DBRS, Inc. (DBRS Morningstar) downgraded the Republic of India’s Long-Term Foreign and Local Currency – Issuer Ratings to BBB (low) from BBB. At the same time, DBRS Morningstar downgraded the Republic of India’s Short-Term Foreign and Local Currency – Issuer Ratings to R-2 (middle) from R-2 (high). The trend on all ratings has been changed to Stable from Negative.
KEY RATING CONSIDERATIONS
The downgrade reflects the material deterioration in India’s public finances as a result of the global health and economic crisis. The country arrived to the crisis with a comparatively weaker fiscal position than most of its BBB-rated peers and a slowing economy. Although a recovery is underway, the economic impact of the virus has been severe. The government remains committed to a sound macroeconomic policy framework, but the spread of the novel Coronavirus Disease (COVID-19) compounds India’s existing credit challenges, including structural impediments to faster productivity growth, elevated government debt levels, and asset quality concerns within the financial sector. The downgrade reflects the deterioration in the ‘Debt and Liquidity’, and ‘Economic Structure and Performance’ building block assessments.
India’s BBB (low) rating balances India’s high potential growth rate with public finance challenges and financial system weaknesses. Although the pandemic has had a severe health and economic effect on India, structural factors of the economy, such as relatively high domestic savings and favorable demographics, continue to underpin the country’s high growth potential. Moreover, the economy has demonstrated a high degree of resilience in recent years, due in large part to a well-regulated financial system, a credible inflation-targeting regime, and a flexible exchange rate. However, the impact of the pandemic will add to an already high stock of public debt. The IMF projects that general government debt will increase from 73.9% of GDP in FY20 to 89.3% of GDP in FY21. This is significantly higher than 79.5% of GDP expected during our review last year. Moreover, higher debt is translating into higher interest costs, despite lower rates. DBRS Morningstar expects only a gradual repair to public finances in the coming years.
The trend change to Stable from Negative reflects DBRS Morningstar’s expectation that the policy response will preserve macroeconomic stability and support the economic recovery once the pandemic is contained. While direct fiscal response was limited, the regulatory and monetary policy measures have eased domestic financial conditions as reflected in lower interest rates and compressed spreads across the spectrum. Exchange rate flexibility, a relatively low level of external debt, and high forex reserves have also reduced external vulnerabilities. The implementation of structural reforms announced as part of the COVID-19 relief package and budget also bodes well for India’s medium term growth prospects.
The ratings could be upgraded if the public debt ratio is placed on a firm downward trajectory, or if the execution of policy reforms significantly improves economy-wide productivity growth.
The ratings could be downgraded if the debt-to-GDP ratio continues to materially rise over the medium term. The ratings could also be downgraded if there is a weakening in the country’s macroeconomic policy framework.
Pandemic’s Second Wave Casts a Shadow on The Ongoing Recovery; Policy Execution Key to Medium Term Prospects
India’s tally of COVID-19 cases has increased at an alarming pace in recent days. Newly reported cases have averaged over 300,000 in May, significantly higher than the peak of 87,000 cases in the first wave in September 2020. Given India’s limited health infrastructure, this has had a devasting impact on health outcomes across India. However, the economic impact of the second wave is likely to be less severe. Lockdowns are more localized, households and businesses have learnt to adapt to and work around the virus, and the vaccine program is underway. Thus, once the pandemic is contained and restrictions are eased, pent-up demand and investment-enhancing and growth-supportive reform measures taken by the government will help the upturn. Following a contraction of 8.0% in FY21 (April 2020-March 2021), official estimates (RBI) peg growth at 10.5% in FY22. Private sector estimates, though slightly higher, are seeing a slight moderation following the recent surge of COVID-19 infections. Nonetheless, the outlook remains uncertain as the pace of the economy recovery will depend in large part on the evolution of the virus, when the second wave peaks, and the pace of vaccine distribution.
While the pandemic has had severe near term effects, India’s favorable demographics, relatively high savings, and potential catch-up in technological know-how suggest that India’s medium-term growth prospects remain strong. Over the last few years the government has been tackling some of the structural issues to improve the investment climate. This includes simplifying business regulation, enacting the Insolvency and Bankruptcy Code, easing restrictions on foreign direct investment, introducing the Goods & Services Tax and reducing corporate tax rates. In addition, the Jan Dhan–Aadhar–Mobile (JAM) trinity which links bank accounts, Aadhar IDs and mobile numbers has increased financial inclusion.
Government measures are having a positive effect. In the World Bank’s Ease of Doing Business report, India’s international ranking improved from 142nd in 2014 to 63rd in 2019 among 190 countries. Net foreign direct investment flows have also increased sharply rising to USD 43 billion in FY20 compared to an average of USD 32 billion during FY15- FY19. Measures announced as part of the COVID-19 relief package – mining, FDI, production linked incentive schemes and labor reforms – and recent budgetary announcements regarding privatization, asset monetization, creation of a bad bank are credit positive if implemented efficiently. As a result, India’s growth prospects has a positive impact on the ‘Economic Structure and Performance’ building block assessment.
COVID-19 Compounds India’s Weak Fiscal Position
The global shock brought on by COVID-19 has weighed heavily on key credit metrics. Despite India’s limited direct fiscal support (1% of GDP), India’s central government deficit rose from 4.6% in FY20 to 9.5% in FY21. In addition to the pandemic related spending and the contraction in growth, this was primarily due to (1) greater transparency in the subsidy bill (2% of GDP), as borrowings of Food Corporation of India have been brought on the balance sheet; and (2) lower non-tax revenues arising from lower-than-expected receipts coming from divestments and telecom spectrum auctions.
The budget for the current fiscal year pegs the central government’s deficit at 6.8% of GDP in FY22. Though the headline deficit is expected to narrow, the shift in spending composition towards investment should be supportive of the recovery. The expansionary fiscal stance is reflected in the government's decision to keep expenditures-to-GDP at the pandemic level, and with limited changes to the tax structure, the revenue estimates are based on higher tax buoyancy through improved compliance and higher disinvestment proceeds. Authorities expect a gradual fiscal consolidation of 0.5% each year, reaching 4.5% of GDP in FY26.
India’s low score in the ‘Fiscal Policy and Management’ building block is due to its fiscal space that has historically been limited by its low revenue base and high non-discretionary expenditures. In addition to structural challenges in central government finances, state deficits have been averaging 3% of GDP. As a result, the general government deficit averaged 7.5% of GDP over the last two decades. In the recent past, the government has been taking measures to raise revenues and increase the efficiency of expenditures. Measures to improve the revenue base include the passage of the Goods and Services Tax Bill (GST). This along with progress on rationalization of tax rates, financial inclusion and digitalization, is positive and could increase tax buoyancy. On the expenditure front, while 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, they have been partially offset by spending pressures generated by the Pay Commission on government salaries.
Public Debt Levels Increase Substantially in 2020, But Are Expected to Stabilize in the Near Term
The larger fiscal deficit combined with the contraction in FY21 growth have led to a higher level of government debt across countries. For India, the IMF projects that debt-to-GDP for the general government will increase from 73.9% in FY20 to 89.3% in FY21. This is significantly higher than 80% levels expected during our review last year. Moreover, higher debt is translating into higher interest costs, despite lower rates. While the weighted average cost of borrowing across all maturities has trended down to 6% currently, India’s interest payments as a percentage of GDP at 5.4% is higher than its emerging market peers. The trajectory on public debt in the coming years will depend on the pace of economic recovery and fiscal consolidation. DBRS Morningstar expects only a gradual repair to public finances in the coming years. The IMF in its April WEO expects India’s public debt-to-GDP ratio to gradually fall from its peak last year to 83.8% in FY26.
Nonetheless, despite the deterioration in the credit metrics, given India’s medium term growth prospects and low real rates, DBRS Morningstar sees limited risks to debt sustainability. In addition 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 creates a captive domestic market for debt. At the same time, limits on foreign portfolio investments in government bonds are being increased incrementally, and thereby expanding the pool of funds for government securities and diversifying the investor base. The potential inclusion of Indian bonds in the global bond indices would further diversify the investor base.
RBI’s Proactive Steps Ease Financial Conditions and Support the Recovery in Activity
Following the COVID-19 outbreak, the Reserve Bank of India (RBI) took several conventional and unconventional measures to support the economy and maintain liquidity in the financial system. These measures eased domestic financial conditions, as reflected in lower interest rates and corporate bond spreads compressing across the spectrum. The RBI also facilitated the successful completion of central and state government borrowing programs at record low costs and with longer maturities over the course of FY21. In its latest policy in April 2021, the RBI stated that it would likely retain an accommodative monetary policy stance until the recovery firmly takes hold. While acknowledging that the economic hit from the second wave is likely to be less severe than a year ago, earlier this month the RBI announced targeted measures to help buffer the impact on the retail and small business sectors.
The RBI infused liquidity measures have also eased the stress in the financial sector that affected monetary policy transmission prior to the pandemic. On the assets side, the introduction of stricter guidelines on asset quality review 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. Thanks to the resolution and recovery of assets under the reformed Insolvency and Bankruptcy Code, the corporate assets quality downcycle was coming to an end with NPL’s reducing to 7.5% in September 2020. While banks appear to have made adequate provisions and capital adequacy ratios currently stand at 15.1%, the RBI in its Financial Stability Report warned that as the COVID-related regulatory relief measures are rolled back, there could be balance sheet impairments. Given the uncertainty on the evolution of the pandemic and recovery, we maintain the negative qualitative adjustment in the ‘Monetary Policy and Financial Stability’ building block.
India’s External Position Acts as a Buffer to Changes in Risk Appetite
India’s external accounts have improved significantly since the taper-tantrum episode in 2013. This is reflected in the narrowing of the current account deficit and buoyant capital flows led primarily with FDI consequently resulting in India’s forex reserves doubling to USD 600 billion since 2013. External solvency and liquidity indicators have also marginally improved and remain at moderate levels. India’s net international investment position has remained stable at -13.0% of GDP in FY21 while India’s gross external debt stands at USD 563 billion (21.6% of GDP) and short term debt remains under 5% of GDP. This coupled with exchange rate flexibility provide buffers in the event of global market volatility.
The current account deficit narrowed from 4.8% of GDP in FY13 to 0.8% in FY20. The improvement in the current account deficit is largely due to a policy-induced fall in gold imports and low oil prices. While the sharp fall in demand due to COVID-19 is likely to have led to a small surplus in FY21, this is not sustainable as the economy recovers and oil prices rebound from 2020 lows. Nonetheless, the upturn in the global economy coupled with recent policy measures to encourage domestic production is likely to keep the current account deficit under 1% of GDP over the medium term.
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. 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. 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.
Institutional Strength is a Positive, Second Wave of Virus Could Weaken the Reform Momentum
Given India’s 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. Furthermore, a vibrant press and active civil society support India’s democracy.
Following the May 2019 elections, the Bharatiya Janta Party (BJP) expanded their majority from 282 seats to 301, thereby providing policy continuity and returning Prime Minister Narendra Modi to a second term in office. Policy measures enacted over the last few years on improving the governance framework and the business environment have resulted 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). However, the COVID-19 pandemic has resulted in a devasting health and humanitarian crisis. As per Morning Consult’s estimates, public approval of the government’s performance has fallen from over 80% in August 2019 to 63% in May 2021. While general elections won’t be held in India until 2024, results of India’s recent state elections were disappointing for the BJP party. In DBRS Morningstar’s view, this could potentially result in delays in some of the recently proposed contentious reforms such as privatization as well as addressing the logjam on farm sector legislation.
Resource & Energy Management (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. India’s balance of payments and public finances are vulnerable to oil price shocks as India imports 70% of its crude oil requirements. Agriculture and allied activities account for 18% of the economy and directly and indirectly accounts for close to 60% of employment. However, with 45% of the area under cultivation irrigated, most of the arable land is dependent on the vagaries of the monsoon. Similar to other emerging market economies and many of its regional peers, India’s GDP per capita is low at USD 2.7k (USD 6.5k on a PPP basis), reflecting low levels of productivity. According to World Bank Governance Indicators, India ranks in the 48th percentile for Control of Corruption, the 52nd percentile for Rule of Law, the 58th percentile for Voice & Accountability and in the 60th percentile for Government Effectiveness. While there have been occasional peace talks, border skirmishes along Jammu & Kashmir in the North West and Arunachal Pradesh in the North East with both Pakistan and China have contributed to India’s low (20th percentile) rank for the Political Stability and Absence of Violence/Terrorism indicator. 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 can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/378732.
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
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 https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments (July 27, 2020).Other applicable methodologies include DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3 2021).
Generally, the conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are monitored.
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, World Bank, United Nations’ Gender Inequality Index 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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