The puzzle of India’s sovereign ratings

The argument that high debt-to-GDP ratio is the reason for not upgrading India, is fundamentally flawed

India has been languishing at the bottom of the investment grade ladder in the ratings universe. In fact, to put it on record, India has had a net rating upgrade only once in the last 25 years. One of the common arguments made by rating agencies for not upgrading India’s rating is its high debt to gross domestic product (GDP) ratio. At 69.5% of GDP, the agencies argue that this is on the higher side and effectively acts as an enabling factor for crowding out private investment. This argument that high debt to GDP ratio is the reason for not upgrading India is, however, fundamentally flawed, for two reasons.

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First, there are a number of countries which are rated above India but have a significantly higher gross general government debt. In fact, most of these countries have debt positions which have been worsening over time but this has not affected their ratings much. India, on the other hand, has been consistently on the path of reducing its debt to GDP ratio to its present level from a peak of 84% in 2003.

One may think that it may be because of other macro fundamentals of these developed countries. If we look at major economic indicators of India in comparison to developed countries, India fares reasonably well in most of these. India is the fastest growing economy in the world, with a low unemployment rate and improving inflation and current account trajectories.

Next we look at how India is performing with respect to the group of countries that are rated one or two notches higher—almost all of them are developing countries. Here again we see India is performing much better in terms of macro performance, albeit with higher gross general government debt, but much lower external debt.

Thus, it seems the only indicator or figure that matters to rating agencies for the sovereign ratings of developing countries is the domestic debt to GDP ratio. The performance on other indicators does not get its due importance.

The other reason why we think the rating agencies’ rhetoric is fundamentally flawed is that it is the composition of the government debt to GDP per se that matters for any discussion on debt solvency. For India, public debt is mostly internal. As a conscious strategy, issuance of external debt (denominated in foreign currency) is kept very low in India. Overseas investors account for only 4% of the total government bonds and the majority of the investment comes from scheduled commercial banks, insurance companies, Reserve Bank of India and provident funds (accounting for around 85%).

It is ironic that Japan, which has a composition of government debt profile almost similar to that of India (bank and insurance companies account for 50% of the government debt), is rated at A+ with a debt/GDP ratio of 239%.

Interestingly, if we plot the debt/GDP and rating action (proxied by a numeric scale) for countries like Portugal, Ireland, Italy and Spain during the worst years of the financial crisis (2008-2011), we find there is little causation between the rating actions and movements in domestic debt/GDP. In fact, the regression coefficient (dependent variable is the rating action and independent variable is debt/GDP) is weak and not statistically significant. This result shows that even in periods when the European debt crisis was at its worst phase, there was little evidence to support rating actions acting as a leading indicator of deterioration in economic fundamentals.

There is another aspect to this debt to GDP ratio. Based on stock prices on the Mumbai stock exchange, as on 30 April 2017, the market capitalization of public sector undertakings (which includes Centre and state-level public enterprises, public sector banks as well as other companies where Centre and/or states and/or government companies and financial institutions have the single largest shareholding) stood at Rs13.7 trillion. These assets are equivalent to around 12% of the overall gross government debt. This also provides an additional comfort in debt management, and we wonder whether they are taken into account while examining India’s debt solvency.

Our primary concern is, however, different. Despite robust macro fundamentals, India may not witness a rating upgrade soon. This is because with the fiscal responsibility and budget management (FRBM) committee emphasizing attaining a 60% debt to GDP ratio with a ceiling of 40% for the Centre and 20% for the states, by 2023, the rating agencies will get a reason to maintain the status quo, despite the other visible advances which India has made.

The interesting point is that even in the FRBM committee report, there have been conflicting opinions about the 60% target of debt to GDP ratio. The methodology for arrival of the 60% number has been questioned. Furthermore, the fiscal deficit number of 2.5% to be achieved in the medium term also seems to have been arbitrarily arrived at and is based on unrealistic assumptions. In fact, the dissent note by chief economic adviser (CEA) Arvind Subramanian clearly states that India is not in any dire situation that it should adopt such a drastic reduction in debt and fiscal numbers. Moreover, the country was able to do significantly well when the debt to GDP ratio was as high as 84% in 2003 without failing to meet any of its debt servicing obligation. We also second the opinion of the CEA about focusing on primary deficit, rather than targeting multiple indicators (namely debt to GDP ratio, fiscal deficit and revenue deficit) to maintain the sustainability of our fiscal position (FRBM Review Committee Report Volume I, Annex-V).