High Fiscal Deficits, Weak Infrastructure Constrain India's Credit Profile

Moody's Investors Service says that India's Baa3 government bond rating reflects the sovereign credit support derived from a large and diverse economy, high domestic savings, and adequate foreign exchange reserves as well as the challenges posed by large fiscal deficits, recurrent inflation and weak infrastructure.


The report notes that while India's GDP growth remains above the median for similarly rated countries, it has slowed from an annual average of 8.5% between 2003 and 2010 to 4.8% in Q3 2013. Moreover, India's investment climate and competitiveness indicators are weaker than those of similarly rated countries. Although there have been policy efforts to induce investment in the last year, their impact may not be evident in the near term.


Moody's expects a slow economic recovery in the second half of 2014, if global growth increases while domestic inflation and interest rates decline. The outcome of national elections next year could affect growth, depending on how it impacts sentiment and policies.


Noting that rupee depreciation in 2013 has increased inflation and the government's fuel subsidy costs, the report also points out that depreciation has not materially raised the government's debt service burden because a very small portion of government debt is owed in foreign currency.


Moody's expects India's fiscal deficit to remain higher than peers as the country's low per capita incomes limit the government's income tax revenue base, while raising spending pressures. However, despite high fiscal deficits, India's government debt to GDP and interest to revenue ratios are lower than a decade ago due to the country's high nominal growth and its high savings rate, which has provided favorable financing conditions for government debt.


The rating outlook is stable, reflecting Moody's view that the currency, maturity and real interest rate structure of government debt supports the sovereign credit profile during a period of slower growth, high inflation, currency volatility and political uncertainty, and that the level of foreign exchange reserves is an adequate buffer against balance of payments pressures.


Downward pressure on the rating could develop if: the medium term growth and fiscal outlook weakens further; or there is a material decline in foreign exchange reserve coverage of external debt and imports, or state-owned banks' asset quality deteriorates such that bank recapitalization costs rise well above current estimates; or high inflation persists, damaging the fiscal, growth and balance of payments outlook.


On the other hand, upward pressure on the rating would develop if fiscal metrics and competitiveness indicators improved to levels comparable to Baa3 peers.


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