Sovereign rating risk | Business Standard Editorials

Clipped from: https://www.business-standard.com/article/opinion/sovereign-rating-risk-121051701487_1.html

Govt must take steps to avoid a downgrade

Daily Covid-19 cases are showing initial signs of stabilising, with India reporting less than 300,000 cases for the first time since April 21. However, the caseload is still very high, and it might take a while before the situation is brought under control in a meaningful way. The impact of the second wave and a potential threat of a third wave mean state governments would be cautious in permitting public mobility. Forecasters are lowering their growth projections for the current fiscal year, and, as news reports suggest, lower economic growth, which would increase fiscal stress, can also put pressure on India’s sovereign rating.

The biggest casualty of a sovereign rating downgrade would be India’s loss of reputation in the global market. This can affect the flow of foreign capital at a time when India needs to increase investment to boost its medium-term growth potential. Capital outflow could also result in currency market volatility. Covid-related economic disruption and India’s inability to contain the damage in time would also affect medium-term potential growth. That said, it is equally true that although the fiscal position is under pressure, it may not pose an immediate threat to financial stability. India’s external account is in a strong position. India added over $100 billion worth of foreign exchange reserves last fiscal year, and they stand at about $590 billion. As economic activities improve, the current account would move into deficit. However, financing a moderate current account deficit should not be a problem in the foreseeable future. According to the Reserve Bank of India’s latest report on foreign exchange reserves management, reserves cover for imports increased to 18.6 months in December 2020. Further, although there are risks to the inflation outlook in the near term, India’s record has improved significantly in terms of maintaining price stability since the adoption of the inflation-targeting framework.

But there are still enough reasons to be cautious. The country’s public finances are under stress and the second wave would only complicate matters further. India’s public debt has expanded to about 90 per cent of gross domestic product (GDP) and is expected to remain elevated in the foreseeable future. Slower than expected growth can again push up the fiscal deficit. The Union government ran a fiscal deficit worth 9.5 per cent of GDP in the last fiscal year, which is expected to come down to 6.8 per cent in the current year. Slower growth will not only affect revenues, but Covid-related disruption would also increase expenditure in terms of providing relief to the vulnerable sections.

So while some macroeconomic indicators are in a favourable position, policymakers would do well to not underestimate the medium-term economic risks. Higher levels of debt and budget deficit could increase inflationary pressure, particularly if the central bank is seen to be supporting government borrowing for too long. This would also affect the credibility of monetary policy. Thus, as soon as the situation stabilises and the pandemic is under control, the government should come up with a clear fiscal road map and measures that would boost growth in the medium term. Higher debt and deficit, along with slower economic growth in the medium term, could lead to a number of problems. A sovereign rating downgrade could be one of them.

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