Moody's: India's In Trouble Without More Fundamental Fiscal Reform

The classic signs of an overheating economy increasingly visible in India can only be addressed through far-reaching structural reforms to boost productive capacity, according to Moody's Investors Service.

"The pursuit of macroeconomic stability by India's monetary authorities is at a critical phase, and is important not only from a business, policy, and political perspective, but also for ensuring the long-term sustainability of public finances," said Moody's Vice President Kristin Lindow.

To date, said Lindow, most of the improvement in the government accounts has been cyclical or attributable to ample global liquidity. The more manageable external debt position and strong external liquidity is reflected, she said, in Moody's investment-grade Baa3 foreign currency issuer rating for the government and Baa2 foreign currency country ceiling, despite widening current account deficits.

She pointed to the current signs of overheating, including higher-than-acceptable inflation, a growing merchandise trade deficit, still-high rates of domestic credit growth, and, most recently, rapid rupee appreciation driven mainly by strong capital account inflows.

However, she cautioned, in the absence of deeper reforms, Indian fiscal policymakers have no option but to rely on stop-gap measures to contain the buildup of macroeconomic imbalances and inflationary pressures.

One way to accomplish this is to affect relative prices, including the rupee exchange rate, both to encourage greater foreign demand for India's output and to discourage domestic demand in an effort to restrain the growth of the external deficit. Other strategies would rely on monetary and fiscal tools to curb domestic demand in hopes of achieving price stability.

"In India's case, macroeconomic policymaking has lately been deeply complicated by strong capital account inflows that far exceed its current account deficit. The flows have put upward pressure on the rupee, and resulted in considerable foreign exchange reserve accumulation," said Lindow. "Such inflows are partly debt-creating in nature -- commercial borrowings and non-resident Indian [NRI] deposits -- and can be quite volatile, especially speculative foreign institutional capital or yield-seeking portfolio inflows."

In this situation, she said, the burden of re-establishing macroeconomic stability has increasingly fallen on monetary policy, although the magnitude and nature of the capital inflows have blunted the efficacy of various policy tools. The flows have also contributed to a loss of external competitiveness and emerging foreign currency mismatches on the balance sheets of Indian private-sector borrowers -- just at the peak of a domestic credit cycle.

Fiscal measures, such as price and export controls on wheat and cement, have also played a part in restraining wholesale prices, said Lindow. But, she said, in the absence of more fundamental fiscal reform, current efforts merely address the symptoms rather than the underlying causes of supply shortages and price pressures.

"As a result, it comes as no surprise that the RBI's annual credit policy statement of April 24 stressed structural mechanisms -- easing up on the prepayments of external commercial borrowings, increasing hedging opportunities, lowering the interest rates paid on NRI deposits, and permitting greater flexibility to send portfolio and debt capital abroad -- to foster a more competitive exchange rate that could ameliorate the growing external imbalances," said Lindow.

The RBI statement also reiterated that work is progressing on developing niches often found in more sophisticated local financial markets, such as an interest rate futures market. Finally, although key policy rates as well as the cash reserve requirement were left unchanged and the credit expansion targets were edged up, RBI left no one in doubt about its continuing hawkishness, particularly now that it has lowered its inflation goal to 5% for the current fiscal year and its medium-term comfort range to 4.0%-4.5%.