Sovereign warning

There are fears that India's sovereign rating will be downgraded in the near future. This may, however, not happen if the policy environment is better than it was a few months ago. The new finance minister and his team have already raised the hopes of both Indians and foreigners. If the government accepts the GAAR committee recommendations on taxation, and the Kelkar committee recommendations on fiscal consolidation, the policy environment will certainly look better. A diesel price hike, if implemented next week, as reports suggest, would also play a crucial role in preventing a downgrade.

There are two issues related to a downgrade. First, when good governance and fiscal prudence can keep India's credit rating high, Indian companies are able to compete on an equal footing with the rest of the world. By adopting better policies both for its budget and for economic growth in general, the government can provide Indian companies a better environment. Second, at a time when India has a difficult balance of payments situation, it cannot afford to have lower capital inflows that could put further pressure on the rupee. Not adopting measures that would improve the rating, but simply criticising either the ratings agencies or the ratings mechanism, will be damaging for the economy.

Today, if India does see a ratings downgrade, it will make the cost of borrowing abroad higher. When borrowing is cheaper abroad, it is attractive to borrow in dollars. A ratings downgrade will serve to raise the cost of borrowing, thus imposing a private cost on companies that borrow in dollars. Even if an Indian company is as good as a comparable one, say, from China, if India gets a downgrade then the company has to pay more for its borrowing. In a domestic environment that is already difficult, imprudent fiscal policy imposes further costs on Indian companies.

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