Interview: Moody's to re-examine India's fiscal strength when deficit well below 4.5%

The Indian government has been pitching global ratings agencies for an upgrade for several years and has previously expressed its displeasure at what it has termed as bias against emerging economies. In fact, the Economic Survey for 2020-21 contained an entire chapter titled 'Does India's Sovereign Credit Rating reflect its fundamentals No!'.

In a wide-ranging interview with Moneycontrol, de Guzman discussed Moody's assessment of India's potential growth rate and its impact on public debt, the challenges the government faces in growing the manufacturing sector, the need for policy predictability, and why he does not expect much when it comes to revenue reforms in the coming 12 months.

"We don't expect much in the way of revenue reforms, especially ahead of the elections. Revenue reform is going to be undoubtedly unpopular – either you raise taxes or you broaden the tax base, and that's not going to win votes," de Guzman said.

Edited excerpts:

In its statement affirming India's rating, Moodys noted that the potential growth rate has reduced over the last 7-10 years. How much has that weakened the economy's natural ability to consolidate government finances and ease debt-to-GDP levels?

In the context of our ratings, 7-10 years ago, we were quite bullish about India's long-term economic growth outlook. We agreed with the views of the market and the government at the time that the potential growth rate – on the back of some of the reforms that were mooted in the early years of the Modi administration – was over 7 percent. That led us to form a view around that very high rate of growth leading to a more rapid reduction in debt. Subsequently, given the fragilities in the financial system that occurred around 2018-19, our view on growth evolved such that we saw that those issues constraining the ability of the financial sector to provide credit to fuel growth. In essence, that very rosy picture on growth that we held at the time of our upgrade to Baa2 from Baa3 in 2017 did not materialise. Consequently, the reduction in debt that we had foreseen as a result of the rapid rate of growth and fiscal consolidation also did not materialise. In fact, even ahead of the pandemic, the debt ratios were already worsening and we ended up downgrading India's rating.

In the current context, where we have seen an improvement in potential growth from an estimated sub-6 percent levels during the pandemic to 6-6.5 percent now, we want to acknowledge that the situation is much better. However, at that rate of growth, we do not see a material reduction in debt that would necessarily lead us to reassess our view on India's fiscal strength.

India's high rate of growth has been key to reducing debt levels as opposed to reducing debt itself. A few weeks ago, we saw US' rating being downgraded by Fitch Ratings, with the high debt levels being the focus. Could that be the case for India too, especially when growth is just not high enough to lower debt levels materially?

When you look at our downgrade triggers, we do highlight a worsening in fiscal metrics as a consequence of a worsening in long-term growth potential; a worsening in potential growth to levels that we saw during the pandemic could be quite detrimental to the debt trajectory. But we want to be clear about where we see India today – given our view that the fiscal consolidation trend is intact and that the government is committed to their fiscal deficit targets, we do see a fairly stable debt trajectory in the context of relatively buoyant growth.

Moody's has repeatedly called for greater clarity on how the fiscal deficit target of 4.5 percent of GDP will be achieved by 2025 26, especially in terms of the revenue measures. Considering we are less than three years away from that deadline, do you see any meaningful slippage?

No, we don't see very meaningful slippage. As I have mentioned, the government is committed to that target, and they have publicly declared that commitment. So, we do believe that the slippage will not be very material. They may not meet that target, but they will come close.

But fiscal deficits much narrower than 4.5 percent of GDP would lead us to re-examine our assessment of fiscal strength. Why? Because much narrower deficits – much narrower than the current target of 4.5 percent of GDP – would lead to more material debt reduction than we currently project.

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Your statement also made note of the manufacturing sector's limited ability to create jobs and the fact that there are structural weaknesses in the form of trade barriers and other protectionist measures. What do you make of the government's decision earlier this month to impose restrictions on the import of laptop and personal computers?

It is these types of policies that prove our point about the challenges of growing the manufacturing sector. We want to acknowledge that India has made gains in attracting higher value-added investments in manufacturing, such as those aimed at starting a semi-conductor industry. But, India is still well short of the government's target of getting to 25 percent of GDP in terms of the share of manufacturing. And that target, I believe, had a due date of 2025. So, it is challenging.

One of the things the ban on import of laptops does illustrate is perhaps room for improvement with regards to policy predictability. This is not as much of a concern in a lot of other jurisdictions that already have the kinds of manufacturing capabilities that India wants to have. For example, you don't see these kinds of protectionist measures in other nodes of the electronic supply chain in Southeast Asia. There aren't the same challenges with regards to policy predictability or protectionism.

The government is pushing the use of the Indian rupee globally. It has entered into multiple bilateral agreements to use local currencies to settle trade. Does this further strengthen India's external profile?

In terms of the rating and our methodology, this would fall under our assessment of external vulnerability risk. And to put it simply, the internationalisation of the rupee in the manner that's being discussed does not really impact our view on external vulnerability risks. So, it's not going to be a key driver of the rating even if the Indian government did manage to enter into bilateral agreements and facilitate greater use of the rupee to settle trade with some countries. This is not going to be a factor that changes our assessment of external vulnerability risk, which is actually relatively strong. This is not the India of 2013, as it has sufficient supply of foreign exchange reserves to meet the external financing and debt servicing needs of both the government and the private sector. So, while these kinds of developments are positive, it is not going to be a key driver of the rating.

Your statement drew a link between rising political polarisation and populist policies. Over the last year or so, the central government has been vocal in its opposition to so-called pre-election freebies. Is the central government's stance credible in your view, considering the national elections are less than a year away?

Yes, the central government's stance is credible, and they are on track with regards to keeping the current fiscal consolidation trend intact. We don't expect much in the way of revenue reforms, especially ahead of the elections. Revenue reform is going to be undoubtedly unpopular – either you raise taxes or you broaden the tax base, and that's not going to win votes. So, what we are likely to see is ongoing expenditure consolidation, perhaps with some sort of reallocation of spending that makes it look like the government is supporting growth.

I would take the 2023-24 budget as an example. The headlines were dominated by how much more is being spent for infrastructure. But when you take a step back and look at overall spending as a share of GDP, it has actually come down a little bit. If the Centre had announced freebies ahead of next year's election, then of course there is a risk that fiscal consolidation may go the other way. But given how it has actually played out, their stance is quite credible.

But our assessment doesn't look just at the Centre. When we look at India's fiscals, it is on a general government basis – combining the central government and the states. And we have already seen some states where the opposition has taken over and announced changes to the pension system which are not necessarily positive for their own fiscal situation. This is an illustration of how we see political tensions leading to less than desirable policy. These kinds of announcements that are meant to curry favour with the voting public are a demonstration of how political polarisation can impact policy.

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Another example from the last couple of years is how the agricultural reforms, which would have been a positive, were rolled back in response to popular, widespread protests. That is a very clear demonstration of domestic political risks that made our previous assessment of political risk inconsistent with what we are seeing elsewhere.