Rationale
The ratings on India reflect the country's sound external profile and improved monetary credibility. India's strong democratic institutions and a free press, which promote policy stability and predictability, also underpin the ratings. These strengths are balanced against vulnerabilities stemming from the country's low per capita income and weak public finances.
India's governing parties have made progress in building consensus on a passage of laws to address long-standing impediments to the country's growth. These include comprehensive tax reforms through the likely introduction in the first half of 2017 of a goods and services tax to replace complex and distortive indirect taxes. Other measures include strengthening the business climate (such as through simplifying regulations and improving contract enforcement and trade), boosting labor market flexibility, and reforming the energy sector.
We believe these measures, supported by India's well-entrenched democracy, will promote greater economic flexibility and help redress public finances over time.
India's external position remains a credit strength. The country has a floating exchange rate and limited reliance on external savings to fund its growth. While India experiences modest volatility in its terms of trade, we expect it to record a moderate current account deficit of 1.4% in 2016 (2.1% in 2015), and to average similar levels through 2018. Our forecasts are partly informed by our view of enhanced monetary policy credibility. In addition, we expect India to fund this deficit mostly with inflows without adding to debt.
We forecast that India's external debt net of public and financial sector external assets will average only 5% of current account receipts over 2016-2018 (our forecasts reflect the adoption of the sixth edition of the IMF's Balance of Payments and International Investment Position Manual). Although we expect some decline in India's external liquidity metrics in the next three years as its banks increasingly turn to external financing, we project that India's gross external financing needs will remain below its current account receipts plus usable reserves through 2018.
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The Reserve Bank of India's foreign reserves reached US$369 billion as of September 2016 (or four-and-a-half months of current account payments, US$352 billion, in September 2015). The authorities also maintain contingent financing facilities of US$68 billion through bilateral swaps and contingency reserve arrangements.
A rating constraint is India's low GDP per capita, which we estimate at US$1,700 in 2016. That said, India's growth outperforms its peers and is picking up modestly. We expect GDP growth of 7.9% in 2016 (6.6% in per capita GDP) and 8% on average over 2016-2018 (6.7% in per capita GDP). We believe domestic supply-side factors will increasingly bind economic performance, and the government has little ability to undertake countercyclical fiscal policy given its current debt burden.
This debt load and India's overall weak public finances are additional rating constraints. India has a long history of high general government fiscal deficits (averaging 8.8% of GDP over the past 20 years and 7% in the past five years). The deficits have not closed India's sizable shortfalls in basic services and infrastructure. The country's fiscal challenges reflect both revenue underperformance and constraints on expenditure. India's general government revenue, at an estimated 21% of 2016 GDP, is low among rated sovereigns. Its expenditure constraints are mainly related to subsidies (about 2% of 2016 GDP) for food, energy, and fertilizers. Although we expect the administration to pursue medium-term fiscal consolidation, we foresee that planned revenues may not fully materialize and subsidy cuts may be delayed. In the medium term, we expect improved fiscal performance primarily from revenue-side improvements brought about by the coming introduction of the GST and administrative efforts to expand the tax base.
India's high fiscal deficits have led to the accumulation of sizable general government borrowings (about 69% of GDP, net of liquid assets) and debt servicing costs (over a quarter of general government revenue). We project net general government debt to decline only modestly over our forecast horizon. A high proportion of India's resident banking sector's balance sheet is exposed to the government sector via loans, government securities, or other claims on the government (partly for regulatory requirements, as banks are required to invest 22% of their net demand and time deposits in government securities).
This implies that there may be limited capacity for India's banks to lend more to the government without further crowding out private-sector borrowing. India's government borrowings are mostly denominated in rupees, which mitigates the risks. The small portion of external government debt is mostly sourced from official lenders over long terms and at concessional rates.
These fiscal figures do not include losses of electricity distribution companies. Although we expect their operations to improve with lower oil prices, they will remain exposed to India's terms of trade. Hence, overall, we believe public finances are set to remain key rating constraints for some time.
India has a divided banking sector. Its private sector banks (about one-quarter of banking system assets) have better profitability, higher internal capital generation, and capitalization with lower-stressed assets than government-owned banks. We estimate public-sector banks need capital infusion of about US$45 billion (2% of GDP) by 2019, given their weaker profitability, to meet Basel III capital norms. The government has committed US$11 billion (0.5% of GDP) to support public-sector banks. The government may have to increase the allocation if the banks are not able to secure capital from alternative sources, such as equity markets, additional tier-1 bonds, and insurance companies. We include this assessment in our assumptions of the sovereign's fiscal balances. Our Bank Industry Credit Risk Assessment for India is '5' (with '1' being the highest assessment and '10' being the lowest).
Combining our view of India's government-related entities and its financial system, we view the country's contingent fiscal risks as limited.
The Reserve Bank of India (RBI) has made progress in lowering CPI inflation following the introduction in February 2015 of its medium-term inflation target band (with 4% CPI inflation 2% as the principal nominal anchor for monetary policy). We expect the RBI to achieve the inflation target of 5% by March 2017 as it advances along a glide path to the medium-term inflation target. Further steps to strengthen policy formulation are being taken through the introduction of a monetary policy committee, improved communication, and efforts to strengthen monetary policy transmission (such as through new guidelines requiring banks to determine their lending rates using marginal cost of funds).
We believe these RBI measures will support its ability to sustain economic growth while attenuating economic or financial shocks. We see some risks that strong inflows to the financial sector combined with higher inflation in India vis-vis its trading partners could pressure the real and nominal effective exchange rates, which in turn could hurt competitiveness, if not matched by strong productivity growth.
Outlook
The stable outlook balances India's sound external position and inclusive policymaking tradition against the vulnerabilities stemming from its low per capita income and weak public finances. The outlook indicates that we do not expect to change our rating on India this year or next, based on our current set of forecasts.
Upward pressure on the ratings could build if the government's reforms markedly improve its general government fiscal outturns and, with them, the level of net general government debt so that it falls below 60% of GDP.
Downward pressure on the ratings could reemerge if growth disappoints (perhaps as a result of stalling reforms); if, contrary to our expectations, the new monetary council is not effective in achieving its targets; or if the external liquidity position of the nation deteriorates more than we currently expect.
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