DBRS Morningstar Assigns BBB Ratings to India, Negative Trend

DBRS, Inc. (DBRS Morningstar) has assigned Long-Term Foreign and Local Currency – Issuer Ratings of BBB and Short-Term Foreign and Local Currency – Issuer Ratings of R-2 (high) to the Republic of India. The trend on all ratings is Negative.

KEY RATING CONSIDERATIONS

The assignment of the BBB rating to the Republic of India is supported by DBRS Morningstar’s assessment that structural factors of the Indian economy – relatively high domestic savings and favorable demographics – underpin the country’s growth potential. Favorable growth and interest rate dynamics 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, structural impediments to faster productivity growth, and asset quality concerns within the financial sector.

The Coronavirus Disease (COVID-19) is having a severe impact on the Indian economy. To stem the spread of the virus, India was under a lockdown from March 25 to May 3. The government recently began phasing out restrictions, but close to half of all non-essential businesses are expected to remain closed until at least the end of May. Financing conditions have tightened due to concerns over deteriorating asset quality and heightened risk aversion globally. While the government’s response to the epidemiological crisis has likely helped to slow the spread of the virus, economic activity has declined precipitously. At a minimum, DBRS Morningstar assumes the shock will have a severe negative impact on economic activity in the first half of the year. The latest projections from the Ministry of Finance forecast a contraction of 10% in the first quarter of the fiscal year (April 2020 to March 2021) before recovering in the second half of the year, thereby resulting in growth of 2% for FY21. The IMF’s World Economic Outlook (April 2020), estimates growth to slow to 1.9% in FY21 before recovering to 7.5% in FY22. That said, there is a high degree of uncertainty and risks to the growth outlook appear skewed to the downside, in DBRS Morningstar’s view.

The Negative trend reflects the high degree of uncertainty around the magnitude and duration of the coronavirus shock. In DBRS Morningstar’s view, the government remains committed to a sound macroeconomic policy framework, but the severity of the shock combined with weaker recovery prospects will have an adverse impact on public finances. India arrived to the crisis in an already weak economic environment, with growth slowing to a decade low and limited fiscal space. If the shock proves durable, India’s credit profile could be negatively impacted by a combination of weaker growth and larger fiscal deficits, over the medium term, both of which would contribute to a rising public debt burden. However, the relief measures taken by the government and RBI could provide the support necessary for the economy to recover from this shock. To assess whether there is a material change in credit quality, we will be monitoring the spread of the virus as well as the progress of the economic policy response.

RATING DRIVERS

The ratings could be downgraded if India’s medium-term growth prospects or fiscal outlook materially weaken, thereby leading to a substantial deterioration in public debt dynamics relative to our current expectations, or if increased stress on the financial system leads to the materialization of contingent liabilities on the public sector balance sheet.

An upgrade of the ratings is unlikely in the near term. However, the rating could be upgraded over the medium term if the post-pandemic fiscal and growth dynamics put the public debt ratio of a firm downward trajectory.

The trend could return to Stable if the economic, fiscal and financial impact of COVID-19 proves to be largely temporary. In this context, structural consolidation of the fiscal accounts and productivity-enhancing reforms would be credit positive.

RATING RATIONALE

The Global Pandemic Forces India to Make Difficult Decisions on Lives and Livelihoods

India reported its first COVID-19 case on January 30. As of May 19, the number of reported infections (1,12,359) and deaths (3,435) associated to the coronavirus have remained low given the size of its population. However, testing is limited and uncertainty remains about the extent and duration of the health crisis. Given India’s limited public-health infrastructure, the government issued strict stay-at-home measures covering its 1.4 billion population on March 25, 2020 to slow the proliferation of the virus. These measures include the closure of schools, non-essential businesses, and public transport (including interstate road, rail, and air transport), as well as a ban on public gatherings. The comprehensive shutdown of the economy may have prevented a more severe health crisis from overwhelming the healthcare system thus far.

India’s struggle to contain the outbreak is illustrative of the challenges facing much of the developing world. The densely populated cities make social distancing difficult, the large informal and migrant workforce cannot subsist without daily wages, and sanitation issues complicate measures to reduce infection. The sudden stop in activity in a largely informal economy is such that it could steepen the economic cost in the near term with more people vulnerable to hunger than succumbing to the disease. Thus while the government has extended the general lockdown to May 31, the Prime Minister has announced a relaxation of restrictions beginning May 3 in districts deemed safe.

COVID-19 Stresses an Already Slowing Economy, But Efficient Policy Implementation Would be Credit Positive

Even before the coronavirus outbreak, the Indian economy was experiencing a slowdown. In FY20 (April 2019 – March 2020), GDP growth declined to 4.9%, its slowest pace in the last decade. The slowdown is led by both consumption and investment growth decelerating owing to (1) weak income growth – both in the urban sector due to the inability to lever up and in rural India due to food price dynamics and the disruption in the informal economy, (2) stresses in the financial sector that have affected monetary policy transmission despite a series of rate cuts and surplus of liquidity in the interbank market, and (3) weaker global demand. The economy has also been weighed down by sector-specific weaknesses in energy, real estate, construction, telecom, and airlines.

With the coronavirus outbreak, India’s FY21 growth outlook has markedly deteriorated. Social-distancing measures, combined with weaker labor market conditions and lower remittances, will adversely affect consumption. The outlook for investment is also poor: the domestic shutdown and weak business confidence add to the existing issues of financial market stress. On the external side, supply chain disruptions and depressed global demand will negatively impact exports. To help the economy recover from the lockdown and prevent liquidity concerns morphing into solvency issues, the government announced a INR 20.9 trillion relief package (10.3% of GDP) and is expected to announce a set of reforms focused on land, labor, liquidity, and legal frameworks to help industry become competitive.

That said, there is a high degree of uncertainty with both the government’s and IMF’s growth estimates of 1.5%-2% for the current fiscal year and growth could be considerably lower. In addition to uncertainty on the spread of the virus, the Indian economy is simultaneously being subjected to demand destruction from the pandemic and tightening financial conditions due to stresses in some private-sector banks and non-bank financial companies (NBFCs). On the other hand, India may experience a positive supply shock due to lower crude prices and may benefit from firms relocating from China to India.

DBRS Morningstar believes that India’s medium term prospects will depend in part on the government’s ability to improve the investment climate. Encouragingly, the government has begun tackling some of the structural issues. These include administrative steps to improve the investment climate by simplifying business regulation, easing restrictions on foreign direct investment, amending regulations to make the financial system more efficient, expanding the scope of the insolvency and bankruptcy proceedings to cover NBFCs, and reducing corporate tax rates. Recent policy announcements on agriculture if implemented efficiently are promising. These actions, coupled with India’s large diverse economy, favorable demographics, relatively high savings, and potential catch-up in technological know-how suggest that India’s medium-term growth prospects remain strong. As a result, India’s growth prospects has a positive impact on the ‘Economic Structure and Performance’ building block assessment.

Direct Fiscal Response is Limited, but COVID-19 Compounds a Weak Fiscal Position

India’s fiscal space has historically been limited by its low revenue base and high non-discretionary expenditures, resulting in an average general government deficit of 7.5% of GDP over the last two decades. Although India adopted a rules-based fiscal framework in 2003, which targets the center’s (central government) deficit at 3% of GDP, the Fiscal Responsibility and Budget Management Act (FRBM) was suspended during the Global Financial Crisis. The Act was reinstated in FY13 with the deficit-reduction strategy focused on raising revenues and increasing the efficiency of expenditures. On the revenue front, the passage of the Goods and Services Tax Bill (GST), along with progress on financial inclusion and digitalization, has been a significant development. On the expenditure front, savings from market-based pricing of fuels and the switch to direct transfers for subsidy payment have created some space for increased health and education expenditures. Nevertheless they are partially offset by spending pressures generated by the Pay Commission on government salaries. As a result, India’s consolidated deficit is the highest among its emerging market peers.

In response to COVID-19, Prime Minister Modi announced a relief package of INR 20.9 trillion, amounting to 10.3% of GDP, that aims to support the economy and dampen the impact of the pandemic. The relief measures are a combination of direct fiscal support, credit guarantees and subsidized loans, monetary policy actions including rate cuts and liquidity injection, and regulatory and structural policy measures.

The direct fiscal support estimated at INR 1.9 trillion (around 1% of GDP), primarily targets low income households and migrant laborers through distribution of free food grains and income support measures such as immediate cash transfers to Jan Dhan-linked bank accounts. In addition to increasing wages, the government has raised the outlay of the rural employment scheme MGNREGA by INR 400 billion to INR 1 trillion. MGNREGA – the right to work – provides at least 100 days of wage employment to every household in rural India and will help in partially alleviating the stresses faced by rural India and the migrant labor force.

The credit guarantees, subsidized loans and special liquidity schemes are estimated at INR 10.9 trillion (5.4% of GDP). This includes a non-bank liquidity package of INR 5.9 trillion for the micro, small and medium enterprises (MSME) sector, NBFCs, micro and housing finance companies and the power sector. Perhaps most significant is the INR 3 trillion credit guarantee on collateral-free loans to the MSME sector up to 20% of their outstanding credit. While details are forthcoming, the credit guarantees indicate the government’s willingness to absorb credit risks of the vulnerable MSMEs and will likely facilitate the transmission of monetary policy. An additional agriculture, farm and migrant labor package of INR 4.5 trillion includes concessional credit for farmers, support for fisheries and animal husbandry, funding for street vendors and other micro loans. While liquidity injection from the measures are substantial, the net impact on the center’s deficit is likely to be limited to the extent of explicit provisions for credit guarantees.

The INR 20.9 trillion package also includes the Reserve Bank's interest rate cuts and liquidity boosting measures of INR 8.1 trillion (4.0% of GDP), as well as several regulatory and structural reform measures. The government has relaxed tax filing dates and allowed tax deferrals, extended completion dates for real estate projects, instituted a one year suspension in IBC proceedings, as well as the excluding COVID-19 related debt from the definition of default for IBC proceedings. Structural reforms include the introduction of commercial mining in coal, increasing the FDI limits in defense from 49% to 74%, and agricultural reforms. The proposed amendments to the Essential Commodities Act, enabling the deregulation of food items and marketing reforms to remove inter-state restrictions, are significant steps towards increasing productivity and raising farm incomes. On the whole, the structural reforms outlined by government are likely to address long standing bottlenecks if implemented efficiently. However, the positive impact of these reforms would help medium-term but not immediate growth issues.

While the direct fiscal support of these measures on the budget is limited to 1% of GDP, the center’s deficit could see a significant overshoot to over 6.5% of GDP from 3.5% budgeted. This is primarily due to (1) tax buoyancy being impacted by lower growth and (2) lower non-tax revenues arising from lower-than-expected receipts coming from divestments and telecom spectrum auctions which more than offset the higher excise taxes on petroleum products and cuts in government dearness allowances. The deficit at the general government level will likely be substantially larger. In addition to the slippage at the central government level, revenue losses at the state government level coupled with additional stimulus measures could result in the general government deficit at double-digit levels. Taking into account financial liabilities of entities owned or controlled by the central government, the overall public sector borrowing requirement could be closer to 12-13% of GDP. All these factors contribute to a low score in the “Fiscal Policy and Management” building block.

India’s Public Debt Ratio is High and Will Rise, But Debt Dynamics are Sustainable

India’s fiscal consolidation efforts have focused on bringing down the deficit of the central government, but state deficits have remained high. This coupled with the government’s role in many sectors of the economy through public sector enterprises, have kept overall public borrowing elevated. Consequently, despite India’s favorable growth and interest rate dynamics, high public sector borrowing requirements have resulted in India’s public debt to GDP ratio remaining high and averaging 69% over the past decade. Latest data indicates that India’s general government public-debt to GDP ratio rose to 71.9% in 2019 while the interest bill stands at around 5% of GDP, both of which are high in comparison with other major emerging market economies.

Weaker near-term growth amid mounting fiscal pressures are likely push the debt ratio higher to close to 80% of GDP in FY21.The trajectory on public debt in the coming years will depend on the pace of economic recovery and fiscal consolidation. Given India’s medium term growth prospects and low real rates, DBRS Morningstar sees limited risks to debt sustainability.

In addition to favorable growth and interest rate dynamics, India’s public debt profile is characterized by its long maturity structure (10.5 years), fixed interest rates, and marginal external debt (4% of GDP), most of which is on concessionary terms from multilateral and bilateral lenders. Moreover, the statutory liquidity requirement at 18% creates a captive domestic market for debt. At the same time, limits on foreign portfolio investments in government bonds are being increased incrementally (currently at 6% and 2% of outstanding stock of securities at the central and state government level), and thereby expanding the pool of funds for government securities and diversifying the investor base. These factors reduce the sensitivity of the debt stock to liquidity, interest rate, and exchange rate risks. The potential inclusion of Indian bonds in the global bond indices would further diversify the investor base. A weighting of 1.5%-3% in the global indices could generate flows to the tune of USD 60 billion equivalent to India’s gross borrowing requirement in FY20.

RBI Takes Several Proactive Steps to Mitigate the Impact, But Financial Vulnerabilities Remain

While India’s overall financial system is relatively healthy, stresses in the financial sector have affected monetary policy transmission. These stresses have only worsened following the COVID-19 outbreak, resulting in banks’ surplus liquidity rising to INR 8.1 trillion as of May 14, 2020. This could potentially change following the recently announced credit guarantees which indicate the government’s willingness to absorb credit risks of the vulnerable sectors.

During the last few years, the Reserve Bank of India (RBI) has strengthened its regulatory and supervisory framework and introduced stricter guidelines on asset quality review (AQR) for banks. Capital injections from the government have resulted in the capital adequacy ratio improving to 15.1% as of September 2019. The front-loaded recapitalization and consolidation among public sector banks with the plan to merge 10 public sector banks into four, bodes well for the overall health of the system. However, non-performing assets (NPA) remain a key concern. The revision in AQR guidelines resulted in non-performing assets rising from 4.6% of gross advances in March 2015 to a high of 11.5% of gross advances in March 2018. While the resolution and recovery of assets under the reformed Insolvency and Bankruptcy Code helped lower the banking system’s gross NPA ratio to 9.3% of advances in September 2019, the deterioration in asset quality has resulted in many public sector banks reducing lending operations.

Non-Bank Financial Companies (NBFCs) filled in the gap began providing credit to key retail and wholesale segments in their stead, by borrowing from public sector banks and mutual funds. Unlike banks, NBFCs which now account for over 20% of the financial system have not yet undergone a full-fledged AQR. Gross non-performing loans for NBFCs stand at 6.6% of advances as of September 2019. Following the default by a large NBFC in September 2018, there is fear that NPAs could be higher than reported as NBFCs have more exposure to stressed sectors such as real estate and construction than banks. Non-banking financial companies are now borrowing at elevated credit costs and shrinking their balance sheets. There remains extreme risk aversion in the credit market resulting in elevated credit spreads.

Following the COVID-19 outbreak, the Reserve Bank of India has taken several steps to support the economy and maintain liquidity in the financial system to avoid solvency issues. These include a reduction in policy rates (the repo rate to 4.4%; reverse-repo to 3.75%); liquidity injection of over INR 3 trillion through a 100bps cut in the cash reserve ratio (CRR); and targeted long term repo operations (TLTRO) via banks for corporate bonds and NBFC’s. RBI also created a special liquidity window of INR 500 billion for mutual funds to provide a backstop against redemption pressures; and a special refinance facility of INR 150 billion for the Small Industries Development Bank to provide liquidity support to the MSME sector through banks, NBFCs, and microfinance institutions.

While these measures are positive, the liquidity injection has added to the already large surplus that existed, taking the surplus in the system to INR 8.1 trillion. Moreover, even as rates at the short end have eased, yields at the long end remain relatively high and credit spreads in the corporate bond market continue to widen. Banks remain hesitant to lend to small and mid-size NBFCs due to asset quality concerns, even as these firms have greater need for credit. Credit growth slowed to 6.7% in May 2020, down from 13% one year ago. While the recently announced credit guarantees indicate the government’s willingness to absorb credit risks of the vulnerable sectors, the overall stresses in the financial system contribute to a negative qualitative adjustment in the “Monetary Policy and Financial Stability” building block.

India’s External Position Has Improved

Dynamics in India’s balance of payments have improved significantly since the taper-tantrum episode in 2013. The current account deficit narrowed from 4.8% of GDP in FY13 to 1.1% in FY20 and is likely to remain low in FY21. The improvement in the current account deficit is largely due to a policy-induced fall in gold imports and low oil prices. Gradual liberalization of the capital account has added to the pool of savings available for domestic investment and, in the case of FDI, facilitated technology spillovers. Although the capital account is not fully convertible, most portfolio and FDI is unrestricted, while external borrowing limits and foreign investor participation in the domestic bond market are being incrementally raised.

The government’s strategy on FDI flows has improved the quality of the capital account, with FDI inflows now covering most of the current account deficit. The smaller current account deficit, combined with buoyant capital inflows, have boosted international reserves. External solvency and liquidity indicators have marginally improved and remain at moderate levels. India’s net international investment position has remained stable at -15.7% of GDP in FY20. While gross external debt has risen to USD543 billion (23.7% of GDP), short term debt remains under 5% of GDP. Moreover, India’s comfortable reserve level currently at USD 475 billion and exchange rate flexibility provide buffers in the event of global market volatility.

Institutional Strength A Positive, But Some Recent Developments A Concern

Given India’s strong democratic and legal institutions, India compares favorably to other lower-middle income countries in World Bank’s Governance Indicators both in terms of Voice and Accountability as well as Rule of Law. India has also made strides on improving the governance framework and the business environment, which are reflected in India’s ‘Ease of Doing Business’ World Bank ranking rising from 142 in 2014 to 63 in 2019 (79 rank improvement in six years).

The BJP government led by Narendra Modi passed several major reforms in its first term commencing May 2014. These include the Goods and Services tax, the Insolvency and Bankruptcy Code, and the transition to market-based prices for fuel. The government also launched the Jan Dhan–Aadhar–Mobile (JAM) trinity which links bank accounts, Aadhar IDs and mobile numbers aimed at financial inclusion. The government has also successfully reduced the corporate tax rate from 30% to 22%% (15% for new companies), a move that puts India closer to the OECD average. Following the 2019 elections, the BJP expanded their majority of seats from 182 to 301 providing policy continuity and stability to India and returning PM Narendra Modi to a second term in office. Recent policy announcements such as the introduction of commercial mining in coal, increasing the FDI limits in defense, proposed overhaul of the public sector policies and agricultural reforms are likely to address long standing bottlenecks if implemented efficiently. However, other proposals such as the National Register of Citizens and the Citizenship Amendment Act have seen some social unrest and opposition.

ESG CONSIDERATIONS
Climate and Weather Risks (E), Human Capital & Human Rights (S), Bribery, Corruption & Political Risks (G), Institutional Strength, Governance & Transparency (G), and Peace & Security (G) were among key drivers behind this rating action. Similar to other developing economies and many of its regional peers, per capita GDP is low, at USD 2k (USD 9k on a PPP basis). According to World Bank Governance Indicators, India ranks in the 49th percentile for Control of Corruption, the 60th percentile for Voice & Accountability, the 55th percentile for Rule of Law, the 64th percentile for Government Effectiveness and 15th percentile on Political Stability and the Absence of Violence/Terrorism. Additionally, Climate and Weather Risks (E) are a consideration as 55% of India’s population are dependent on agriculture and are subject to the vagaries of the monsoons as less than 60% of the land under cultivation is irrigated. These considerations have been taken into account within the following Building Blocks: Fiscal Management and Policy, Economic Structure and Performance, and Political Environment.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/361293/.

Notes:
All figures are in USD unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments, September 17, 2019.
See: https://www.dbrsmorningstar.com/research/350410/global-methodology-for-rating-sovereign-governments.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The primary sources of information used for this rating include Ministry of Finance, Reserve Bank of India, Central Statistical Organization, Ministry of Health and Family Welfare, UIDAI, NREGA, PMJDY, IMF, BIS, and Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating was not initiated at the request of the rated entity.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

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