India's fractious politics keeps government debt high. Source: Google Images
In an earlier post, I discussed a theory I developed that democratic countries with divided, often coalition, governments generally produce weaker public finances than countries where two dominant parties alternate in power. India is the posterchild for the former, with government debt at about 80% of GDP, very high for an emerging market economy. In order to keep weak coalitions together, governments must buy off constituencies, at the expense of sound public finances. We shall see if India’s current government led by the Congress Party can deliver on promises to reduce the government debt burden.
India’s weak fiscal position (with government deficits at around 6% of GDP) have constrained its credit ratings to low investment grade. Below find a press release issued today by Fitch in which the rating agency adjusts the rating outlook on India’s sovereign bonds to stable from negative, not due to improved management of government finances, but to stronger GDP growth prospects. The one-off positive impact on government accounts of recent telecoms auctions also helped sovereign creditworthiness.
CSFB published a note today (also below) explaining how output growth is starting to bump up against capacity constraints. Fitch forecasts output growth at a healthy 8.5%, though the Reserve Bank of India might tighten monetary policy, keeping the expansion in check. This is because of another important characteristic of Indian political economy — political sensitivity to inflation. India is a populous country with high levels of poverty, so when inflation creeps up even a point or two, especially for food prices, people starve (or at least become more malnourished). In a place as big as India, this can mean millions more malnourished people. Complicated policy making…
From Fitch Ratings:
Fitch Revises India’s Local Currency Outlook To Stable; Affirms at ‘BBB-‘
14 Jun 2010 5:33 AM (EDT)
“India’s strong growth prospects and the one-off positive impact from the telecoms auctions underpin Fitch’s forecast that government debt to GDP ratio will decline, easing the near-term pressure on India’s local currency ratings. However, public finances remain a clear weakness, and downward pressure on the ratings could resume if India veers too far off the deficit reduction path as outlined by the Thirteenth Finance Commission,” said Andrew Colquhoun, Director in Fitch’s Asia-Pacific Sovereigns Group.
Fitch projects general government debt to fall to 80% of GDP by end-March 2011 (end-FY11) from 83% at end-FY10, reflecting the impact of strong GDP growth on the denominator and the one-off revenues from the 3G licence and broadband spectrum auctions. The agency has revised India’s FY11 growth forecast up to 8.5% from 7% on signs of strong growth momentum, including industrial production growth of 17.6% in April 2010, year-on-year. The telecom licence auctions together netted the government INR1,060bn, representing about 1.6% of projected FY11 GDP, as against the INR350bn budgeted originally (Fitch’s February review of India took the cautious approach of assuming zero auction revenues). The agency anticipates some pressure on the government to spend some of the revenue windfall and estimates an additional 0.3pp spending in FY11, still delivering a net 1.3pp fiscal saving.
However, fiscal management remains relatively weak. Fitch anticipates that the central government’s deficit on the government basis (including privatisation and auction receipts as revenue and excluding some off-budget items) to be at 5.7% of GDP in FY11, just 1pp down from FY10, despite the 1.6% of GDP reaped from the telecom auction. The report of the Thirteenth Finance Commission (TFC) in February laid out a path of deficit reduction towards a “golden rule” of borrowing only to finance investment by FY15. India’s track record on sticking with medium-term fiscal plans is not good, although the Congress-led government has at least voiced its commitment to debt reduction. If the authorities stray too far from the TFC’s consolidation path and debt ratios resume rising, it could impact the ratings negatively.
A significant drop in the country’s growth momentum to below Fitch’s projections would worsen India’s debt dynamics and put downward pressure on its ratings. However, India’s credit profile continues to benefit from the largely local-currency profile of its debt (95% of the stock), and from the sovereign’s stable access to domestic-currency financing, mainly from the banking system. Signs that India’s banking system was under stress would likely be negative for the sovereign ratings, although this is not the agency’s base case. Inflation remains uncomfortably high, with wholesale prices up 10.2% in the year to May, prompting the central bank to hike rates twice in response so far in 2010. An intensified inflation shock that is severe enough to disrupt macroeconomic and/or financial stability would be negative for India’s ratings.
India’s strong external finances, including its sovereign and overall net creditor status and official reserves of USD271bn by June 4 2010 (up 3.6% on a year earlier), continue to support its foreign currency ratings. By contrast, poor physical infrastructure, underdevelopment reflected in low average incomes, and weak governance indicators relative to rated peers constrains the ratings.
Contacts: Andrew Colquhoun, Hong Kong, Tel: +852 2263 9938; Vincent Ho: +852 2263 9921.
From CSFB today:
India
Devika Mehndiratta
+65 6212 3483
[email protected]
April IP surprised on the upside, with the index rising 17.6% yoy compared with our and consensus estimates of 14.3%. In seasonally adjusted level terms, the IP index had been flat in recent months – after strong gains from June to December 2009, IP was flat in January and February and then declined in March (Exhibit 6). In April, the IP index increased by a notable 3.4% mom.
The large upward surprise in April IP was not that broad-based, however. It was dominated by a 33% mom jump in the capital goods sub-index. This sub-index has been volatile recently (Exhibit 7). It jumped over 30% in December/January, fell back in February/March and was up again by 33% mom in April. A breakdown by product for capital goods is not available for April yet, but data until March showed that these large ups and downs were limited to only a few goods such as computers, ship building & repair, railway wagons, and oil wells/platforms.
Capacity constraints could become an issue. Even if we assume that the broad trend in capital goods (even though volatile) indicates that corporate investment activity is picking up, it is possible that, in the months ahead, capacity constraints start to show up. Anecdotal evidence suggests that industries such as autos, fast moving consumer goods, steel and power are operating near full capacity (the power sector has been capacity constrained for years). This could slow the pace of month-on-month rises (from around 3% pace in April) in industrial production going ahead.
Could the RBI now hike policy rates inter-meeting before the scheduled July meeting? An inter-meeting hike is not entirely inconceivable, but we would still maintain that it is unlikely. This is because: 1) the RBI has indicated ‘cautiousness’ in its policy stance in recent comments, and 2) monetary conditions have anyway tightened in recent weeks triggered by the large one-off 3G auction-related borrowings by telcos. The short-term call rate has consequently moved up from the reverse repo rate (3.75%) to the repo rate (5.25%) without the RBI having taken any policy tightening action since April.
