India’s journey from Fragile Five to favoured investment destination

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Moody’s Investors Service’s decision to upgrade India’s local and foreign currency issuer ratings after 13 years has ignited a debate on the health of the Indian economy and how far the upgrade reflects it.

The government and its supporters have been quick to claim that the upgrade reflects a validation of the economic policies it has put in place. Critics of the government have questioned the upgrade, its importance, timing, and pointed to the chequered past record of the rating company.

The truth, as is often the case, lies somewhere in the middle. While India’s near-term macroeconomic outlook remains clouded, the improvement in India’s macro-economic fundamentals compared to even five years ago is real.

And while the past record of Moody’s and other ratings agencies suggeststhat they may often be behind the curve, the upgrade is likely to have real economic effects, most notably on the cost of corporate borrowing.

The significance of the upgrade becomes clear when we look at the ratings upgrade record of the major emerging market economies. Of the 10 emerging market (EM) economies in the G20, India is only one of the two countries to have secured a ratings upgrade in the last five years, along with Mexico. In contrast, five of these major EM economies—Brazil, South Africa, Russia, Saudi Arabia and China—have been downgraded by at least one notch in the last five years by Moody’s.

Thus, India now ranks somewhere in the middle of the above 10 EM countries, compared to the situation in 2012, when its ranking (Baa3) was among the bottom three in the group, along with Indonesia and Argentina.

How far India has progressed since then can be understood if we rewind to the 2012-2013 period. The central government’s fiscal deficit hovered around the 5% mark even as the consolidated fiscal deficit averaged about 7% in the fiscal years 2012 and 2013.

The current account deficit was close to 5% of gross domestic product (GDP).

India found itself relegated to the pack of ‘fragile five’ emerging markets—along with Brazil, South Africa, Indonesia and Turkey—and the Indian rupee was one of the worst hit in the summer of 2013, when foreign investors pulled out funds from emerging markets in anticipation of rising yields in developed markets (the so-called “taper tantrum”).

The crisis also led to an almost immediate course correction, with the then central government, led by the Congress, tightening its belt and initiating reformist measures such as deregulation of fuel prices.

The present government led by the Bharatiya Janata Party (BJP), which assumed office in 2014, has built upon those steps, helping lower the twin deficits and control inflation. The turn in the global commodity cycle, which kept prices of key commodities such as oil on the leash so far, also helped India improve its macro-economic balance sheet.

No wonder, India’s external vulnerability metrics today look far more stable than they were in 2012. India’s external debt ratio is significantly lower than five years ago, and India’s foreign exchange reserves now provide more than 10 months of import cover compared to around six months in 2012.

The improvement in macro-economic fundamentals and some of the reformist steps taken by the government have led to an impressive surge in foreign investments into the country, which has helped stabilize India’s external sector metrics. According to data sourced from the International Institute of Finance, India was the second-highest recipient of foreign capital inflows (including both foreign direct investment and portfolio investments), trailing only China, in 2016.

The return to macro-economic stability, benign commodity prices, and India’s growth differential with other major economies has ensured that fund flows continue unabated till today. The ratings upgrade will also help lift investor sentiment.

However, several headwinds including rising oil prices, uncertain revenue collections, slowdown in export growth, and anaemic credit off-take cloud the near-term outlook for the economy. While at the moment, India does not face a 2013-like situation, the macro-economic risks have risen compared to even a year ago.

How India deals with these challenges and the choices our policymakers make will determine whether Moody’s upgrade is a sign of things to come, or that of a false dawn.