The Covid-19 pandemic has turned out to be the acid test for the Narendra Modi–led National Democratic Alliance (NDA) government. As the government enters the second year of its second term, international credit rating agency Moody’s downgraded India’s rating to Baa3 from Baa2 (with a negative outlook) on growth and fiscal risks, bringing it to the lowest investment grade.

Indranil Sen Gupta and Aastha Gudwani, India economists at BofA Securities, who had cautioned investors about the rising risks of a sovereign downgrade, do not see the development as a surprise. “This is not unexpected,” the economists wrote in a new report.

Sen Gupta and Gudwani highlighted that the rating action was driven by risks of a sustained period of relatively low growth, further deterioration in the fiscal position, and stress in the financial sector. “It’s (Moody’s) negative outlook reflects dominant, mutually-reinforcing, downside risks from deeper stresses in the economy and financial system that could further erode fiscal strength,” the duo wrote. “S&P and Fitch Ratings currently rate India at BBB- with stable outlook, that also happens to be the lowest investment grade,” the economists say.

However, they see the current slowdown as cyclical, driven by excessive Reserve Bank of India (RBI) tightening in mid-2018; a real lending rate shock on falling core wholesale price index (WPI) inflation in 2019, and now, the global Covid-19 shock. “While we see the Center's fiscal deficit, at our 6.3% of GDP FY21 forecast, breaching the long-run average by 180 basis points (bps), this is surely justified with growth falling nearly 900 bps below potential,” Sen Gupta and Gudwani added.

The key question now is whether India can fall below investment grade? “Not really, in our view, due to three buffers,” the duo wrote. First, the RBI's high FX (foreign exchange) reserves should protect the rupee from any speculative attack.

Second, the finance ministry will likely recapitalise public sector banks (PSBs) through non-fiscal levers such as issuing recapitalisation bonds and/or using the RBI's $127 billion revaluation reserves.

And, third, a run of good harvests should cushion the Covid-19 shock. The silver lining is that while BofA Securities’ expects India’s GDP to contract by 2% in FY21, they foresee that FY22 growth rebounding to 9%.

Both economists argue that fiscal stimulus is the need of the hour, notwithstanding Moody's. Reiterating the fiscal deficit number, and the GDP growth projections for FY21 and FY22, the duo argues that it is the fall in growth, due to the Covid-19 shock, that is leading to a higher fiscal deficit than vice versa. In a separate note, Sen Gupta and Gudwani have cut their FY21 GDP contraction forecast by 70 bps to 2%, assuming that the lockdown extends to mid-July from end-June with the re-start stretching all through August.

“We estimate that a month's slowdown will cost 100-200 bps of GDP, and the six week restart to shave off nearly 60 bps,” the duo highlighted. “If the economy is kept in a semi lockdown phase until a vaccine is found, then India's GDP will likely contract by 5% in FY21,” they added.

On FY20 growth, which expectedly dropped to an 11-year low of 3.9% (versus BofA expectation of 4.1%) from 6% in FY19, the economists highlighted that March quarter growth, at a higher than expected 3% was buoyed by higher winter (rabi) sowing as well as public spend.

As mentioned earlier, going forward, BofA Securities expects good harvests as one of the strong buffers against the sub-investment grade rating. “After a bumper summer (rabi) harvest, we expect the winter (kharif) sowing to benefit from the Met's forecast of 102% of normal south-west monsoons.”

With Covid-19 positive cases nearing 2 lakh, including 95,526 recoveries and 5,598 deaths reported until June 2, the government has been on war footing to fight the pandemic. The series of fiscal stimulus measures are expected to help the economy, as the lockdown is phased out and economic activity resumes.

Follow us on Facebook, Twitter & YouTube to never miss an update from Fortune India. To buy a copy, visit Amazon.