India's Deficit Threatens 'Junk' Rating

Standard & Poor's warns India of further downgrades as the country's exports sink and extra borrowing raises its deficit to 12% of GDP

By Mehul Srivastava

Indian Prime Minister Manmohan Singh RAVEENDRAN/AFP/Getty Images

Faced with a slowdown in growth, an exodus of foreign investors, a huge corporate accounting scandal at a top , and a make-or-break election, India's government has been struggling to find ways to rev up the economy. First came an $8 billion stimulus package in December. Then, on Jan. 2, as the country digested the news that exports had fallen for the first time in nearly 15 years, the central bank cut interest rates and allowed state governments to borrow another $6 billion. And last week, Prime Minister Manmohan Singh's coalition government slashed taxes.

Now comes the slap on the wrist. On Feb. 24, Standard & Poor's sniffed at all the extra borrowing, which has raised India's total deficit to about 12% of its gross domestic product, and revised the country's outlook downward to negative from stable. While S&P reaffirmed its BBB- rating, Takahira Ogawa, the analyst who recommended the change, says the ratings agency (which, like BusinessWeek, is owned by The McGraw-Hill Cos. (MHP)) would be watching India's fiscal condition closely for the next few months. "We see more possibility for a downgrade later on down the line," he says. "In a sense, this is a warning."

Any more large expenditures announced by the government could trigger a downgrade, says Ogawa. One big problem: BBB- is the lowest investment grade rating. If S&P does downgrade India, then the country would have a junk rating. That would mean the government would have to pay a painfully high yield on any bonds it issues, both overseas and domestically.

S&P isn't the only ratings agency worried about . Moody's (MCO) rates India's local currency debt at BA2, while the foreign debt is rated higher, at BAA3, says Aninda Mitra, a Singapore-based analyst for the company. "The speed at which the deficit has deteriorated is pretty bad," he says. "Worse than comparable countries."

Economy First, Deficit Second

Still, with elections approaching, there's plenty of pressure for the government to go ahead and keep spending. Over the past year, Singh's government has promised an $11 billion debt waiver for farmers, additional billions of dollars for a national employment scheme for rural areas, and other spending that has added to the government's debt burden. In Parliament last week, announcing his interim budget, Finance Minister Pranab Mukherjee said his primary concern was stimulating the economy, not holding down the deficit. Just over two years ago, Indian officials had said they would try to hold the federal deficit down to 2.5%.

Now, though, the government seems to be placing its bets on a simple prediction: Even though the Indian stock market's benchmark index fell a record 52% last year, tight credit lines have stranded infrastructure projects all around the country, exports are dropping, and foreign investors remain wary, India will surf through the global recession at a slightly humbler growth, with higher tax revenues helping to lower the deficit. "The Finance Minister was honest in the sense that he said he doesn't give a serious consideration to the fiscal deficit," says Ogawa, the S&P analyst. "Instead, he has to focus on the countermeasures for the slowdown in the economy."

At least one thing is almost certain: The government is out of bullets now. In Parliament, Mukherjee shrugged off the S&P decision, pointing out that other countries were doing the same to stimulate their economies.