The author is former governor, Reserve Bank of India
The downgrading of India’s debt by the international rating agency, Standard & Poor’s, has invited rather hysterical reactions on the part of some observers, including economists, and angry responses by the government spokesman.
Rating agencies are a fact of life, especially in the increasingly globalized investment community. Many international investors decide their allocations of investible resources based on the ratings by reputed rating agencies. In fact, many funds are statutorily bound to invest only in securities, which are of investment grade, as indicated by the rating agencies. Downgrading of ratings of a borrowing entity has yet another implication. Normally, it raises the rate of interest, which is charged by lenders on their further borrowings. While this may be of limited relevance to India, it is nonetheless important since it is a reflection of the credit of the country. It is the dharma of rating agencies to assess the capacity of entities to service debt. It is up to the rated entities to represent their side of the case to rating agencies and their experts.
International rating agencies are bound to have grim recollections of their bitter experience in the years preceding the 1997-98 Asian crisis. They had wrongly rated various entities in the east Asian crisis as investment grade just prior to their collapse. As a result, millions of dollars were invested in bonds in Korea and Thailand by international investors based on the comfort given by the rating agencies. While rating agencies were not alone in failing to anticipate the crisis, their failure has left a distinct mark on their collective memory. They have become particularly finicky and more meticulous in assessing the grading of entities, including countries.
It is also worth nothing that it is difficult to fault the assessment of Standard & Poor’s about the poor quality of India’s domestic debt, although an argument has been advanced that India will never default on rupee debt since it is open to India to print adequate quantity of rupee notes to finance the debt repayment. It is all the more significant that this argument has been put forth by Sudhir Mulji, the respected economist.
I respect Mulji’s general line of approach that increased monetization may be a way out of the current deflationary problems. But, to argue that printed money can guarantee that India will never default on domestic debt, flies in the face of accepted canons of financial prudence. Particularly so, when India has accepted the requirements of global fiscal responsibility and has committed itself to a Fiscal Responsibility Act, which also sets a limit on the amount of money-financing that can be undertaken.
The rating agency has justly focussed its attention on the increasingly unsustainable fiscal situation. The fiscal deficit, including that of the states, is running at 10 per cent of the national gross domestic product. It is based on the unsustainability of these numbers assessed by Standard & Poor’s that India is in for a potential debt explosion, and that given the internationally accepted criteria of fiscal responsibility, India’s debt justifies a classification of “junk” debt.
While one may feel hurt by the classification of India’s domestic debt as junk, it is a fact that the rating agency has pointed out the Achilles’ heel of India’s economic management. The fiscal situation, with increasing expenditure and revenues not keeping up, is definitely alarming. If the economy does not grow fast enough, such fiscal deficits will become unsustainable and the country inevitably will have to resort to printing more money to repay debt — an undesirable outcome.
Over time, India’s response to downgrading by rating agencies has tended to be emotional. In 1997-98, the last occasion that we had a brush with rating agencies downgrading us, the then leader of opposition, Atal Bihari Vajpayee, had rhetorically stated that it used to be the World Bank and the International Monetary Fund that impinged on India’s sovereignty, but now it was given to a private agency, Moody’s. Parliamentarians also lost no time in trashing Moody’s presentation of a 49-point questionnaire to the government. These emotional reactions show that India is quick to take offence. Fortunately, this time around, politicians have been otherwise preoccupied. But, we should not forget the fact that rating agencies are only doing their job of conveying their assessment of the situation. It is best not to shoot the messenger for bringing bad tidings.
Standard & Poor’s may very well have done an important service to India by highlighting the problem of unsustainability of debt and the poor progress of economic reforms. It cannot be denied that there has been backtracking on various segments of reforms by the government in recent times. That international analysts have taken into account the recent bickering in the ruling alliance on important issues, such as divestment, cannot be condemned as political interventions. It is part of the process of rating the political economy of the country.
Instead of quarrelling with the rating agency’s assessment, policy-makers may do well to see where the fiscal shoe pinches and take into account their criticism in their further policy approaches. It is not my contention that rating agencies are infallible in their approaches. But, it is our responsibility to try and prove them wrong by subsequent better performance.
The recent trends in the fiscal performance of the Centre and the states leave me with an uneasy feeling that the situation is deteriorating fast. There have been reports that major financial institutions based in Mumbai have had experience of states’ defaulting on repayment of their guaranteed bonds. This is a serious matter and reflects the reality of the situation, which conforms more to Standard & Poor’s description than the reverse.
It would be a pity if by this failure to repay, the state governments close a promising window of opportunity to raise funds for their infrastructure development in power, roads and water supply. The crux of the problem lies in the political failure to raise user charges, be they power tariff, road tolls or water charges. If the projects are not made remunerative by levying and collecting adequate user charges, the guarantees are naturally bound to fail. The ambitious projection of the tenth plan of large infrastructural investments using resources available with the banking system and borrowing through special purpose vehicles will be a failure if such defaults continue.
There is need for establishing a dialogue with the rating agency by the professional representatives of the government. I recall that in the Nineties when a downgrading of India had partly led to the then crisis of India’s balance of payment. I had, as governor of the Rerserve Bank of India, such a dialogue along with a few representatives from the State Bank of India. We approached the rating agencies in New York with an explanation of the steps we were taking to correct the situation. While it is true that the rating agencies strongly defended their downgrading, there emerged a better understanding of the actions being taken by the government, and further downgrading of India, which would have been disastrous in the then circumstances, was averted.
I am sure that the mandarins of Delhi and Mumbai would have already tried their best to convince the rating agency of the facts of the macro-economic situation. While it is true that the rating agencies’ procedures should become more transparent, the authorities should also help in the process. Presentations by the government and the central bank to rating agencies should also be made public to assess how far the rating agencies have made their assessments on an objective basis. Such transparency would itself act as a kind of check on the behaviour of the rating agencies.
It is not much use pointing out that India’s downgrading does not have immediate practical impact because the foreign institutions are not invited to invest in domestic debt. This is true insofar as our domestic debt is entirely denominated in rupees and involvement of foreign institutional investors in our domestic debt is marginal. But, nonetheless, the indication that we are running into a fiscal crisis can have damaging implications on the attractiveness of India as a desirable destination for other portfolio flows and foreign direct investments.
From this point of view, if for nothing else, the rating by Standard & Poor’s is a matter of significance. It is not to be discounted just because our domestic debt is essentially rupee-denominated, and our banks are flush with funds, and there is every likelihood of any debt issues by the government of India or by the states being fully subscribed.
The sign of maturity of an economy is to react to criticism with a proportionate response, recognizing the merits of the critique. It is no use trashing the basic assumption of fiscal responsibility. Standard & Poor’s downgrading of India should be a wake-up call to India’s political leadership to reassess their policies and correct their failures. The downgrading of India may, indeed, have performed a useful role by leading to an awakening of fiscal responsibility and the need for taking hard decisions.