Fitch's Zook says India may miss fiscal deficit targets for this fiscal and FY26

Jeremy Zook, a director at Fitch Ratings

Fitch Ratings does not expect the Centre to meet its goal of reducing the fiscal deficit to 4.5 percent of GDP by 2025-26 because of a lack of clarity on the medium-term consolidation path.

"The government has put out its fiscal deficit target of 4.5 percent of GDP by FY26. But there hasn't really been much detail on how it hopes to achieve this target in terms of revenue or expenditure measures," Jeremy Zook, a director at Fitch Ratings and the primary rating analyst for India, told Moneycontrol in an interview.

"That’s our key concern – a clearer path towards fiscal consolidation would be supportive of the rating as that will help us be more confident in our debt dynamics forecasts," Zook said.

In the Budget for FY21, presented on February 1, 2020, before the coronavirus hit the country, the Centre had set a fiscal deficit target of 3.5 percent.

It quickly became apparent that COVID-related expenses and revenue losses would make the target irrelevant. Finance Minister Nirmala Sitharaman, in her FY22 budget speech, set a new target of lowering the deficit to below 4.5 percent by FY26. This new roadmap did not contain targets for each of the years until FY26 nor was there any mention of the original medium-term fiscal deficit target of 3 percent.

The Centre's fiscal deficit target for FY23 is 6.4 percent, which Fitch expects will be missed.

"Right now, we have India's debt ratio coming down as a result of very high nominal growth. But our expectation is that over the long run, nominal growth will settle around 10.5 percent and the debt ratio will just stabilise. So we are not quite expecting the government to hit 4.5 percent by FY26. We think they will fall short of that," Zook said.

Missing targets

When Fitch raised its outlook on India's BBB- rating to stable from negative in June, it had estimated that the FY23 fiscal deficit would come in at 6.8 percent. But the Centre's finances have held up so far, with the deficit at 37 percent of the full-year target in the first half of the financial year.

According to Zook, additional costs – such as subsidies – mean the target may still be missed, but perhaps not by the 40 basis points Fitch expected earlier this year.

One basis point is one-hundredth of a percentage point.

Zook does not have a specific number in mind when it comes to the fiscal deficit target for FY24. What he does want is "a bit more clarity on the medium term consolidation plan," which could give Fitch more confidence in India's fiscal outlook.

When pressed on what details would provide this clarity, Zook declined to get into the specifics.

"We can't give specific policy advice on what measures the government should undertake. It's more an issue of when we look at peer comparisons, India scores relatively low when it comes to revenue-to-GDP ratios. So if there are any policy changes, we will review what they mean," he said.

Growth, inflation dynamics

While there is lack of clarity on how India will lower its fiscal deficit in the coming years, it is clear what helped reduce it from 9.2 percent of GDP in FY21 to potentially 6.4 percent this year – high nominal growth.

"That has had a big impact on the debt dynamics as there has been a bit of inflating away of the debt problem. We estimate that India's debt-to-GDP ratio peaked around 88 percent in FY21 and came down to around 84 percent because of the large deflator," Zook said, adding the phenomenon isn't unique to India.

Real growth is set to diminish. In September, Fitch lowered its GDP growth forecast for India for FY23 to 7 percent and expects it to ease further to 6.7 percent in FY24. And these forecasts may be revisited again given the downside risks to growth and uncertainties around global monetary tightening and potential energy shocks.

"When compared to other countries, we see India as being a bit more resilient in the face of these external shocks. India will be hit by the global growth slowdown. But given that it is not as reliant on external demand to fuel its growth as some other Asia-Pacific sovereigns are, that gives a bit more buffer to India," Zook said.

Fitch expects the Indian economy to grow around 7 percent every year through to FY27.

India's move to a flexible inflation targeting framework was praised by Zook as one of the more positive Indian reforms of the past decade.

The Reserve Bank of India's (RBI) failure to meet its mandate of keeping inflation in the 2-6 percent band has not affected how Fitch views the credibility of Indian monetary policy and its support to the credit profile as inflation expectations seem to be "fairly well anchored" and the central bank has acted "quite aggressively" in the last six months to rein in inflation.

"I must also add that these are abnormal times," Zook said.

"In the case of India, inflation is above the target band, but not wildly so, which makes it less of a concern for us especially as the RBI has taken a lot of steps in that area. If this becomes persistent and the RBI allows inflation to run well above the target band, that would eventually weigh on how we view RBI credibility. But that's a bit of a ways off," he added.

The RBI has increased the policy repo rate by 190 basis points in the last six months to 5.9 percent. But even of the policy rate goes beyond Fitch's assumption of 6 percent, which underpins its forecasts, it may not have a "huge impact" on the growth outlook.

External concerns

The Russia-Ukraine war-induced surge in global commodity prices and the spillover from the resultant synchronised tightening of monetary policy by the world's major central banks to lower multi-decade-high inflation has exerted massive pressure on most currencies, including the Indian rupee.

And the RBI's defence of the exchange rate, along with a drop in valuation of certain currencies, has led to a rapid fall in India's foreign exchange reserves.

As of October 21, the reserves were $525 billion, down $116 billion compared to the same time last year.

According to Zook, it must not be forgotten that the RBI built up a veritable war chest during the pandemic, with the reserves rising by nearly $175 billion in the 17 months leading up to September 2021.

As such, the level of the reserves will only be of a concern to Fitch if pressure persists and they fall dramatically. Such a situation is still "some way off".

"It depends on how the RBI continues its exchange rate policy. There certainly does seem to be intervention to smooth some of the significant volatility and that volatility could increase in the coming months. But we also think that the RBI will likely remain prudent in managing its FX buffers," Zook said.