The Paradox of Prosperity: Why India Must Get a Higher Rating

The Paradox of Prosperity: Why India Must Get a Higher Rating

By R Kannan

India stands today as a global economic paradox. It is the world’s fifth-largest economy and the fastest-growing major nation, yet its sovereign credit rating from major global agencies like Fitch and Moody’s stubbornly clings to the lowest rung of the investment grade: 'BBB-' (or Baa3).This rating, one notch above "junk" or speculative status, belies the nation's robust external buffers—a four-fold rise in foreign exchange reserves since 2006—and its unparalleled demographic potential.

Sovereign credit ratings are an assessment of a country's creditworthiness, primarily evaluating its ability and willingness to repay its public debt on time. This evaluation is based on a mix of economic, fiscal, political, and institutional factors, and it is forward-looking.

The  countries with very high debt and weak growth sometimes see rating increases, while those with lower debt and strong growth see slow or no upgrades. This disparity often stems from the highly complex and often asymmetric nature of the rating agencies' methodologies.

Reasons for the Sovereign Credit Rating Anomaly

The anomaly describes the observation that countries with comparatively strong economic fundamentals (e.g., low Debt/GDP, high GDP growth) often face rating stagnation, while some higher-rated economies with weaker metrics might see stability or even targeted upgrades. This is not arbitrary, but a consequence of the methodology, psychology, and structural focus of the major rating agencies.

Asymmetry in Rating Revisions (Inertia and Momentum)

This section addresses the behavioural and procedural biases in how rating changes are executed.

Under-reaction to Good News: The Downgrade-Upgrade Asymmetry

•  Empirical studies widely confirm that rating agencies exhibit a significant asymmetry in their rating actions. Downgrades tend to be faster and deeper (often by multiple notches in rapid succession, particularly during crises) than upgrades, which are typically slow, incremental, and cautious. This systematic under-reaction to positive news means that a country must not just meet the upgrade criteria but must do so for a prolonged period, overcoming the scepticism inherent in the rating process. Agencies often delay upgrades until they are absolutely certain the positive trends are structural and irreversible, effectively penalising a recovering economy with a "wait-and-see" approach.
• The Implication: High growth in an Emerging Market and Developing Economy (EMDE) may be viewed as cyclical or temporary, whereas high debt in an Advanced Economy (AE) is viewed as manageable due to institutional strength.

Reputational Incentive/Lag: The Post-Crisis Precaution

•  The global financial crisis (GFC) of 2008-2009 and the subsequent European sovereign debt crisis led to intense criticism of rating agencies for failing to anticipate the massive economic and fiscal collapses. They were accused of being too slow to downgrade the debt of advanced economies (AEs) like the US and several Eurozone members. To mitigate future reputational risk, agencies adopted a more conservative and forward-looking risk management approach. When evaluating a potential upgrade, this creates a significant time lag (the reputational lag), as the agency must ensure that its decision won't be immediately reversed by a new economic shock, thereby protecting its image as a prudent arbiter of risk.
• The Implication: For high-growth countries, this translates to having to prove the resilience of their reforms against a hypothetical "next crisis," which delays the credit recognition they seek.

Persistence/Inertia of Ratings: The "Through-the-Cycle" Methodology

•  Sovereign ratings are generally intended to be "through-the-cycle" assessments, meaning they should reflect a country's creditworthiness over an entire economic cycle (typically 5 to 7 years), not just its current position. This methodology necessitates rating stability and avoids frequent, cyclical changes. Therefore, once a country is assigned a rating, there is immense inertia. A powerful, yet transient, GDP growth spurt will not trigger an upgrade unless the agency believes that the new economic trajectory is structural and permanent. The bar for an upgrade is set high to ensure stability and predictability, demanding an unequivocal and sustained improvement across a broad matrix of indicators.
• The Implication: Countries with volatile but high growth often find their rating remains anchored by the long-term, non-economic factors that are slower to change. But for a country like India, which has a secular growth, the approach taken by credit rating agencies should be different.

Focus on Structural and Non-Economic Factors

This set of reasons highlights how qualitative, rather than purely quantitative, metrics can override strong economic data.

"Peer Group" Relativity: The Comparative Constraint

•  Sovereign ratings are fundamentally relative assessments. A country's rating is not determined in a vacuum but is assessed against its peer group (e.g., other countries in the 'BBB' or 'A' category). A country with a Debt/GDP ratio of 50% and 7% growth may have excellent metrics in isolation, but if the average country in the next highest rating bracket ('A') has a much higher GDP per capita, superior governance scores, and deeper financial markets, the low-debt country will remain capped. The rating agencies must justify an upgrade by demonstrating the country's credit profile is measurably stronger than its current peers and comparable to its new, higher-rated peers.
• The Implication: An upgrade requires outperforming not just the country's own past performance, but its new peer group on non-economic, structural measures.

Quality of Governance and Institutions: The "Willingness to Pay" Factor

•  Sovereign risk comprises two elements: Ability to Pay (economic/fiscal strength) and Willingness to Pay (political/institutional strength). Qualitative factors like Rule of Law, Government Effectiveness, Voice and Accountability, and Control of Corruption carry significant weight in the final rating. Weakness in these areas suggests potential political instability or a lack of policy continuity, which can lead to debt repudiation or arbitrary policy shifts that undermine economic stability. Even with low debt, low institutional quality is viewed as a systemic risk multiplier, constraining the rating (acting as a "soft cap" or sovereign ceiling). A country like India, where Institutions are very strong and having Global standards, there is a need to review this approach by Rating agencies.
• The Implication: Until institutional quality scores are brought into line with higher-rated peers, the rating will be capped, irrespective of the fiscal balance.

Low GDP Per Capita: The Resilience Threshold

•  Absolute level of economic development, proxied by GDP per capita (PPP), is a primary determinant in most sovereign rating models. Countries with low absolute income levels are viewed as having lower structural resilience to economic shocks (e.g., pandemics, commodity price crashes) compared to wealthy nations. Low income per capita implies a smaller, less diversified tax base and greater reliance on vulnerable sectors. Even if the growth rate is high, the stock of wealth is low, limiting the government's ability to impose new taxes or cut spending without triggering social unrest.
• The Implication: Rapid growth is necessary but not sufficient; the country must also cross an implicit absolute wealth threshold to demonstrate maturity and resilience equivalent to higher-rated economies.

Depth of Financial Markets and External Vulnerability

These factors relate to how a country is financed and its exposure to global capital flows.

External Vulnerabilities: The Liquidity and Shock Buffer

•  The rating assessment looks critically at external finance risk. Even if public debt is low, high external debt (total debt owed to foreign creditors), a persistently weak Current Account Balance (CAB), or inadequate Foreign Exchange Reserves relative to short-term liabilities (e.g., short-term debt and import cover) pose a significant risk. A negative external balance exposes the country to sudden stops in foreign capital, currency depreciation, and potential balance of payments crises—risks that can trigger a sovereign default faster than high domestic debt.
• The Implication: Rating agencies require a substantial and sustained build-up of external buffers and a narrowing of the CAB to demonstrate immunity to global financial volatility.

Depth of Domestic Capital Markets: The "Local Currency Privilege"

•  Advanced economies with higher debt (like the US or Japan) benefit from a "local currency privilege" where they can issue debt in their own, reserve-currency-level, deep capital markets. This drastically lowers two risks:
• Foreign Currency Risk: The government is not exposed to a currency crash that would balloon the cost of foreign-denominated debt.
• Refinancing Risk: The government can always rely on the central bank (Monetary Flexibility) and local pension funds/banks to buy its debt, reducing dependence on fickle foreign investors.
• The Implication: For developing nations, even low debt carries a higher inherent risk if the local capital market is shallow or the currency is not freely convertible/a reserve currency, limiting monetary and fiscal flexibility.

Vulnerability to Shocks: The Diversification Test

• Rating agencies test the resilience and diversity of the economic growth model. If a country's high growth is overwhelmingly dependent on a single, volatile sector (e.g., commodities, or a narrow IT export base) or favourable global liquidity conditions, the growth is considered non-diversified and vulnerable. A downgrade can be triggered not just by current weakness, but by an elevated probability of a future negative shock. The agency must be convinced that the economy can maintain stability and debt-servicing capacity even during a severe downturn.
• The Implication: Sustained growth must be accompanied by demonstrable progress in economic diversification, moving the country away from cyclical dependencies.

Fiscal Composition and Debt-Servicing Burden

This addresses the qualitative nature of a country's debt and budget structure.

High Interest Payments to Revenue Ratio: The Fiscal Crowding-Out

•  While a country might have a low headline Debt/GDP ratio compared to an AE, the crucial metric for many EMDEs is the interest payments as a percentage of government revenue (i.e., the cost of servicing the debt relative to what the government earns). For many EMDEs, even low debt can have high interest costs due to higher risk premia or elevated domestic interest rates. If this ratio is high (e.g., above 20%), it means a large and increasing share of the budget is locked into debt servicing, creating a "crowding-out" effect. This drastically limits the government's fiscal space for essential, growth-enhancing spending (like infrastructure, health, and education), hindering future growth potential and increasing the risk of social instability.
• The Implication: Agencies see this high interest burden as a major structural fiscal rigidity that limits policy flexibility and caps the rating until it is substantially reduced.

 

What India can do to Secure a Rating Upgrade

This section is categorized into three main parts: Fiscal Consolidation and Debt Reduction, Economic Resilience and Institutional Strengthening, and External Stability and Long-Term Potential.

Fiscal Consolidation and Debt Reduction (The Core Constraint)

Based on the long-standing concerns articulated by rating agencies regarding India's fiscal profile, the three actions most likely to have the most immediate, demonstrable impact on convincing them to upgrade the rating are:

Achieve and Sustain Debt/GDP Target

This is arguably the single most critical factor. India's General Government Debt-to-GDP ratio (combining central and state debt, often above 80%) is a major outlier compared to its peers in the 'BBB' (lowest investment grade) category.

• The Impact: Rating agencies place immense weight on this ratio, as a persistently high figure limits the government's fiscal flexibility to respond to future crises. Demonstrating a clear, credible, and most importantly, sustained downward trend to a level closer to 60% (as recommended by the FRBM Review Committee) would directly remove the largest numerical constraint on the rating. This signals a fundamental reduction in long-term default risk.

Reduce Interest-to-Revenue Ratio

A corollary to high debt, this action addresses the quality of the government's budget and its ability to function.

• The Impact: When a large portion of government revenue is consumed by interest payments, it severely crowds out essential public spending on infrastructure (Capex), health, and education. A high interest-to-revenue ratio suggests low fiscal resilience. A material reduction in this ratio (by both increasing revenue and managing borrowing costs) provides immediate proof of improved fiscal health and enhanced policy space, making the government's finances more resilient and therefore creditworthy.

Strengthen Rule of Law and Judicial Efficiency

This action addresses the "soft" institutional and governance constraints that often cap the ratings of high-growth Emerging Market and Developing Economies (EMDEs).

• The Impact: While economic metrics show ability to pay, institutional metrics reflect the willingness and environment to pay. Poor judicial efficiency is seen as a key impediment to the Ease of Doing Business and deters long-term foreign direct investment (FDI). Demonstrating tangible progress in:
• Contract Enforcement: Significant reduction in the time taken to resolve commercial disputes.
• Regulatory Predictability: Making the tax and regulatory environment more stable and predictable.
• This addresses the qualitative and structural weaknesses that rating agencies view as long-term risks, even when short-term economic growth is strong.

 

Other Strategies

Enhance Central-State Fiscal Coordination: Formalize mechanisms to monitor and manage state government debt, ensuring a synchronized national effort toward fiscal consolidation. This is essential because the sovereign rating accounts for state borrowings. This can be achieved by using incentives (like long-term Capex loans) for states that enforce strict fiscal discipline. This reduces the risk of large, undisclosed contingent liabilities and assures agencies that the entire national fiscal apparatus is consolidating.

Revenue Augmentation

Broaden the Tax Base: Implement reforms to increase the number of direct and indirect taxpayers, improving the overall tax-to-GDP ratio. The primary mechanism is leveraging the Digital Public Infrastructure (DPI) (Aadhaar, UPI, GST network) to formalize the economy, simplify tax filing, and use data analytics to identify non-filers. This signals greater revenue resilience and reduces dependence on volatile revenue sources.

Rationalize and Improve GST Compliance: Further streamline the Goods and Services Tax (GST) structure, simplifying compliance, and enforcing mechanisms to curb evasion, thereby boosting revenue collection efficiency. This involves moving towards a simpler two/three-slab structure and strengthening the GST network's fraud detection capabilities. This demonstrates a commitment to institutional tax reform, leading to a more predictable tax structure and improved fiscal credibility.

Expenditure Management

Improve Subsidy Targeting: Shift from blanket subsidies to more targeted, direct benefit transfers (DBT) to reduce wasteful expenditure while maintaining social safety nets. Mandating the use of the DBT framework for all major central and state subsidy programs eliminates ghost beneficiaries. This demonstrates fiscal prudence, enhancing flexibility by reducing reliance on unplanned borrowings.

Quality of Spending Focus: Increase the share of capital expenditure (Capex) in total government spending, as Capex boosts long-term growth potential. This requires legislating a minimum floor for the Capex-to-GDP ratio and ring-fencing this spending from budget cuts. This action improves the growth outlook and economic resilience scores in rating models, justifying the sustainability of future debt servicing.

Economic Resilience and Institutional Strengthening

These measures aim to address the qualitative constraints like governance, rule of law, and financial sector stability, which often cap the ratings of high-growth Emerging Market and Developing Economies (EMDEs).

Structural Reforms

Accelerate Asset Monetization/Disinvestment: Expedite the sale of non-core government assets and public sector undertakings (PSUs) to reduce debt and improve overall economic efficiency. This involves establishing a dedicated, autonomous body with a multi-year mandate to manage the monetization pipeline. This provides a non-debt source of financing for Capex and demonstrates commitment to market efficiency.

Deepen Labor Market Reforms: Implement comprehensive labour reforms to enhance worker productivity, promote formalization of the workforce, and improve the ease of doing business. This involves implementing simplified, modernized labour codes focused on flexibility, coupled with a robust social security net. This addresses a fundamental structural weakness, enhancing overall Total Factor Productivity (TFP) and increasing the economy’s potential growth rate. The Government India has introduced four new labour codes substituting many of the old codes with effect from November 2025.

Boost Manufacturing via PLI Schemes: Sustain and expand Production Linked Incentive (PLI) schemes to attract Foreign Direct Investment (FDI) and establish India as a global manufacturing hub. Linking incentives to incremental output and job creation diversifies the export base. This demonstrates commitment to diversification of the economic base, bolstering the Current Account Balance (CAB) and reducing external vulnerability. The scheme in India has gained lot of traction and the leading companies in the world have come to India availing the incentives under the PLI Schemes.

Institutional Quality

Improve Government Effectiveness: Enhance administrative efficiency, transparency in public procurement, and the quality of public service delivery. This involves implementing "Whole-of-Government" approaches like PM GatiShakti to ensure seamless coordination for project execution. This reduces project risk and enhances the economic resiliency component of the rating. Government has taken lot of new initiatives across the sectors making many of the processes relating to Government approvals simple through using the Digital applications

Anti-Corruption Measures: Intensify efforts to improve Control of Corruption. This is done by enhancing transparency in government procurement via e-tendering and strengthening the independence and capacity of anti-graft bodies. An improved score on the Control of Corruption indicator signals a more predictable and fair operating environment.

Financial Sector Stability

Sustain Bank Deleveraging: Continue to strengthen the banking sector balance sheets by reducing Non-Performing Assets (NPAs) and ensuring robust capital adequacy. Banks must maintain high Capital Adequacy Ratios (CAR). This reduces the government’s contingent liability risk (the risk of a massive bailout), thereby strengthening the sovereign’s balance sheet indirectly. In the last few years, the balance sheet of banks and corporates have shown a very improvement in India.

Deepen the Bond Market: Encourage corporate and municipal bond markets to develop as a deeper source of financing, reducing the burden on the banking system and diversifying risk. This involves introducing tax incentives for domestic institutions to invest in bonds. This reduces the sovereign’s refinancing risk and enhances monetary policy effectiveness. In India, new innovative instruments are being introduced to reduce the dependence on banks for funding projects.

External Stability and Long-Term Potential

This final section focuses on reducing external vulnerability and demonstrating a commitment to long-term, sustainable growth drivers.

External Metrics

Sustain Forex Reserves Buffer: Maintain a strong and consistent buffer of foreign exchange reserves relative to external liabilities. The RBI could ensure coverage for at least 100% of short-term external debt and 8-10 months of imports consistently. This enhances the perception of external resilience and reduces the risk of a Balance of Payments crisis.

Maintain Current Account Stability: Manage trade deficits through export promotion and import substitution to ensure the Current Account Deficit (CAD) remains at a sustainable level . This focuses on high-value service exports and strategic import management. A sustainable CAD signals the economy can finance itself without undue reliance on "hot money."

Long-Term Growth Drivers

Boost Human Capital Investment: Significantly increase public spending on health and education (aim for 3% of GDP on health) to improve productivity and long-term economic potential. This involves linking educational outcomes to industry needs. This improves the crucial long-term growth potential score and is necessary for sustaining high-quality growth.

Energy Transition Commitment: Implement and fund credible, long-term plans for climate change mitigation and energy transition. This means accelerating investment in solar and wind capacity via the National Green Hydrogen Mission. This demonstrates proactive risk mitigation against environmental and commodity price volatility.

Communication & Transparency

Proactive Communication with Agencies: Engage in transparent, regular, and data-driven communication with the rating agencies, detailing the execution and long-term impact of reforms to address their specific concerns directly. This involves providing detailed, standardized data (including state-level debt) and holding structured briefings. This improves transparency and reduces information asymmetry, which can lower the subjective risk premium and accelerate the upgrade process. Government of India focuses on communication and gives the required data to rating agencies at regular intervals and they also have meetings with rating agencies to explain, why India deserves a much better rating.

India has proved its Ability to Pay through decades of growth and zero sovereign default. There is an increased Commitment to Institutional Strength. India’s stability is improving year on year.  Few rating agencies have increased the India’s rating . But they are not enough. Rating agencies should seriously consider upgrade in ratings by few notches without delays.  They should give the  rightful place to India in the global credit hierarchy.