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S&P downgrade is a timely warning

T N Ninan

India tends to see itself as one of the global biggies on many counts - which is why it seeks a permanent place on the UN Security Council.

And despite the recent troubles, it sees itself as a reforming economy, the fourth largest in the world (using purchasing power parity) and one that has performed very creditably over the past couple of decades. Indeed, the economy is stronger in many ways than it has ever been.

So it comes as a rude shock when
Standard & Poor's brackets India along with Guatemala and El Salvador, not to speak of Kazakhstan and Costa Rica, and says that the domestic bonds that the Central government issues are no more than junk bonds.

That explains in part why the initial reaction from so many people late on Thursday evening was one of shock, even anger: It just couldn't be possible. That such a psychological shock has caused barely a ripple in the real world of markets points to the economy's many strengths.

But once you look at the relevant data, it becomes immediately obvious that we have a problem: among the highest fiscal deficits in the world, and an uncomfortably high level of domestic debt, both seen in relation to GDP.

It is worth bearing in mind by way of background perspective that while India may (or may want to) rank among the global biggies, in hard economic and technical terms it counts for pretty little: less than 1 per cent share of world trade, less than 1 per cent share of global capital flows, less than 1 per cent citations in refereed technical journals, a miserable share of global patents, less than 1 per cent share of the international tourist traffic...

If the various countries in the world were to get their size on a model of the globe to reflect their economic significance, India would show up as roughly the geographical size of Pakistan or Bangladesh.

From that perspective, it is easier to focus coolly on the question posed by Standard & Poor's: Are we in, or are on the edge of, a domestic debt trap? In one respect, the question has an easy answer: since the government can always print money, there can never be the risk of default on domestic public debt, in the way that there is with foreign debt.

Which explains why many millions of Indians prefer the safety of government paper to anything else, as a place to park their savings; it also explains why the banks are buying far more government paper than they are obliged to.

But there is more to it, of course. No government can print endless currency notes and buy its way out of trouble, because if it printed that much money, it would create hyper-inflation, serious external imbalances and general economic chaos. So it does matter whether the level of domestic public debt is high.

As to whether it is too high, and whether we are in a debt trap (which means borrowing more and more to stay in the same place), we must apply the old test: Is the real rate of interest on government debt higher than the growth rate of GDP?

The answer is, No. Ten-year government bonds now command an interest rate of 7.2 per cent. Adjusting for inflation, the real rate of interest is about 3.7 per cent. The GDP growth rate is still above 5 per cent. So we have a 1.3 per cent cushion.

The obvious conclusion must therefore be that S&P has been harsh. But since the domestic debt market is not going to be thrown off balance, not much damage has been done. S&P's action should usefully be read as a warning.

The fiscal deficit at the Centre is climbing again; half the state governments are in a financial crisis; the stopping of the divestment programme and the willingness to announce financial giveaways only add to the problem. So, yes, one could rubbish S&P.

But the more constructive course would be to get the reform programme and fiscal rectitude back on track. Unfortunately, there seems to be little chance of that. May be, then, we should take S&P more seriously than we have.

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