Higher growth is likely to increase tax revenues and capital inflows. This will reverse some of the weakening that has occurred in India's fiscal and external position in recent years. India's macroeconomic outlook will also improve if, as we expect, the authorities implement policies that ease inflationary pressures and increase infrastructure investment.
Nonetheless, we forecast India's fiscal, inflation and infrastructure metrics to remain weaker than the median for similarly rated peers. While stronger growth in this large and diverse economy will help to counterbalance these credit challenges, they limit further upward momentum in the sovereign rating.
Manufacturing activity will lead GDP recovery
The deceleration in economic expansion since 2011 was largely due to a cooling in manufacturing output, which recovered in the June quarter, reviving GDP growth. We expect manufacturing activity to accelerate over the next two years, supported by positive sentiment and a policy focus on investment. Lower agricultural output due to a weak monsoon and more modest government spending growth as authorities aim to meet budget targets will likely temper the pace of GDP acceleration in the coming months. But growth will still likely remain above 5% this year, and rise further in fiscal 2016.
Tax revenues are likely to improve with growth
Even without policy efforts, the cyclical turnaround in growth will increase the consumption and corporate tax take, and help meet the central government's budget deficit target for the fiscal year ending March 2015 (fiscal 2015) of 4.1% of GDP.
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Higher revenues alone will not boost the sovereign credit profile
A decline in the deficit based on revenue buoyancy alone would be credit neutral at best, as the fiscal position would remain vulnerable to future cyclical downturns and external shocks.
On the other hand, a significant reduction in long-term expenditure commitments, particularly those that are exposed to inflation, global or currency shocks, could lower this vulnerability. At the current time, it is unclear whether the government will reduce such commitments. Public spending has played an important role in supporting growth when private demand has slowed, but this practice has kept the fiscal deficit much higher than those of similarly rated peers.
Portfolio flows will continue to accelerate, boosting foreign reserves
We also expect a recovery in growth to have a positive effect on India's balance of payments and foreign reserves, via renewed investor appetite and capital inflows.
Rising portfolio and debt flows also increase vulnerability to shocks
Rising reserves, in and of themselves, are unlikely to provide uplift to India's credit profile, as long as capital flows are skewed towards increasing portfolio investment and higher external bond and bank borrowing. In such a scenario, India will remain vulnerable to domestic or global shocks that could lead to a cessation or reversal of these flows.
On the other hand, achieving greater competitiveness for manufactured goods - both those destined for export and those competing with imported products for local demand - through lower inflation or infrastructure development would lower India's merchandise trade deficit, benefiting the sovereign credit profile. So too would a more significant rise in foreign direct investment, which would offer efficiency gains and be unlikely to reverse as quickly as debt or portfolio flows.
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