The Indian government’s response to the market collapse that followed the U.S. debt standoff and subsequent Standard and Poor’s downgrade was predictable. While acknowledging that India was impacted, the effort was to play down the likely intensity of that impact. “Our institutions are strong and [we] are prepared to address any concern that may arise on account of the present situation,” Finance Minister Pranab Mukherjee reportedly stated. He also promised that the government “will fast track the implementation of the pending reforms and keep a close eye on international developments.”

That response misses the point. The problem is not that India is not adequately reformed, but that past reforms have resulted in its integration through flows of finance with global capital. This makes the perceptions and behaviour of global capital, whether stimulated by India’s fundamentals or not, of importance to the country. And unlike China, a lot of the reserves that insure the country against adverse global responses are not earned through current account surpluses, but are drawn from what foreign investors have delivered in the past. Keeping legacy capital satisfied is crucial for stability.

Put simply, independent of whether there would be a global slowdown that would impact India, the country is exposed and vulnerable to global financial uncertainty. So even when some of its fundamentals are ostensibly strong it is liable to be hit by weak investor sentiment. India is vulnerable because international finance may assess its so-called fundamentals very differently from the way they are assessed by the government.

Consider the issue that now captures financial market attention: public debt. The experience in Greece, Spain, Portugal and elsewhere suggests that finance capital is increasingly “intolerant” of what is perceived as excessive public debt. In some instances this may be understandable. International financial investors are substantially exposed to government bonds in some of those countries, and their governments seem increasingly incapable of meeting their debt service commitments. Sovereign default threatens investor solvency. What is not understandable is the austerity that finance demands in those countries. It not only triggers protest and social disruption. It also results in contraction of employment and incomes, and undermines the ability of governments to garner the revenues needed to pull themselves out of the crisis.

Trapped in its own ideological quagmire, finance now seems to have lost its bearings. The cause for concern about public debt in a particular context has been extended to an unthinking abhorrence of all debt. The standoff over public debt in the US was not because the US government was over-indebted relative to its GDP. There are many other OECD countries from Greece to Germany that have a higher public debt to GDP ratio than the US. And even to the extent that debt has risen sharply in recent times in the US, it is largely the result of the failure of finance. The huge stimulus and bail-out package adopted by the US government to deal with the crisis delivered by irresponsible financial agents in 2008 took the net public debt to GDP ratio in the U.S. from 42.6 in 2007 to 72.4 per cent in 2011.

Financial interests benefited from that package and also bought into that debt using the near-interest free liquidity provided by the Federal Reserve. In the process they increased their exposure to sovereign debt in the US and elsewhere. But now that they are overcome by fears of sovereign default, they want a “correction”. So even in the U.S. they have not merely backed the irresponsible Republican refusal to accept a routine hike in the debt ceiling cap, but have through discredited rating agency Standard & Poor’s delivered an irresponsible first time downgrade of U.S. debt. That has been enough to trigger the turmoil in world markets.

It is in that background that we should view reports of S&P’s statement that fiscal capacities in Asian emerging markets, including India, have shrunk relative to 2008. This, it has argued, would mean that in the event of a second global slowdown: “The implications for sovereign creditworthiness in Asia-Pacific would likely be more negative than previously experienced, and a larger number of negative ratings actions would follow.”

This is more of a threat than an analysis. But if a wrong downgrade can make a difference to US markets and interest rates, so can it for India’s. The real difficulty is one that emerges from an analysis by Cornell economist Easwar Prasad in the Financial Times. That analysis suggests that though India’s gross public debt to GDP ratio declined from 75.8 per cent to 66.2 per cent between 2007 and 2011, it still is among the highest in the region. India’s 66.2 per cent level compares with Malaysia’s 55.1, Pakistan’s 54.1, Philippines’ 47, Thailand’s 43.7, Indonesia’s 25.4 and China’s 16.5.

So if S&P needs a target to declare that some governments in the Asia-Pacific are excessively indebted, then India is in the firing line. It is no doubt true that a number of factors make Indian public debt less of a problem than in many other contexts. To start with, much of public debt in India is denominated in Indian rupees and is owed to resident agents and therefore is unlikely to be adversely affected by uncertainty in international debt and currency markets. Secondly, within the country public debt is largely held by the banking system dominated by public sector banks. They are subject to government influence and are unlikely to respond to developments in ways that make bond prices and yields extremely volatile. Given these circumstances, public debt is not a potential trigger for a crisis and in any case should not worry private financial interests.

But that is unlikely to satisfy the likes of S&P. India has been a favoured target of foreign finance. And if it does not satisfy its requirements, it can fall out of favour. In its search for new investment targets, global finance has viewed with interest debt markets in countries like India. And in any debt market, what better instrument than relatively risk-free government securities. So, anything that muddies that potential market would disturb finance capital. India may be put on alert and even downgraded. The fact that, at the moment, publicly owned banks largely hold government paper is inadequate insurance.

Besides, there are other reasons why international finance would resent excessive debt-financed spending by governments. One is that given the monetarist mindset that characterises finance, such autonomous debt-financed public expenditure is seen as potentially inflationary. Since inflation erodes the real value of financial assets, it is anathema and, therefore, so is deficit-financed spending. The other is that when rising debt increases the interest burden in the budget and restricts the manoeuvrability of the government, it may push for a reduction interest rates. Private financial interests do not favour such intervention in financial markets. They, therefore, seek to address the problem at its source.

For reasons such as these, international finance is strongly opposed to the build up of public debt as a result of large and rising fiscal deficits. It is no doubt true that even if institutions like S&P flag India’s public debt as excessive, it may not lead to a fall in bond prices and an immediate rise in interest rates. But, it may signal, however erroneously, the overall unreliability of Indian markets and encourage the exit of financial investors from markets other than debt. This perhaps partly explains the current volatility in the equity market.

The issue is not whether India is directly coupled with global bond markets. It is whether India is financially integrated enough for any adverse assessment by sections of international finance to destabilise its markets. That much India’s reform has indeed achieved. So when irresponsible ratings by a rogue agency create instability, the response should not be a pledge to undertake further “reform”. Rather, it should be to rethink which facets of reform have increased India’s vulnerability and how.