DBRS Upgrades Republic of India to BBB, Stable Trend

DBRS, Inc. has upgraded the Republic of India’s long-term foreign and local currency issuer ratings to BBB from BBB (low) and upgraded the short-term foreign and local currency issuer ratings to R-2 (high) from R-2 (middle). The trends on all ratings have been changed to Stable.

The ratings are supported by DBRS’s assessment that structural factors of the Indian economy – high domestic savings and favorable demographics – underpin the country’s strong growth potential. High growth and low real interest rates are likely to support sustainable public debt dynamics over the medium term. Exchange rate flexibility and a relatively low level of external debt also reduce external vulnerabilities. These underlying strengths are balanced by several challenges, including India’s large fiscal deficit, underdeveloped infrastructure, deteriorating bank asset quality, and restrictive market regulation.

The upgrade reflects positive developments on two fronts. First, macroeconomic policymaking has improved. The government is implementing a medium-term fiscal consolidation plan that redirects expenditure toward public investment, and institutional changes have strengthened the monetary policy framework. These measures will help reinforce macroeconomic stability and foster a favorable environment for medium-term growth. Second, the government is taking administrative steps to improve the investment climate. This includes simplifying business regulation, easing restrictions on foreign direct investment, and amending regulations to make the financial system more efficient and competitive. Cumulatively, these micro-reforms have helped alleviate supply-side bottlenecks and boost investor sentiment.

Risks to the ratings are broadly balanced. The ratings could be upgraded if the fiscal deficit is substantially reduced on a durable basis. Supply-side reforms that increase growth potential could also provide upward support to the ratings. On the other hand, if the political commitment to reduce the fiscal deficit wanes and economic growth materially underperforms, the ratings could come under downward pressure.

India’s ratings are underpinned by several fundamental strengths. India is one of the fastest growing economies in the world and, notwithstanding the FY12-13 slowdown, growth prospects remain strong. Real GDP expanded at an average annual rate of 7.7% over the last decade. High domestic savings, driven by rising incomes and an increase in the working age-population ratio, have supported elevated rates of investment and spurred economic growth. The positive outlook for capital and labor inputs, combined with the potential for technology absorption, suggest India’s long-term growth prospects remain strong. In the near term, growth is set to gradually accelerate in an environment characterized by low inflation and sound external accounts. According to the IMF, the economy is expected to expand 7.3% in FY16 and 7.5% in FY17.

The favorable composition of India’s public debt also supports the ratings. The average maturity of central government securities was 10.4 years in June 2015 and nearly all issuance is at fixed rates. External debt accounts for less than 8% of government debt, and of this amount, most is on concessionary terms from multilateral or bilateral lenders. The government is able to finance high fiscal deficits on favorable terms due to the large pool of domestic savings, coupled with financial regulations that require institutional investors to hold public securities. Although this arrangement leads to an inefficient intermediation of savings, the public sector benefits from better terms and reduced rollover risk.

India appears well-positioned to manage external volatility. The China slowdown could indirectly affect India through weaker global demand and reduced risk appetite among investors. Rising interest rates in the United States will also result in tighter global financing conditions. Nevertheless, the current account deficit is small, net FDI inflows fully cover the external gap, and external debt levels are moderate. In the event of an adverse shock, exchange rate flexibility and international reserves totaling $350 billion can act as buffers. Moreover, the decline in international commodity prices that has accompanied the slowdown in China is equivalent to a positive terms-of-trade shock for India.

However, India’s credit profile is characterized by several challenges. Persistently large fiscal deficits since the onset of the global financial crisis have contributed to inflation and lowered public savings. Spending commitments generated by the 7th Pay Commission as well as large social development needs could put additional pressure on public finances. This highlights the importance of fiscal reforms that raise additional revenue and reorient expenditure toward more productive sectors of the economy.

Inadequate infrastructure is also a major challenge. According to the 2015-16 Global Competitiveness Report by the World Economic Forum, India ranks 81st out of 140 countries in terms of the quality of overall infrastructure. Efforts to upgrade the country’s infrastructure have been impeded by land acquisition problems, the slow delivery of environmental clearances and financing difficulties. If unaddressed, poor infrastructure could constrain economic growth.

In the banking sector, the deterioration in asset quality presents a concern. The weakness is most acute in public banks, where the sum of nonperforming and restructured loans amounted to 13.5% of gross advances in March 2015. In order to ensure adequate credit supply to the real economy, banks will likely require additional capital – either by raising equity in the private markets or public capital injections - particularly as Basel III requirements are introduced. Notwithstanding concerns over profitability and asset quality, Indian banks remain well-capitalized, thereby limiting macro-stability risks stemming from the financial system.

In addition, sustaining high rates of growth over the medium term will likely require market reforms. Structural weaknesses in key markets – such as power, land and labor – dampen productivity and distort the allocation of factor resources. Without a majority in the upper house, the government has been unable to pass major market reforms, including the land acquisition bill. Instead, the Modi administration has focused its efforts on the non-legislative agenda and encouraged reform at the state level.

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 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 Ministry of Finance, Reserve Bank of India, Central Statistics Office, The Conference Board Total Economy Database, Lok Sabha, Rajya Sabha, 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.

DBRS does not typically accept editorial changes other than to correct for factual, accuracy and/or to remove confidential, material non-public, or sensitive information that might otherwise be inadvertently disclosed.

Lead Analyst: Michael Heydt
Rating Committee Chair: Roger Lister
Initial Rating Date: 26 June 2007
Most Recent Rating Update: 5 November 2014

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