The decision to downgrade India's ratings reflects Moody's view that the country's policymaking institutions will be challenged in enacting and implementing policies which effectively mitigate the risks of a sustained period of relatively low growth, significant further deterioration in the general government fiscal position and stress in the financial sector.
The negative outlook reflects dominant, mutually-reinforcing, downside risks from deeper stresses in the economy and financial system that could lead to more severe and prolonged erosion in fiscal strength than Moody's currently projects.
Moody's also lowered India's long-term foreign-currency bond and bank deposit ceilings to Baa2 and Baa3, from Baa1 and Baa2, respectively. The short-term foreign-currency bond ceiling remains unchanged at Prime-2, and the short-term foreign-currency bank deposit ceiling was lowered to Prime-3 from Prime-2. The long-term local currency bond and bank deposit ceilings were lowered to A2 from A1.
Policymakers will be challenged to mitigate risks of broad erosion in India's credit profile
India faces a prolonged period of slower growth relative to the country's potential, rising debt, further weakening of debt affordability and persistent stress in parts of the financial system, all of which the country's policymaking institutions will be challenged to mitigate and contain.
Moody's upgrade of India's ratings to Baa2 in November 2017 was based on the expectation that effective implementation of key reforms would strengthen the sovereign's credit profile through a gradual but persistent improvement in economic, institutional and fiscal strength. Since then, implementation of these reforms has been relatively weak and has not resulted in material credit improvements, indicating limited policy effectiveness.
While today's action is taken in the context of the coronavirus pandemic, it was not driven by the impact of the pandemic. Rather, the pandemic amplifies vulnerabilities in India's credit profile that were present and building prior to the shock, and which motivated the assignment of a negative outlook last year.
Slow reform momentum and constrained policy effectiveness have contributed to a prolonged period of slow growth, compared to India's potential, that started before the pandemic and that Moody's expects will continue well beyond it. Real GDP growth has declined from a high of 8.3% in fiscal 2016 (ending March 2017) to 4.2% in fiscal 2019. Moody's expects India's real GDP to contract by 4.0% in fiscal 2020 due to the shock from the coronavirus pandemic and related lockdown measures, followed by 8.7% growth in fiscal 2021 and closer to 6.0% thereafter.
Thereafter and over the longer term, growth rates are likely to be materially lower than in the past, due to persistent weak private sector investment, tepid job creation and an impaired financial system. In turn, a prolonged period of slower growth may dampen the pace of improvements in living standards that would help support sustained higher investment growth and consumption. While the government responded to the growth slowdown prior to the coronavirus outbreak with a series of measures aimed at stimulating domestic demand and recently announced a support package aimed at supporting India's most vulnerable households and small businesses, Moody's does not expect that these measures will durably restore real GDP growth to rates around 8%, which had seemed within reach just a few years ago.
Moreover, persistent stress among banks and non-bank financial institutions (NBFIs) weighs on growth dynamics through a constrained supply of credit for consumption and investment. Moody's does not expect the credit crunch in India's undercapitalized financial sector to be resolved quickly. In turn, subdued growth further challenges the banking system's incomplete resolution of legacy non-performing assets and governance reforms, and is likely to further weaken asset quality and the health of banks and NBFIs.
Together with the immediate coronavirus-related policy support, the government has announced a series of reforms aimed at enhancing productivity, investment, employment and the ease of doing business across a variety of sectors including agriculture, mining, defence and power. Factor market reforms, including more flexible labour laws, are also being pursued by some states with support from the central government. While achieving the objectives laid out in these announcements would be credit positive, challenges with implementation of previous reforms suggest that the benefits to medium-term growth will likely be less than intended.
Fiscal constraints point to a higher debt burden for longer
In turn, lower real and nominal GDP growth over the medium term will diminish the government's ability to reduce its debt burden, after a significant rise as a result of the coronavirus economic shock. A mixed track record on implementation of revenue-raising measures lowers the prospects of fiscal policy-driven budget consolidation, amplifying a long-standing weakness in India's credit profile.
Prior to the coronavirus outbreak, at an estimated 72% of GDP in fiscal 2019, India's general government (combined central and state governments) debt burden was 30 percentage points larger than the Baa median. Although large private sector savings and long government debt maturities provide some stability and resilience to shocks to the cost of debt, interest payments comprised about 23% of general government revenue, the highest interest burden among Baa-rated peers and around three times the Baa median. Moody's expects the coronavirus shock to cause the debt burden to rise higher still, to about 84% of GDP in fiscal 2020. While it should stabilise at that point, it is unlikely to fall materially thereafter.
Measures to improve India's fiscal strength, which were at the heart of the government's policy framework a few years ago, have underwhelmed. Fiscal performance in recent years has been weaker than expected, with fiscal deficit targets consistently missed and a persistent lack of clarity on how medium-term fiscal consolidation objectives would be achieved. Rather than beginning to fall, the debt burden remained at around 70% of GDP.
India's high debt is a product of persistent general government fiscal deficits, which in turn partly reflect rigidities in the government's finances. Wages and salaries account for a large portion of total expenditure, and low incomes add to the government's social and development spending requirements. Achieving significant and durable spending restraint is therefore highly challenging. These constraints may encourage greater reliance on state-owned enterprises to meet India's need for social and physical infrastructure which would raise contingent liability risks to the government.
Meanwhile, India's large low-income population limits the government's tax revenue base. Earlier prospects of a broadening of the tax base have not materialized, even during years of more robust growth than Moody's new projects.
Overall, with very limited room for outright fiscal consolidation, the outlook for India's debt burden will depend on trends in nominal GDP growth and is unlikely to decline unless growth accelerates markedly and sustainably above 10%.
Rationale for the negative outlook
The negative outlook reflects mutually-reinforcing downside risks from potentially deeper stresses in the economy and financial system that could lead to more severe and prolonged erosion in fiscal strength than Moody's currently projects.
Persistent growth challenges, including weak infrastructure, rigidities in labour, land and product markets, and rising financial sector risks, continue to constrain the economy's potential. These structural weaknesses may impair the economy's recovery from domestic or external shocks, like the current one, to a greater extent than Moody's currently assumes.
Moreover, the nature of stress among NBFIs and banks is still being revealed and may prove deeper and broader than Moody's has assessed so far.
The materialization of economic and financial system risks would be mutually reinforcing as a deeper and more prolonged credit crunch would constrain GDP growth further, which in turn would increase the pressure on financial institutions' balance sheets.
Should the downside risks to growth and/or the financial system materialize, negative consequences for India's fiscal strength would follow. The longer the period of relatively subdued growth, the more likely India's debt burden will continue to rise beyond 85% of GDP. And the materialization of further contingent liabilities for the government, should renewed financial support to financial institutions be needed, would only add to the debt burden.