India: Credit Downgrade and Associated Reforms May Mean Change of Ruling Parties

India was hit with some more bad news earlier this week when Fitch warned New Delhi that it would downgrade the country’s credit risk rating to junk grade if the government was unable to reverse the existing trend of slow growth, high inflation and rising fiscal deficit. This announcement renewed the financial markets’ longstanding concern that India’s policy paralysis was having a real impact on the country’s economy thereby placing more pressure on the government to do something to break the ongoing logjam.

It’s important, however, to place the news about the slowing economy in the proper perspective. India’s real gross domestic product (GDP) is projected to grow at 4.9 percent in 2012-13 and 6 percent in 2013-14. Since most nations – including every developed country – would be ecstatic with this rate, it’s clear that the market’s concerns have less to do with what’s going on in the world and more with New Delhi not living up to its fiscal promises.

Fitch and Standard and Poor’s (S&P) cut India’s rating outlook last year and by announcing another proposed downgrade, Fitch hopes to shake New Delhi out of its stupor – hence the 24-month timeframe. The Indian government seems to be listening as it has increased railway passenger fares for the first time in nine years, opened some sectors for foreign investment and communicated its intention of reducing fuel subsidies.

While admirable, New Delhi faces significant headwinds in implementing future reforms. The continuing global slowdown and a swelling fiscal deficit requires the government to take such responsible steps but the mid-2014 national election and India’s increasing dependence on consumer spending make them politically unpalatable and economically dangerous. The government, therefore, finds itself between a rock (instituting unpopular measures) and a hard place (a fiscal deficit that overshot its target by 1.2 percent last year).

There is no doubt that credit rating downgrades have a real impact on a country’s ability to attract investment and loans thereby hurting its economic prospects. It’s also true that credit agencies are being forced to take these actions due to New Delhi’s inaction and consistent non-compliance with its own mandates. The Indian government’s best option seems to be to implement the unpopular but necessary measures immediately in the hope that subsequent economic growth will wipe out the bad taste of these measures. Otherwise, New Delhi will go into the 2014 elections riding a continual economic slowdown and hand the elections to its rivals.