Last week, rating agency Standard & Poor's published an article indicating that India's sovereign rating was under threat from the "triple whammy" of rising inflation, the fiscal deficit and the current account deficit. The agency viewed the factors driving the credit deterioration as temporary but warned that, if they persisted, the sovereign rating could be lowered to the speculative grade that it was in before January 2007. This week, a second agency, Fitch, went a step further and actually lowered its outlook on India's local currency rating to negative. Although this is short of a ratings downgrade, which would also take India down to speculative grade on the Fitch scale, it indicates that the likelihood of a downgrade in the next review has significantly increased. The main reason for this change cited by Fitch was the "considerable deterioration" in the central government's fiscal position during the current year, stemming from the mounting burden of off-budget borrowings.
At a time when rating agencies are viewed with deep suspicion with regard to their role in the sub-prime crisis, it is tempting to dismiss these announcements as mere irritants. For one thing, no downgrading has actually been done and the lowering of Fitch's outlook is for local currency exposures only. The outlook on foreign currency exposures, which is much more important from the foreign investors' perspective, is significantly influenced by the size of the foreign exchange reserves, on which score India still has plenty of cushion. The impact on investor perceptions and actions could, therefore, be negligible, if at all. However, for the government to ignore these red flags would be a big mistake. While the agencies are under fire for their assessments of complex financial instruments, there have been no serious questions raised yet on their more conventional and long-standing activities, of which sovereign rating is one. Their views on individual countries are taken seriously by investors, who, given the conditions in global financial markets, are more risk-averse today than they have been for a long time. Any whiff of a problem with an emerging market could well trigger significant outflows, putting further pressure on both markets and the balance of payments. In India's case, it is currently at the bottom of the investment grade scales of both Standard & Poor's and Fitch. A move to the speculative grade will reinforce the outflows because several sources of funds are mandated to put their money in investment-grade countries. The flood that was seen in early 2007 will be reversed in the event of a downgrade. But, beyond the implications for capital flows, the balance of payments, and the exchange rate, these warnings should make the government think hard about its fiscal legacy. Has it, over the past few months, undone the commendable gains of the past few years?
Fortunately, these are as yet early warnings and there is still both room and time to turn around. This government, or its successor, cannot but take the hard decisions on fuel and fertiliser prices that are necessary to stop the fiscal slide. As much pain as this inflicts in the short term, it is going to be preferable to the far more dire consequences of postponement. India may have travelled a very long distance from the dangerous waters of 1991 but, in so many ways, has yet to reach safe shores. editorial BS-
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