New Delhi: The ratings upgrade India received from Moody’s Investors Service last week after a gap of 13 years is a big boost to investor sentiment, and is likely to lower borrowing costs of Indian firms. But what the upgrade does not change is the fact that India’s near-term economic outlook has deteriorated because of global and domestic headwinds.

Topping the list is oil. As a previous Plain Facts column pointed out, the entire reduction in the fiscal deficit under the Narendra Modi-led National Democratic Alliance government can be attributed to increased taxes on petrol and diesel. The centre’s tax revenue from petrol and diesel rose from 0.44% of gross domestic product (GDP) in 2013-14 to 1.44% of GDP in 2016-17, a gain of 1 percentage point or 100 basis points (bps). This has precisely been the extent of improvement in the fiscal deficit over the same period, from 4.5% of GDP in 2013-14 to 3.5% in 2016-17.

The fall in oil prices allowed the government to raise fuel taxes without sparking any outcry by consumers but the rising price of crude oil has changed that. After raising the excise duty on petrol and diesel nine times since November 2014, the Union government was forced to cut excise duty on those items last month, forgoing significant revenue.

The reversal in the global commodity cycle also impacts growth and incomes in India adversely. India was one of the biggest beneficiaries of declining commodity prices, experiencing terms-of-trade windfall gains amounting to 3.4% of GDP in 2015-16, according to estimates by the International Monetary Fund (IMF). IMF calculates the windfall gains by estimating the change in disposable income arising from commodity price changes. The terms-of-trade windfall gain declined to 0.6% of GDP in 2016-17, and has turned negative for India in the current fiscal year, according to IMF estimates published in the latest World Economic Outlook report.

Higher oil prices, therefore, dampen the outlook on the economy as they drag down growth, tend to widen the twin deficits (fiscal and current account), and raise inflationary risks. Among the major emerging market economies, India remains particularly vulnerable to rising oil prices, as it now imports almost 90% of its petroleum requirements.

Oil is not the only factor that has put a strain on public finances. The uncertainty over revenue from the goods and services tax (GST) and the significant spending by state governments on farm loan waivers all add to the deterioration in the outlook for India’s public finances, which appear to be in weaker shape compared to emerging-market peers despite the improvement in recent years.

In upgrading India’s sovereign rating, Moody’s cited a deterioration in fiscal metrics as a key risk factor even as it noted the likelihood of further upgrades if the metrics improve. How the fiscal metrics shape up over the next year will depend to a large extent on whether the government resists the temptation to splurge in the last full budget ahead of the next Lok Sabha elections.

Any deterioration in fiscal metrics will also likely add to inflationary pressures which have begun building up again, lowering the room for rate cuts. Given the central bank’s inflation targets, there doesn’t seem to be any room for rate cuts over the next few months, even without taking into account possible fiscal slippages.

In the event of a sharp rise in oil and commodity prices, and deterioration in the twin deficits, the risks of capital outflows will increase sharply. Rate cuts may only exacerbate such outflows at a time when global yields are expected to rise.

Thus, the risks to India’s macroeconomic stability are far higher today than they have ever been over the past three years. Several tailwinds that helped India repair its macroeconomic balance sheets and attract capital inflows such as favourable commodity prices and low global yields are turning into headwinds today, even as the room for policy action has shrunk.

Will our policymakers reconcile themselves to the new reality and shun adventurism in the coming months? Or will they give in to populism? The verdict from the upcoming assembly elections may well end up deciding the choices they make, and the trajectory that the Indian economy takes.

This is the final part of a two-part data series on the health of the Indian economy. The first part examined India’s transition from one of the “Fragile Five" to a favoured investment destination.

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