Moody's upgrade is a milestone in India's development journey

This was published in the Economic Times dated 20th Nov, 2017

In India’s argumentative ideas space, no news is good news. Therefore, the kerfuffle over the upgrade of India’s sovereign ratings by Moody’s (to Baa2, from Baa3) is entirely expected. For the partisan, it is a definitive validation of the government’s economic management. To naysayers, it is at best empty optics at a time when the economy is slowing down, at worst highly suspect on timing and credibility. Curiously, both miss essential woods for trivial plants.

First, the basic point – credit ratings, like most ratings, are predominantly an evaluation of the past, even though the objective is to provide guidance for the future. An upgrade is typically rare, especially so after the global financial crisis in 2008. It takes years of evaluation of policies (primarily related to macro-stability – debt-levels, sustainability of public finances, stability etc) before rating upgrades are done. In this case, the upgrade is especially creditable as it comes barely four years since India was classified as one of the “fragile five” economies, struggling with high twin deficits in fiscal and current accounts. To that extent, the current government deserves a lot of credit – it has privileged macro-stability over growth from its first day. It started with its first Budget, when the Finance Minister stuck with the deficit target set by his predecessor, a number that was received with much scepticism when it was presented by P Chidambaram. Since then, government has been a dogged “fiscal fundamentalist”, refusing any slippages even as growth plunged in the recent quarters. On the external account, a combination of luck (declining oil prices) and pluck (RBI ignoring shrill calls for massive reduction in interest rates), has kept the situation on an even keel.

Second, in many ways, this upgrade is merely a partial correction of a historical anomaly. Baa3, the toe-end of investment grade, clubs India with a bunch of countries with far worse macro-indicators. It’s a point that has been made repeatedly by Indian policymakers, most notably by Chief Economic Advisor Arvind Subramaniam in a section in the last Economic Survey. India’s structural strengths, eg, public debt entirely funded via rupee loans, all but a small part via local savings – were seemingly ignored while benchmarking on headline numbers.

Third, and most important point, is one of future signaling. What does it mean for India’s economic prospects going forward?

To start with, the sovereign rating is an estimation of the sovereign’s ability to repay its loans. An upgrade, technically, lowers the cost of borrowing for the sovereign. This is of limited practical utility to India, as the Indian government does not fund its deficits via offshore commercial bond markets. The entire public debt of India is funded via the domestic Rupee (INR) bond market, and foreign investor participation there is very small, and tightly regulated through quotas.   

Sovereign rating also serves as a benchmark for corporate entities domiciled in that country, as corporate ratings are (barring very exceptional cases) capped at the sovereign rating of the home-country of the corporate. Soon after the sovereign upgrade, Moody’s upgraded a bunch of Indian corporate entities (largely public sector companies). Over time, this has an impact on corporate ratings down the chain as well. While not automatic with a sovereign upgrade, a higher sovereign rating opens up fresh space for corporate upgrades too. This would result in reduction in cost of borrowing for Indian companies looking to raise financing from offshore bond markets.

Most important though is the optical macroeconomic signal. A ratings upgrade gives out a positive narrative on policy and builds incremental confidence in foreign investors. There are material benefits of the same, eg, in terms of incremental foreign investment pools from global Pension and Life Insurance firms that have minimum ratings criteria for investing. Typically, such incremental flows would tend to bid up Indian bond prices (both onshore and offshore) – we have already seen the first signs of the same in the form of dropping yields on government bonds. Higher bond prices, or lower yields, would tend to lower cost of funds – marginal for the government, but significant for corporate sector. Incrementally higher foreign flows tend to bid up INR too, making investments in a host of other Indian financial assets – equities, Real Estate – incrementally more attractive to foreign investors. It is especially propitious time for Public Sector Banks (PSB), that would find it easier to raise capital as part of the recapitalization plan announced earlier this month (PSB are expected to tap public markets to raise nearly 60,000 crores as a part of this plan). Lastly, as a net importer, a higher INR flows through as lower inflation into the economy, as imported goods become cheaper.

This isn’t an unmixed blessing. High levels of foreign flows resulting in rapid currency appreciation can result in loss of export competitiveness, with adverse consequences. South Korea’s meltdown in 1997-98 was at least partially due to a similar situation, barely a couple of years after it received a sovereign ratings upgrade.

In a nutshell, a ratings upgrade isn’t a major climax, nor is it much ado about nothing. It is a positive milestone, and quibbling about the size of the same is essentially narcissism of minor differences. But it is merely one milestone in India’s development journey, where there are miles to go before we can even think of dozing off!