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Crunch time looms for India’s IG rating

S&P's Kim Eng Tan and Abhishek Dangra discuss the challenges facing India's next government as the election continues.

Why is India's election crucial for its sovereign creditworthiness?
The outcome of India's general election can provide an insight into the political stability of the new government, as well as its ability and willingness to implement reforms that could augment sovereign credit fundamentals.

We believe a decisive mandate can create an enabling environment for speedier resolution of policy bottlenecks and reforms, and improve private sector investments. This can lay the foundation for India's return to a stronger and healthier GDP growth of above 6% in the medium term. It could also improve structural fiscal stability. Conversely, a fragile government could further delay critical reforms as decision-making gets hampered, curbing revival in the investment cycle and derailing growth. In this scenario, India’s fiscal metrics could deteriorate from already weak levels.

How have India’s sovereign credit metrics performed in the past few years?
India's sovereign credit metrics have weakened over the past few years. This is reflected by Standard & Poor's negative outlook on India’s 'BBB-' long-term sovereign rating since April 2012. During this time, the government has made limited policy responses to fight slowing economic growth. After posting average growth of 8.2% between fiscal years 2004-2012, India's real GDP growth dipped to 5% in the fiscal year ended March 2013, and is likely to have fallen further in fiscal 2014.

Capital spending appears to be the weakest component of recent GDP growth, with possible negative implications for future growth. The central government's fiscal flexibility has diminished due to inadequate measures to counter rising commodity prices, in our view. What’s more, government spending on subsidies has increased sharply since the mid-2000s, squeezing government spending on infrastructure, which could help boost the economic growth.

The negative outlook on the long-term sovereign rating on India indicates that we may lower the rating to speculative grade in the next year or so if the next government does not appear capable of reversing India's low economic growth. Conversely, the outlook could revert to stable if we believe that the agenda can restore some of India's lost growth potential, consolidate its fiscal accounts, and permit the conduct of an effective monetary policy.

Is there any visibility of the policy orientation of the next government?
The winners of the election and the composition of the next national government remain unclear. Hence, there is still little visibility on whether the next government will enact policies that may reverse the deterioration in credit metrics. The policy orientation is likely to be determined by not just the winning party, but also the shape of the next ruling coalition government. We believe that the current political landscape in India suggests that no single party could win an outright majority. An important factor is how fragmented the government will be. The more parties involved in the next coalition government, the more likely policies will be incoherent and less supportive of credit attributes.

How can the next Indian government begin to tackle the issues related to its sovereign creditworthiness?
The next Indian government faces various issues in strengthening its sovereign creditworthiness. First is whether the policy environment can improve sufficiently to sustain investor confidence and ease funding costs to promote investment. In our view, policy uncertainty has been a reason for the weak investment trends of recent years. It also appeared to have sparked capital outflows, which tightened financing conditions and further crimped investments. Government measures that suggest a more consistent and business-friendly policy environment are likely to lift investor confidence and spur an investment recovery.

The second key issue is to reduce the vulnerability of India’s finances to shocks such as commodity price increases. The Indian government is likely to be able to boost its fiscal stability only with more policy reforms. Continued commitment to reducing fuel subsidies is one. Reforms to simplify the tax system, perhaps including the introduction of a goods and services tax, could also help stabilize tax revenue. In addition, India's food subsidy program currently poses a threat to fiscal stability. Making the program a more targeted one could reduce the strain on the budget.

Finally, whether the next government can return the economy growth to a sustained level of above 6% is another key issue. The Indian government can address key infrastructural bottlenecks in the economy if it can revitalize investment spending. Regulatory changes to encourage private sector participation in infrastructure projects and promote competition in domestic sectors could also lift growth potential.

How would the credit profiles of Indian corporates be affected by possible reform policies?
We believe government actions supporting higher economic growth, reforms in key sectors, and lower leverage are crucial to improve the credit profiles of Indian corporates. The investment climate for corporates can improve only with greater policy clarity and better overall growth prospects. Improving the framework for land acquisition, environmental clearances, and the tariff-setting mechanism can help corporates and the economy in general.

At the same time, more specific and directed policy actions in key sectors like infrastructure, power, metals and mining, and petroleum (oil and gas) can have a high impact on companies in these industries. The cost of inaction could be significant as some companies in these sectors are already facing stress because of a deteriorating economic and policy environment over the past few years. These sectors together account for over 50% of outstanding gross bank loans to industries.

What are the key challenges facing Indian banks?
Indian banks face three key challenges ahead of the election outcome: (1) asset quality problems; (2) sizable capital needs, especially for public sector banks; and (3) the system's high financing costs. We believe the new government and its policy choices can play a crucial role in directly addressing these issues.

Given that loans to the corporate account for a large part of gross bank credit, policy reforms in key corporate sectors could affect the banking sector's asset quality. In addition, policy actions could have a greater impact on some sectors that have a higher degree of corporate debt restructuring, and loans to many of these sectors have grown rapidly in the past five years. However, in the next 12 months, we expect the asset quality of Indian banks to remain weak, because it will take some time for policy measures to bring about an improvement in stressed loans.

Indian public sector banks need sizable capital to support growth and meet Basel III requirements, which were effective from April 2013, and will gradually increase till 2019. Public sector banks' reliance on capital infusion from the government is likely to remain very high. The new government will have to increase the allocation for capital infusions to enable banks to maintain healthy balance sheets, given deteriorating asset quality, and also to support growth. However, it will be essential for the new government to balance this with medium-term fiscal consolidation, given India's sizable fiscal deficit.

The authors of this article are Standard & Poor’s credit analysts: Kim Eng Tan, senior director of sovereign ratings, and Abhishek Dangra, director of corporate ratings.

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