An Upgrade To India’s Ratings By S&P Could Be Some Time Away

The S&P has upgraded its outlook on India’s sovereign rating to 'positive' from 'stable' and affirmed an investment grade rating of 'BBB-'. A positive outlook indicates higher chances of rating upgrades sometime in the future.

The change reflects a strong growth outlook, the government's commitment to fiscal consolidation and the strength of the banking system. One of the conditions for a possible rating upgrade was that the net change in general government debt fell below 7% of GDP on a consistent basis. The net change in general government debt is, in effect, the fiscal deficit (taking into account on and off-balance sheet items). 

Currently, the general government deficit is estimated at 7.9% of GDP in FY25, which is expected to reduce to 6.8% by FY28, as per S&P. Hence, it will take some time before the positive outlook translates into a rating upgrade.

Compared to other investment-grade economies, India outperforms on growth, inflation, financial stability and external metrics but lags on the fiscal metric. India’s consolidated fiscal deficit is estimated at 8.7% of GDP in FY24 and is expected to reduce to 7.9% in FY25, led by consolidation by the central government. The recently announced RBI dividend, which exceeded expectations by a wide margin at Rs 2.1 trillion, provides fiscal space to the central government to further consolidate the fiscal deficit.

The quality of fiscal expenditure has improved both at a central and state level, with a continued focus on capital expenditure. Capital expenditure in FY24 by the central government has risen by 36% (April to February) and state government capital expenditure has increased by 21.5%. The support from the government has resulted in the capex cycle leading the recovery in FY24, with GDP growth closer to 8%, despite muted consumption recovery.

The ability of the central government to focus on fiscal consolidation and remain growth-supportive reflects improvements in tax collection efficiency, with gross tax collection rising to 11.5% of GDP in FY24 versus 11.3% in FY23. The RBI dividend is likely to result in the central government's fiscal deficit undershooting the FY25 interim budget deficit target of 5.1% of GDP by 0.2% of GDP. This assumes that expenditure remains at interim budget levels.

The positive rating outlook also reflects improvements in credit quality, with banking sector GNPA at multi-year lows. Moreover, banking sector credit growth has been strong in FY24 at 20.2%, led by retail credit and services sector credit.

The one metric on which India has the highest score is the external sector. This reflects exceptionally low external debt levels, at 18.7% of GDP. Moreover, the current account deficit in FY24 is estimated at 0.7% of GDP versus a 2% deficit in FY23, led by a reduction in the trade deficit and a strong service surplus. The current account represents the gap between domestic savings and investments. The reduction in the current account deficit represents a lower reliance on external savings to fund domestic investments.

Another important safeguard against external volatility is adequate forex reserve cover, which is tracking at 11.5 months. The FX reserve cover measures how many months of imports can be purchased with the current level of FX reserves (spot reserves plus forward book).

The change in outlook on the sovereign rating is a welcome move and reflects the positive mix of domestic macro and policy conditions. Another positive change on the fiscal horizon is India’s inclusion in the JPMorgan EM bond index, which will start from June-end onwards. The combination of fiscal consolidation by the central government and bond index-related inflows will support further reductions in government bond yields.