Rating alarm

Persisting slow economic growth could affect India’s sovereign rating, S&P Global Ratings has warned in its latest note. In a late night statement on Thursday, S&P said it could consider downgrading India’s sovereign rating in case the economy failed to recover. Last month, another global rating agency, Moody’s, changed its outlook for India’s credit rating from stable to negative due to the economic slowdown, financial stress in the rural sector, and liquidity issues in the financial sector.

The Indian economy is in a difficult situation and the possibility of rating downgrades will only exacerbate the complications in economic management. Growth in the Indian economy slipped to a six-year low of 4.5 per cent in the second quarter of the current fiscal year and high-frequency indicators are not pointing to a sharp recovery in the coming quarters. Both transient and structural reasons are responsible for a sharp deceleration in growth. Even though S&P expects economic growth to pick up, it rightly notes that a return to sustained high growth will depend on structural reforms. Among other factors, stress in both the banking and non-banking financial sectors is affecting the flow of credit in the economy, resulting in lower growth. This has also limited the transmission of lower policy rates of the Reserve Bank of India, despite the availability of ample liquidity in the system. Till the system is cleaned up, and this may require large-scale capital infusion in both banking and non-banking financial companies, the financial sector would limit the possibility of economic recovery. 

Further, as S&P correctly highlighted, complications in the implementation of goods and services tax (GST) created some disruption in the economy. The importance of addressing all issues in the GST system cannot be overemphasised. The GST Council should comprehensively review and urgently address all the gaps in the system. The underperformance of the GST system has also worsened the fiscal position of both the central and state governments. In fact, India’s fiscal condition is another red flag. S&P expects India’s general government deficit to rise to 7.4 per cent of gross domestic product (GDP) in the current fiscal year. The combined deficit is expected to come down to 7.1 per cent of GDP in the next fiscal year, assuming an improved macroeconomic backdrop. However, an increase in the fiscal deficit and debt accumulation can put pressure on sovereign ratings. Therefore, a significant fiscal expansion to revive economic growth, as being proposed by some commentators, is not a viable option for India.

The government will have to find ways to revive growth while remaining committed to maintaining the fiscal balance. Besides the pressure on sovereign ratings, higher deficit and borrowings can create distortions in the financial system, impeding growth in the medium term. Thus, the focus should be on easing restrictions on the functioning of markets, including factor markets such as land and labour, to push India’s potential growth. The government should also revisit its approach to global trade. Stagnation on the exports front, as has been the case over the last few years, will restrict the possibility of returning to a higher growth path. The sharp deceleration in economic growth clearly suggests that India needs policy intervention at multiple levels. Policymakers would do well to not ignore the views of global rating agencies.