.

The country’s institutions are robust enough and strong enough to meet some of these challenges head-on... Those are the sorts of things we are looking at when we speak of low probability but high impact events that could otherwise affect the economic environment.

In your estimation, what is India’s biggest strength and the biggest weakness?
India is a large, well-diversified, reasonably balanced economy: that’s its biggest strength. It doesn’t have that much leverage outside of the government sector. And it’s very resilient to the external shocks it is facing. That alone should provide a lot of space for the government to get its act together and make sure that its fiscal fundamentals are well-positioned going forward.

The weakness, on the other hand, is the sort of very populist inclination within the government itself —where it tends to step in very quickly to meet any challenge that could otherwise be resolved through structural reforms or by getting the private sector to absorb the shocks and learn to survive on their own. When you had the crude oil price hikes, it was absorbed by the government and the Indian Oil Corporation. This kind of risk sharing could damage the long-term fundamentals of companies that should are put through such exercises. That’s the kind of socialisation of risks that’s putting their own balance-sheets on the line... For instance, getting the RBI to start buying up government bonds... That’s the kind of stuff that could limit in the medium-term the resilience that I talked about.

Is India’s long-term growth at risk of being impaired by a potential rating downgrade?
Our credit ratings are merely a statement of credit-worthiness. Whether or not the opinion itself has a bearing on the long-term potential of the economy is uncertain. But having said that, the long-term potential is possibly at an inflexion point. What the newly elected government does from here on could have substantial effects, we think, on the direction in which the economy heads. If the government truly believes that budget deficits of the order of 9-10% of GDP are very necessary and here to stay for the next two or three years, then the prospects for the private sector’s access to credit and its ability to improve its capital formation would clearly come under question. India’s growth is a massive investment-driven story — and productivity as well. Those two things will come under pressure. So, it is at an inflexion point. The long-term trajectory will be determined in near future by this government.