(Bloomberg) -- Prime Minister Narendra Modi's wriggle room to relax his deficit targets just got reduced by Moody's Investors Service.
On Thursday, the government was talking about easing its budget goals as sweeping policy changes hurt growth and revenue. Then, early Friday, Moody's upgraded India's sovereign rating to the highest since 1988, prompting a U-turn from the administration.
"We'll continue to maintain the glide path," Finance Minister Arun Jaitley said at a briefing in New Delhi on Friday, referring to his plan to shrink the budget shortfall to 3.2 percent of GDP in the year through March 2018 and a decade-low of 3 percent the next year. "The upgrade is a recognition of the fact that India continues to follow a path of fiscal prudence."
Jaitley's words contrast with his comments to investors in Singapore on Thursday, when he said "challenges arising from structural reforms could change the glide path." He can't afford to follow through on that now because Moody's one-notch rating upgrade is a bet that India will contain public debt.
Both S&P Global Ratings and Fitch Ratings rate India at BBB-, a notch above junk status. S&P's highest ever rating for India stood at BBB in 1990 from which it was downgraded in March 1991. Fitch Ratings' current rating stands as its highest ever.
While rating companies have lost some of their allure abroad after they failed to predict the financial crisis of 2008, they're still considered a stamp of credibility in emerging markets, where local statistics can often be dodgy.
Modi needs such a boost: he faces elections in his home state of Gujarat next month, where polls point to the closest contest in years. Voters are concerned about a lack of jobs and higher inflation after Modi's decision last year to invalidate almost 90 percent of currency in circulation and the disruptive roll out of a consumption tax this July. Moreover, India's financial assets have seen a sell-off over the past weeks.
Read: Moody's Upgrade Is Christmas Come Early for Modi
"The government will likely remain on the path of fiscal consolidation as it is mindful of maintaining investor confidence," said Dhawal Dalal, chief investment officer for debt at Edelweiss Asset Management Ltd. "There has been significant increase in positivity generated among foreign investors as they have appreciated fiscal policy and various measures taken by the present government in order to improve economic growth."
The rupee strengthened as much as 1 percent in Mumbai on Friday, the most since mid-March, while the main equity index rallied 0.7 percent. The yield on 10-year sovereign bonds, which slipped from a 14-month high to 7.05 percent, could fall to 6.95 percent by March, according to Yes Bank Ltd. It predicts the currency may strengthen further if Fitch Ratings and S&P Global Ratings follow Moody's in upgrading India.
Currency and bond markets have come under pressure in recent weeks due to rising crude oil prices and talk of potential fiscal slippage.
“The timing is a surprise given concerns regarding the fiscal metrics right now,” said Sue Trinh, head of Asia foreign-exchange strategy at RBC Capital Markets in Hong Kong of Moody's move.
More Cautious
"S&P and Fitch are more cautious and will not follow suit soon," said Anthony Chan, an Asian sovereign strategist at AllianceBernstein Holding Ltd. in Hong Kong. "The upgrade cited reform progress, especially GST, but GST's tax dilution was a disappointment and caused many to forecast bigger fiscal slippage."
Chan was referring to Jaitley's decision last week to slash tax rates on more than 200 goods and services. The move will cost 200 billion rupees ($3 billion) in lost revenue. It is seen as a step to curb prices that are rising at the fastest pace in seven months and an attempt to encourage companies to invest and hire more, ultimately soothing voters.
Read: Four-Month Old Tax Regime Revamped as Indian Businesses Founder
Growth in gross domestic product slipped to a three-year low in the April-June quarter, muddying the near-term outlook, though the GST is expected to boost productivity in the longer term. Moody's predicts annual expansion will slow to 6.7 percent in the year through March 2018 -- from 7.1 percent -- but rebound to 7.5 next year.
"The space for expenditure contraction is much less than other years," said Pronab Sen, country director at New Delhi-based International Growth Centre and India's former chief statistician. "There will be pressure when it comes to meeting the fiscal deficit target."
--With assistance from Manish Modi Candice Zachariahs Arijit Ghosh and Subhadip Sircar
To contact the reporters on this story: Archana Chaudhary in New Delhi at achaudhary2@bloomberg.net, Kartik Goyal in Mumbai at kgoyal@bloomberg.net.
To contact the editors responsible for this story: Ruth Pollard at rpollard2@bloomberg.net, Jeanette Rodrigues, Shikhar Balwani
©2017 Bloomberg L.P.
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