Moody's links India's credit rating to drought vulnerability

India may avoid drought this year, but its economy remains vulnerable to fluctuations in annual rainfall, a factor that continues to constrain the country's sovereign credit, Moody's Investors Service said on Tuesday.

But India's vulnerability to drought will come down if the government's efforts to improve infrastructure, food distribution and non-agricultural employment opportunities were successful.

"These efforts would also benefit India's overall sovereign credit profile because they would lead to higher incomes, a stable and lower inflation, and a lower fiscal burden related to food subsidies," it said a report titled

'Vulnerability to Drought Poses Credit Challenges'.

India's sovereign credit profile was more vulnerable to drought than most of its Baa-rated peers because of the relatively high share of agriculture in GDP and employment, weak rural infrastructure, inefficient food distribution and the relative share of food subsidy cost in the fiscal deficit.

"Although India may avoid drought this year, its economy remains vulnerable to future drought or fluctuations in rainfall, and its sovereign credit profile is more exposed to the negative effect of drought than those of most Baa-rated sovereigns," Moody's said in a report.

It currently rates India at 'Baa3', the lowest investment grade -- just a notch above 'junk' status.

Drought can lower GDP growth, raise inflation and add to fiscal pressure. "This combination constrains the ability of monetary policy to respond to ongoing macro-economic developments. This is particularly so in years such as the current one when a weak monsoon forecast coincides with an uncertain cyclical recovery," it said.

Policy efforts to increase India's resilience to drought were still at their initial stages, Moody's said.

The efforts at the central and state government level to improve rural infrastructure, food distribution and non-agricultural employment opportunities are credit positive because, if sustained, they are likely to lower the credit challenge that India's vulnerability to drought poses.

"If these government efforts are sustained and successful over the next 2-3 years, they could lower India's vulnerability to drought. They would also benefit India's overall sovereign credit profile because they would lead to higher incomes, stable and lower inflation, and a lower fiscal burden related to food subsidies," it said.

At 18% of 2013 GDP, the share of agriculture in the Indian economy was high relative to that of several Baa-rated peers, but is in line with lower rated countries such as Bangladesh, Egypt, Pakistan and Vietnam.

India's agricultural growth rate (about 3.1% from 1999 to 2013) was slightly lower than Bangladesh and Vietnam that have similar agricultural shares of GDP. 

Moody's said India's inflation was higher than that of similarly rated peers, and constrains its sovereign rating.

"Food inflation is the main contributor to this higher inflation," it said.

India's vulnerabilities to drought will decline over the long term if it proceeds along a path of higher-than-peer GDP growth.

"This growth will create non-agricultural employment opportunities and raise incomes, lowering the growth, inflation and fiscal impact of drought," it added.

"However, it will take several years before these reach a level that can effectively insulate the majority of the population from the negative effects of drought," it further said.

Moody's said it did not expect a rollback of the extensive food subsidy system, but if policies are able to improve food production and distribution, the fiscal risk associated with food subsidies will also fall.

"Our positive outlook on India's rating reflects our view that the measures that central and state governments are taking to improve rural infrastructure, agricultural productivity and food distribution, will over time lower overall inflation levels and volatility, including volatility associated with drought.

"And if they are part of a broader improvement in government effectiveness, they may also improve India's institutional strength assessment," it added.

If the policies succeed in doing so, India's vulnerability to drought will fall and its sovereign credit profile will improve, the report said.

"India achieves agricultural growth by employing a larger number of people in agriculture than those in other sample countries, suggesting a relatively low level of labour productivity in agriculture," Moody's said.

It listed limited progress in expanding irrigation facilities; poor access to inputs including seed, fertilizer, mechanical tools; a low average farm size, which reduces economies of scale and poor rural roads and electricity availability, as reasons for low agricultural productivity in India.

Also, distorted agricultural markets in which price signals do not appropriately capture demand/supply dynamics due to government intervention in procurement, price guarantees and storage, is the other reason, it said.

"After forecasts of a sub-optimal monsoon this year were first released in May, the government appears to have accelerated efforts to improve irrigation," the report said, adding that plans to overhaul the state-run food

distribution and storage system in a way that reduces current distortions in pricing, procurement and production have also been announced. 

"It is still too early to estimate whether these efforts will be successful in improving productivity and reducing volatility in agriculture. If they do, they would build greater resilience to drought as well as improve India's relative sovereign metrics," Moody's said.

The report compares India with several other countries in which agriculture has a major share of GDP and concludes that Indian economy's vulnerability to drought stems from a combination of factors like a relatively high share of agriculture in overall employment and weak rural infrastructure and irrigation.

Besides, "inefficient food distribution, a large proportion of Indian household spending on food and share of food subsidy costs in the government's fiscal deficit makes India more vulnerable to drought", Moody's noted.

"Because of the above characteristics, drought can simultaneously lower GDP growth, raise inflation and add to fiscal pressure, leaving India's sovereign credit profile more susceptible to the effect of drought compared with those of other Baa-rated sovereigns," it said.

India's economic exposure to annual fluctuations in rainfall constrains the ability of the monetary policy to respond to ongoing macro-economic developments. This is particularly so in years such as the current one when a weak monsoon forecast coincides with an uncertain cyclical recovery, Moody's added.

The report said India's vulnerability to drought could decline over the longer term as average incomes rise.

"But in the near to medium term, policies to improve infrastructure, food distribution, and non-agricultural employment opportunities hold the key to reducing the annual economic uncertainty that is linked to the performance of monsoon," it stated.