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

DBRS, Inc. (DBRS) has confirmed the Republic of India’s long-term foreign and local currency issuer ratings at BBB (low) and the short-term foreign and local currency issuer ratings at R-2 (middle). The trend is Stable on all ratings.

The confirmation reflects DBRS’s assessment that India’s high growth prospects and low real interest rates are likely to support stable public debt dynamics over the medium term. Exchange rate flexibility and a relatively low level of external debt provide further support to the ratings. However, the macroeconomic environment is under considerable stress and downside risks are mounting. Slowing growth, high inflation and a large current account deficit are all symptomatic of increasingly binding supply-side constraints. Parliament recently passed several important pieces of legislation, but the likelihood of advancing much-needed structural reforms to address macro-imbalances and restore higher rates of growth will largely depend on the political landscape following parliamentary elections next year.

The Stable trend reflects DBRS’s view that India has sufficient space to manage near-term economic challenges. However, if slowing growth and large fiscal deficits put debt-to-GDP on an upward trajectory over the medium term, the ratings could come under downward pressure. On the other hand, policy actions that narrow fiscal imbalances, tackle supply constraints and revive investment, thereby helping restore higher rates of growth, could lead to an upgrade of the ratings.

The Indian economy is experiencing a marked slowdown. Growth decelerated from 9.3% in FY11 to 6.2% in FY12 and 5.0% in FY13. Recent activity indicators suggest the economy continues to underperform this fiscal year. Although weakness in the global economy has dampened external demand, the slowdown in India appears to be driven largely by domestic factors, particularly on the supply side. Land acquisition problems, environmental clearance delays and infrastructure bottlenecks have intensified, largely reflecting high regulatory barriers, inadequate competition in some key non-tradable sectors and limited public sector capacity to meet the growing demands of a rapidly expanding economy. Gross fixed capital formation fell below 30% of GDP last year for the first time since FY05. If unaddressed, these factors could constrain growth over the medium term.

Fiscal accounts have deteriorated significantly since the onset of the global financial crisis. Expansionary policy helped mitigate the harmful effects of the global downturn in 2009, but stimulus measures were not fully reversed even as the Indian economy recovered. The result has been persistently large deficits which have contributed to inflationary pressures and lowered public savings. The government made some progress reducing the deficit last year. Below-budgeted spending helped narrow the central government deficit from 5.8% of GDP in FY12 to 4.9% in FY13. However, medium-term spending pressures generated by expanding entitlement programs and a rising subsidy bill could put substantial pressure on public finances and divert scarce resources away from public investment.

High inflation has also persisted since the start of the global financial crisis. Supply bottlenecks in the agriculture and transport sectors, rising commodity prices and strong real wage growth have all contributed to the upward trend in prices. Moreover, reducing inflation could prove challenging even as the output gap widens. Inflation expectations are elevated, currency depreciation will pass through to higher import prices, and fuel prices face upward adjustments. Consequently, DBRS believes there is limited space to provide fiscal or monetary policy support if growth continues to weaken.

The prospect of less accommodative monetary policy by the Federal Reserve amid slowing domestic growth has recently resulted in substantial volatility in the foreign exchange market. The nominal USD-INR exchange rate depreciated 23% from April to August before partially recovering in September. While DBRS sees exchange rate flexibility as an essential tool to facilitate an external adjustment and maintain international competitiveness, rupee depreciation has adverse short-term effects on fiscal accounts, inflation dynamics and corporates with unhedged foreign currency liabilities.

Despite near-term challenges, India’s ratings are underpinned by several fundamental strengths. India has been one of the fastest growing economies in the world and, notwithstanding the recent slowdown, growth prospects remain strong. Real GDP expanded at an annual average rate of 7.9% over the last decade. Higher private savings, driven by rising incomes and an increase in the working age-population ratio, have supported higher rates of investment and spurred faster growth. Going forward, favorable demographics, high savings and potential catch-up in technological know-how suggest that India’s long-term growth prospects are strong.

The favorable composition of India’s public debt profile is also supportive of the ratings. The average maturity of outstanding central government dated securities was 9.7 years in June 2013, and nearly all issuance is at fixed rates. External general government debt totals just 4.4% of GDP, and of this amount, most is on concessionary terms at long maturities from multilateral or bilateral lenders. 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, the public sector benefits from better terms and reduced rollover risk.

In addition, India’s external position appears manageable despite rising vulnerabilities. External debt increased last year but remains at moderate levels. In the event of an adverse shock, exchange rate flexibility and international reserves totaling $275 billion (as of September 13, 2013) provide significant buffers. Furthermore, the government recently eased FDI restrictions in several key sectors, including as aviation and retail, which should encourage more stable forms of financing over the medium term.

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

The principal applicable methodology is Rating Sovereign Governments, which can be found on our website under Methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales.

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.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

Lead Analyst: Michael Heydt
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 26 June 2007
Most Recent Rating Update: 17 December 2012

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