Luck helped fix macros, bank recap will test fisc
If the government was hoping credit-rating firm S&P would upgrade India from the current BBB-/A3 for the long- and short-terms, respectively, it was being optimistic. To be sure, India is better off than many emerging economies since it is growing faster and is therefore in a better position to address potential challenges on the fiscal and current account deficits. And it helps that commodity prices, the crash in which made the twin deficits look more attractive, are not looking like they will rise to earlier levels in a hurry. With forex reserves at close to $370 billion, there is enough of a cushion even if oil prices were to move up marginally—FY17 is expected to end with the CAD at 0.5% of GDP. And, despite a likely worsening in the country’s external liquidity metrics over the next three years, the gross external financing needs are expected to be lower than current account receipts plus usable reserves through 2018.
However, both the pace of growth of GDP and its sustainability are debatable, and could even stagnate, especially since the global economy remains sluggish. Economists at Bank of America have pointed out that, based on the old GDP series, the economy grew at an anaemic 4.2% in Q1FY17 and a modest 7.1% as per the new series. So far there is little evidence to show that lower interest rates are stimulating investments; in fact, the festive season has passed by without any serious pick up in the demand for products such as two-wheelers.
While the government is, no doubt, attempting to ease policies—which S&P has applauded—and is ushering in legislation like the bankruptcy code and GST, these measures will have an impact only over the longer term. In the next couple of years, the challenges will continue to outweigh any meaningful gains since the health of PSU banks remains precarious, the state electricity boards are still too cash-strapped to purchase either the existing power capacity or that which will be coming online soon, and the private sector still isn’t ready to invest in the absence of either local or global demand picking up meaningfully. Indeed, while the fiscal deficit looks in control, if the government was to recapitalise PSU banks at the pace required, it too would deteriorate—and, till the balance-sheet repair takes place, the banks’ inability to lend fast will act as a drag on growth. As a result, the government will remain torn between the need to recapitalise banks and increase public investment to replace private investment. That is why S&P has said “the government has little ability to undertake countercyclical fiscal policy given its current debt burden”. This limits growth in per capita income which, like it or not, is something any credit-rater needs to look at since only countries with high per capita incomes can raise taxes in a hurry—or draw down forex reserves—in order to meet impending crises; that is why, despite its current problems, China’s rating still remains high. The good news, though, is that while it will take a longer period for India’s ratings to rise, foreign investors are already seeing the potential and invested $55.5 billion in FY16, making India one of the top FDI destinations. Sustaining this, of course, will require the ratings change which the government is working towards with its reforms.