DBRS Confirms India at BBB (low), Trend Remains Stable

DBRS, Inc. (DBRS) has today confirmed the ratings on the Republic of India’s long-term foreign and local currency debt at BBB (low). The trend on both ratings is Stable. The ratings are underpinned by India’s strong long-term growth prospects and solid external position. The confirmation of the Stable trend reflects DBRS’s assessment that high growth and low real interest rates are likely to continue to support public debt dynamics. However, current macroeconomic conditions in India are stressed, external risks to growth have intensified, and the coalition government is struggling to garner political support for much-needed reforms. If the medium-term growth outlook deteriorates and large fiscal deficits persist, the ratings could come under downward pressure.

The Indian economy has enjoyed one of the highest growth rates in the world over the last decade and, despite the recent slowdown, long-term prospects appear strong. From 2001 to 2011, real GDP growth averaged 7.5%. Higher private savings, driven by rising incomes and an increase in the working age-population ratio, have supported domestic investment and spurred economic growth. Private savings averaged 30% of GDP from 2000 to 2010. At the same time, real income per capita, which improved little during the 1960s and 1970s, picked up in the 1980s and accelerated in the 1990s and 2000s. This led to a significant reduction in poverty and improved standards of living. High savings and investment, an increase in the working age-population ratio, and the potential catch-up in technological and management know-how, particularly as India more fully integrates into the global economy, point to strong long-term growth prospects.

Public debt dynamics in India are supported by strong growth and low real interest rates. General government debt declined from 90.9% of GDP (DBRS methodology) in 2003 to 77.8% in 2007. The downward trend was interrupted in 2008 as expansionary fiscal measures mitigated the adverse impact of the global recession but resumed thereafter as large growth-interest rate differentials more than offset primary deficits. In 2011, general government debt fell to 70.9% of GDP. The government is able to finance large fiscal deficits on favorable terms due to the large pool of domestic savings, coupled with financial regulations that require commercial banks and other institutional investors to hold public securities. Although this arrangement leads to an inefficient intermediation of savings and thereby lowers potential GDP growth, the public sector benefits from lower interest rates and reduced rollover risk.

The ratings are also supported by India’s strong external solvency and liquidity ratios, despite some deterioration since the onset of the global financial crisis. Gross external debt increased modestly in 2011 but remains within historic norms at 20% of GDP. The net international investment position also increased but is still at moderate levels. Moreover, India is well-positioned to confront unfavorable financing conditions. At the end of March 2012, international reserves totaled $294 billion, or 16% of GDP. This amounts to 85% of gross external debt (as of December 2011) and 200% of short-term external debt based on residual maturity. In the event of an external shock, high reserves and exchange rate flexibility provide large buffers.

Notwithstanding these underlying strengths, macroeconomic conditions in India are under considerable stress. In 2011-12, GDP growth slowed to 6.5%, the central government fiscal deficit widened to 5.8% of GDP, and inflation remained high. Moreover, economic and financial fragility in the Euro area pose downside risks to India’s growth outlook through trade and financial linkages. A sustained bout of high risk aversion could weaken capital inflows, particularly portfolio equity and external loans, negatively impacting economy-wide financing conditions and overall economic activity.

Although weakness in the global economy has dampened external demand, the slowdown in India appears to be largely driven by domestic factors, particularly on the supply-side. Infrastructure bottlenecks, land acquisition problems and power shortages have intensified, largely reflecting inadequate regulation and competition in non-tradable sectors as well as the limited capacity of public institutions to meet the growing demands of a rapidly expanding economy. If left unaddressed, these factors could act as major impediments to sustaining high growth.

Fiscal balances have deteriorated significantly since the onset of the global financial crisis. The general government deficit widened from 4.0% of GDP in 2007 to 9.4% of GDP in 2009. The deterioration was due to a combination of scheduled wage increases, the expansion of the National Rural Employment Guarantee Act, three fiscal stimulus packages, rising subsidy costs and, more recently, a cyclical decline in revenues. While expansionary policy helped mitigate the harmful effects of the crisis, stimulus measures were not fully reversed even as the economy recovered, resulting in persistently large deficits. Due to the weak budgetary position and high debt burden, there is limited fiscal space for counter-cyclical policy action in the event of an adverse shock.

Moreover, large fiscal imbalances, combined with financial sector regulations, crowd out private investment and have a negative impact on potential GDP growth. The central government aims to reduce its deficit from 5.8% of GDP in 2011 to 5.1% in 2012 and 4.5% in 2013. However, achieving deficit targets could prove challenging if growth underperforms or subsidies are not curtailed. In the medium term, spending pressures for social programs and much-needed infrastructure are likely to put further stress on public finances, unless they are accompanied by fiscal reforms that restrain current expenditure growth, raise revenue and enhance economic growth.

Inflation dynamics have also worsened over the last four years. Annual CPI inflation has averaged over 10% since 2008. Rising international commodity prices, supply-side constraints in the agriculture and transport sectors, strong real wage growth, and expansionary fiscal policy have all contributed to strong upward price pressures. Persistently high rates of inflation have negative implications for investment and growth.

The ratings could come under downward pressure if large fiscal deficits persist and the medium-term growth outlook deteriorates. On the other hand, if policy actions correct macroeconomic imbalances, enhance competition and revive investment, thereby helping sustain high rates of economic growth, the ratings could come under upward pressure.

Notes:
All figures are in U.S dollars unless otherwise noted.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies.

The sources of information used for this rating include the Ministry of Finance, Reserve Bank of India, Economic Advisory Council to the Prime Minister, Planning Commission, Central Statistical Organization, International Monetary Fund and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Lead Analyst: Michael Heydt
Rating Committee Chair: Roger Lister
Initial Rating Date: 26 June 2007
Most Recent Rating Update: 23 June 2011

For additional information on this rating, please refer to the linking document under Related Research.