Moody’s Upgrade Done – Now, What Next?

The last few weeks have witnessed many developments that have led to a sense of hubris and confidence on the economic front. Coming as it is on the back of pressure from the opposition during the demonetisation anniversary and over some Goods and Services Tax (GST) worries, the measures have given the central government the necessary reinforcement of its economic trajectory. While the World Bank's Ease of Doing Business global rankings report, in which India moved into the top 100, can be treated as a survey prone to an element of subjectivity, Moody’s upgrade, which is based on certain specific economic parameters, can be analysed to evaluate our strengths and scope for improvement.

To do that, a quick understanding of the methodology followed by the rating agency can be useful. The sovereign rating methodology of Moody’s is given in the table below. The methodology focuses on a range of factors and sub-factors and the overall score is a relative placement of a country in the spectrum.

The rating scale provides the government and the country an objective assessment that can be showcased internationally. Improvement in rating provides actual benefits in terms of borrowing cost as well as psychological advantages in providing a counter narrative. Hence, it might be a useful for the government to analyse areas for improvement and identify low hanging fruits.

Economic Strength – GDP Per Capita A Clear Area For Improvement:

The economic strength is measured by the versatility, sustainability and scale as measured by a series of factors. In this sub-segment, India has got a score of H+ driven by the size and spread of the economy. The sub-factor where the score is low is the per capita gross domestic product (GDP) which is at $6,700 compared to the median for the group. (Baa2 rated). So here are a few suggestions to address this growth:

1. Use the demonetisation drive data collection exercise to improve compliance. This can perhaps bring a lot of economic activity that was not captured into the formal economy. This, coupled with GST, will remove some of the opaqueness associated with the informal sector and improve the numerator.

2. Ensure measurable performance in some of the already announced initiatives such as Start Up India specifically targeted at income and employment generation at a granular level.

3.Ensure an aspirational GDP per capita at a state level which can help states choose policies in terms of both income generation and population rationalisation. (The latter can at best be a long term measure)

Institutional Strength – Need To Improve Across The Governance Spectrum Of Sub-Factors

The overall performance in this sub-factor is at M+ (Medium plus), a marginal improvement from Medium. This is an area where literally the government can show results not perhaps to please Moody’s but to improve governance by streamlining processes.

The overall economic resiliency of India as measured by economic and institutional strengths has gone up by one notch from H- to H. While a large and growing economy, inflation targeting and control has helped the overall score, institutional development indices are still not improving as fast as desired.

Fiscal Strength – Need To Improve Tax Base And Compliance

The fiscal strength of the country is measured by four sub-factors - the debt and consequent interest burden vis-a-vis the GDP and revenue of the country. The performance of India in all of three of these four sub-factors is in the low to very low range. Not surprisingly, the fiscal performance pulls down the economic performance leading to the government financial strength moving towards the medium category from high only based on economic strength. The debt burden as on date is perhaps a legacy issue and a combination of many issues such as the need to stimulate the economy through public spending, laxity of fiscal compliance and lackadaisical approach towards tax collection.

The avowed improvement in the tax base and compliance driven by tax reforms and better data analysis can perhaps help improve the cosmetics of this ratio in the medium term. But in the longer run unless there a disciplined approach towards debt is in place this can be a constant quagmire. In a federal multi-party structure, the discipline of the various states in enforcing their FRBM commitments will be critical. Nevertheless, the governments (both Centre and state) can target some of the following recurring obvious problems in a holistic manner.

1. Power sector leakages (While UDAY is expected to address some of the distribution level issues, perhaps the elephant in the room is the transmission losses which are considered as high as distribution losses)

2. Subsidies and adhoc write offs – The direct bank transfer (DBT) for many schemes has reportedly brought down subsidies. The fertiliser subsidy DBT is still not done at an all India level and perhaps can significantly help reduce the fiscal burden. Another policy intervention that periodically upsets the fiscal math is the farm sector write-offs. Technically, given the political setup, there are no solutions although farm insurance to some extent addresses this vagary.

3. Pay commission payouts – It is a recurring problem that throws the fiscal deficit awry once in few years. Creation of a regular allocation in a sinking fund can perhaps help partially address this issue.

4. Ease of tax payment and redressal – This is a systemic issue and has made many improvements in the last few years, at least for individual tax payers. Nevertheless, a quick redressal and closure mechanism can help in better productivity of the fiscal establishment.

Susceptibility To Event Risk –Banking Sector The Biggest Drag

The event risk covers political risk, liquidity risk, banking sector risk and external vulnerability risk. The political risk may not change significantly in the short to medium term as the current setup is expected to continue for the next 18 -20 months at least and has the numbers to push through tough reforms if they choose to. The liquidity risk is again perhaps within agreeable boundaries given that the dependence on external debt and the robust foreign exchange reserves that can more than cover the repayments if need be. Similarly the position of the country on the external vulnerability index is quite high.

The banking sector risk measured by ratios such as total banking sector assets to GDP at 89 per cent and the loan to deposit ratio of banks at 73 per cent indicate a well percolated banking system with an active lending traction. But what perhaps spoils this indicator is the average baseline credit assessment of the banks at Ba2 indicating the inherent weak asset quality. The recent recapitalisation has specifically been pointed out as a specific positive in the analysis by Moody’s. But a sustainable improvement on this front necessitates a strong credit appraisal process devoid of political and other pressures. The recent policy initiatives by the government to help close bad loans and realise value is a step in the right direction although a stronger appraisal process can help avoid the periodic rearing of this problem like the pay commission issue. Also, the recapitalisation through a cosmetic accounting mechanism can address the symptom rather than the cause.

It is intuitive for the government to perhaps focus on controllable factors such as borrowing, tax reforms and compliance to ensure a steady improvement on the rating scale. Other linked factors may automatically be better. The complex factors on governance and prevention of corruption will be combination of government will and public awareness in a vibrant democracy like India.

How Does India Compare With Peers

The comparable peers Italy and Spain are in a downward trajectory. The growth parameters of GDP are near stagnant/declining. Their government debt to GDP is much higher, which implies that the governments in these countries have very little head room for further investment through the borrowing route. They perform better on the institutional strength front. Almost all the other countries in the category fare poorly in comparison with India on the growth front. What is pulling the rating down is essentially the dissipation of GDP due to the huge population, compounded by institutional factors and government fiscal prudence. While fiscal prudence can be overcome through a combination of higher revenues and lower borrowing, institutional strengthening requires sustained and relentless political push.

Compared To China

Notwithstanding certain rating parameters being of a comparable nature, the sheer size and strength of the Chinese economy with high exports provide a tremendous advantage. Interestingly, the banking sector in China and the increase in credit flows to the shadow banking sector and the interconnectedness of the various sections of the banking sector is considered a risk. Using China as a potential competitor and working towards a larger share of global trade can be an aspiration and long term goal for India, in the short term the country is better off focusing on fiscal prudence, institutional reforms and systemic improvements.