Rationale
The ratings on India reflect the country's sound external profile and improved monetary credibility. These factors, combined with strong democratic institutions and a free press, both of which yield policy stability and predictability, underpin the investment-grade rating on India. 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 India's growth. These include strengthening the business climate (such as through simplifying regulations and improving contract enforcement and trade), improving labor market flexibility, and reforming the energy sector. We also observe some progress in comprehensive tax reforms through the likely introduction of a goods and services tax to replace complex and distortive indirect taxes.
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 is a credit strength. This reflects its limited reliance on external savings to fund its growth. While India experiences some volatility in its terms of trade, we expect it to record a modest current account deficit of 1.4% in 2015 and similar levels through 2018. Our forecasts are partly informed by our view of increased monetary credibility, which dampens the demand for monetary gold imports. In addition, we expect India to fund this deficit mostly with nondebt, creating inflows.
We forecast that India's external debt net of public and financial sector external assets will average 22% of current account receipts (CARs) over 2015-2018. 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 less than current account receipts plus useable reserves through 2017.
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We project that usable reserves will stand at US$357 billion (or seven-and-a-half months of current account payments) at year-end 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 2015. India's growth outperforms its peers and is picking up modestly. Following India's early 2015 rebasing of GDP, we expect GDP growth of 7.4% in 2015 (6% in GDP per capita terms) and for it to average just under 8% over 2015-2018 (just under 7% in GDP per capita terms). That said, we believe that domestic supply-side factors will increasingly bind economic performance, and we note that the government has little ability to undertake countercyclical fiscal policy given its current government debt load.
This debt load and India's weak public finances more broadly are another ratings constraint. India has a long history of high general government fiscal deficits (averaging 8.8% of GDP over the past 20 years and 7.4% in the past five years). We note that they have not closed India's sizeable shortfalls in basic services and infrastructure. India's fiscal challenges reflect both revenue underperformance (at an estimated 19.5% of GDP in 2015, India's general government revenues are low among rated sovereigns) and constraints on expenditure (mainly related to subsidies for food, energy, and fertilizers; equivalent to about 2% of GDP in 2015). Although we expect the new administration to pursue its stated fiscal consolidation program, 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 planned introduction of the general sales tax and administrative efforts to expand the tax base.
India's high fiscal deficits have led to the accumulation of sizable general government borrowings and servicing costs (close to 70% of GDP, net of liquid assets, and over a quarter of general government revenues, respectively). We project net general government debt to decline only modesty over our forecast horizon. We note that 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. Somewhat mitigating the risks associated with India's government borrowings is the fact that it is mostly denominated in rupees and 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 state electricity boards. 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. India's private sector banks (about one-quarter of banking system assets) have better profitability, higher internal capital generation and capitalization with lower stressed assets and lower exposure to troubled sectors (mainly infrastructure and iron and steel) than government-owned banks. Given the weaker profitability of public-sector banks, we estimate capital infusion needs at US$35 billion (1.6% of GDP) over 2016-2019 to meet Basel III capital norms. Of this, the government has already committed US$11 billion (0.5% of GDP). 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 (GREs) and its financial system, we view the country's contingent fiscal risks as limited, as defined in our criteria.
In 2015, the Reserve Bank of India (RBI) moved to a formal inflation targeting framework under which the central bank will redirect its attention to the consumer price index, as opposed to its previous focus on the wholesale price index. The government and the RBI have agreed on a 6% target in 2016 (plus or minus 2%) and 4% (with the same band) in subsequent years. In addition, the RBI is reforming is decision-making process for rate setting. Under a proposal that we expect to be adopted by year-end, the RBI will establish a monetary council with seven members (the RBI governor; one executive member of the RBI board nominated by the RBI board; one employee of the RBI nominated by the RBI chairperson; and four persons appointed by the government). We believe that these measures will support the RBI's ability to sustain economic growth while attenuating economic or financial shocks. That said, we see some risk 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 traditions 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 a stalling of 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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