India's fiscal strategy beyond FY26 key to any positive rating action, says Fitch's Jeremy Zook

Fitch's Asia Sovereign Ratings Director Jeremy Zook

India's fiscal consolidation roadmap beyond 2025-26 and its strategy to take the debt to GDP ratio on a more sustainable downward trend may hold the key to a positive ratings action for the country, says Fitch's Asia Sovereign Ratings Director Jeremy Zook.

"If we have confidence that the government’s commitment to fiscal consolidation will put the debt to GDP ratio on a more sustainable downward trend that would potentially be supportive of a positive action for the rating. And, I think for that we will be watching the Budget to get more clarity on the fiscal path beyond FY26," Zook told Moneycontrol in an interview.

The government is looking to bring its fiscal deficit target to below 4.5 percent of GDP by FY26 and is targeting 5.1 percent in the ongoing financial year. Zook added that both these aims are within reach.

According to Fitch Ratings' Zook, the upcoming Budget is likely to see a slight shift in the composition of spending with a bit more thrust on social measures, but that will not have any impact on the government's fiscal consolidation roadmap.

"While we expect capital expenditure (capex) to be a major priority, there is a possibility of more spending on the social measures and maybe a bit less on the capex side due to coalition politics, or concerns about the state of consumption. That is where the most likely impact will be rather than on deficit targets, which we now see as quite achievable," he said.

What’s stopping India from getting a ratings upgrade given the high growth potential and relatively better fiscal management?
We have seen some positive trends in terms of India’s credit metrics, especially around the GDP growth outlook as well as external finances, which is how India managed the very large shocks we have seen globally over the past several years. But where we still see some potential constraints on our side is around the fiscal metrics and outlook.

We have certainly seen quite an improvement when it comes to fiscal consolidation. The government has improved its ability to meet or even surpass, as it did the past year, fiscal deficit targets. But when we look at fiscal deficit relative to rating peers, India still remains well above those rating peers. India’s general government deficit of around 8 percent of GDP this year, coming down closer to 7.5 percent mark next year is higher compared to a BBB median of about 3 percent. And, then on the debt side the BBB median is about 55 percent, whereas India’s debt levels are just about 80 percent.

We are looking for continued momentum on fiscal consolidation that is durable in nature underpinned by other revenue measures that helps to bring down the debt to GDP ratio a bit more quickly and puts India on a more sustained downward trend over the medium term. We don’t expect India to get down to the peer median, when we look at the ratings, we look at a number of other metrics beyond just the fiscal. And, certainly the strong growth outlook does provide a good starting point.

Why is the investment grade rating for the world’s fastest growing economy just a notch above junk?
Ratings, particularly for those above the investment grade, is based in large part on how one compares to one's peers rather than just an absolute measure of default risk. We have had India on this rating for quite some time. India compares well to peers in many metrics, including its growth outlook, size of its economy in the global economy, and external finances. However, it still has what we view as key weaknesses around its public finances and low GDP per capita. We will continue to assess how India’s fundamental metrics are improving given the positive momentum on growth and how this improves metrics not just specific to the country but relative to APAC and global peers.

What is the one key factor that could lead to a positive ratings upgrade for India?
If we have confidence that the government’s commitment to fiscal consolidation will put the debt to GDP ratio on a more sustainable downward trend that would potentially be supportive of a positive action for the rating. And, I think for that we will be watching the Budget to get more clarity on the fiscal path beyond FY26.

Do you see the government continuing on its path of fiscal consolidation in the upcoming Budget given that there are expectations of higher spending on account of coalition governance?
Policy continuity seems to be a big theme for the new government and the Finance Minister remains in place so we feel the fiscal consolidation agenda will be a priority certainly over the next couple of years. The government does have some additional revenues to work with from the RBI dividend, so the deficit target is very much in reach for this year at 5.1 percent. And, the higher dividend could be partly spent while still retaining some of it to perhaps even target a slightly lower fiscal deficit target. That is our most likely base case, that we will see a mix of more spending support combined with saving a bit of that dividend as well.

More fundamentally, the government laid out this 4.5 percent target for FY26 several years ago as its medium-term fiscal guidance and now that the 4.5 percent is very much in reach, we do feel that reaching that aim will be a priority. Where we may see a bit more of shift is in the composition of spending. While we expect capex to be a major priority, there is a possibility of more spending on the social measures and maybe a bit less on capex side due to coalition politics, or concerns about the state of consumption. That is where the most likely impact will be rather than on deficit targets, which we now see as quite achievable.

We will also be watching for signals of the government’s reform agenda in the Budget and how aggressively it plans to pursue some of its reforms and see if there are any surprises around tackling some of the factor market reforms of land and labour.

BJP’s coalition allies are said to have asked for financial packages for their respective states. How fiscally concerning is that?
We will have to keep an eye on the next Budget, on how such competing priorities are balanced and on how the government chooses to manage its fiscal path. We will watch the Budget quite closely to see signs of this commitment to fiscal consolidation.

Would large land labour reforms be challenging given that the current government is a coalition?
The large factor market reforms around land, labour and agriculture have long been a challenge in India since these are contentious issues, especially at the central government level. We do think that because the BJP is more reliant on their NDA coalition partners now and the mandate for the new government is perhaps a bit weaker than it has been in the previous two terms, the outlook for these reforms will become more challenging.

We have seen some successes over the past two Modi terms – GST and the bankruptcy code. But there have been setbacks as well like the agricultural and labour reforms that have kind of stalled from 2020. And we think it will continue to be a challenging prospect for the government. But fundamentally, such reforms could give an upside to our already relatively robust GDP growth outlook. When we think about India’s manufacturing sector, it has been constrained in many ways by some of these regulations in terms of land and labour. We do think there is a large potential for a regulatory framework that supports the manufacturing sector, and bring in more FDIs. Those are key reforms, which may be challenging under the new coalition, but not impossible. We will look out for, in the coming 100 days, as well as around Budget, how aggressively the government will pursue some of these reforms.

Have you taken into account the numbers that indicate India’s weaker consumption levels, rural growth as well as concerns around employment?
That is certainly something that we take into account when we think about the medium-term growth and in trying to assess how durable this strong economic growth will be and whether it is sustainable. What underpins our view on India’s strong growth is that relative to the pre-pandemic period, banks and corporate balance sheets are in quite a healthy position and that should, in our view, facilitate an improvement in the private capex cycle over the medium term and drive these relatively strong growth rates.

The key risk to the growth outlook is that we haven’t yet seen that pick up in private capex and part of the reason for that is consumption has been quite subdued in recent quarters. That means capacity utilisation hasn’t picked up quite fully to high levels, which would bring in private investment more heavily. So, a risk is, if we don’t see a turnaround in some of these consumption metrics that may lead to private capex staying on the side-lines. Public capex though has been supportive, but if the government is hoping to consolidate then that cannot provide most likely the strong growth impetus that we have seen so far. So, it is really about that private investment coming in more fully and then that also relies on the domestic consumption outlook.

When do you see private capex picking up in India given that it seems to be linked to global factors that have been gloomy of late due to conflicts and recessionary fears?
The geopolitical situation is a contributing factor to private capex not picking up, but it isn’t entirely because of it. Certainly, volatility around commodity prices, especially oil, making it difficult for firms to lay out their investment plans, policy uncertainty around the Fed’s outlook, and then more fundamentally, geopolitical tensions, are all not very healthy for global investment prospects and that has spilled over to India as well. One factor that could help bring in private capex more towards the end of this year would be rate cuts that could start towards the end of this year and also, we see the RBI initiating some modest rate cuts around the same time. So, such a trend in the interest rate cycle should support lower borrowing costs and more policy uncertainty around global financial conditions, which could then bring in some of the private capex more aggressively.

How key or concerning are domestic instabilities such as Manipur for Fitch when they assess the key metrics for ratings?
Governance is factored into our ratings; political stability is important as a structural factor for any sovereign rating. But, given that we are seeing political continuity, political stability at the national level, we expect this to continue. Again, it depends on how the government prioritises some of its non-economic priorities but we do not see anything on the horizon that will alter the positive momentum on the economy and governance outlook at the national level.

What according to you are the key risks for India’s inflation outlook?
On the inflation front, the biggest risk is really around food prices and volatility that comes with it. It seems like the monsoon is likely to progress relatively normally, which should help ease potential volatility around the food price outlook. But that is always risky. We have seen the core inflation rate come down sharply, it is now below the RBI’s target. But really it is that volatility around food prices and its impact on headline inflation that we think still gives the RBI some pause.

The other big factor is, globally, around oil prices. We have seen more stability there, but with geopolitical tensions relatively heightened, it is always a risk that more volatility is introduced in the global energy market. And with India being a net energy importer, it is heavily affected by those prices. But we do see inflation gradually coming down over this next year as food price volatility subsides and that should give the RBI room to start reducing its policy rate quite modestly.

Should we worry about hot money flows on Indian bonds getting included in global bond indices
Bond index inclusion is modestly supportive for India. It does help diversify investor base and lower borrowing costs, but very modestly because foreign participation is quite low at the moment. And when we see an increase in foreign participation from bond inclusion we do not think this will be too large of a scale to bring down borrowing costs aggressively.

As for worries around hot money flows that is always a risk as foreign portfolio investment increases in a particular country. But I think a lot of the flows will be passive, matching the index which helps limit volatility. It depends on how much active investment flows comes in around the passive flows. Our expectation is FPI flows will be relatively modest at least for the foreseeable future and that will limit the potential volatility from hot money flows.