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Business Confidence Has Taken A Hit Is Economic Policy At A Turning Point? Recent Economic Developments Point To Slowing Growth Will India's Economic Policy Take A Few Steps Backward? Perceptions Of Poor Governance Could Undermine Economic Reform Populist Solutions May Be Tempting Political Roadblocks Have Delayed Economic Reforms Divided Leadership At The Center May Be The Biggest Hurdle The Government's Response To Possible Scenarios Will Influence India's Credit Quality The Country Is Better Positioned To Weather Setbacks Than In The Past Global Perceptions Of India Are Changing
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India's GDP growth fell to an estimated 5.3% year-over-year in the first quarter of calendar 2012, from 6.1% in the previous quarter. The biggest contributors to growth in the last fiscal year were sectors such as real estate and financial and government services, with manufacturing, infrastructure, and agriculture showing lower growth. The Indian rupee has declined about 20% against the U.S. dollar over the past year. In our view, setbacks or reversals in India's path toward a more liberal economy could hurt its long-term growth prospects and, thus, its credit quality. How India's government reacts to potentially slower growth and greater vulnerability to economic shocks may determine, in large part, whether the country can maintain its investment-grade rating, or become the first "fallen angel" among the BRIC nations (which include Brazil, Russia, India, and China).
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slowdown (in 2008). However, a perceived slowdown in government decision-making, failure to implement announced reforms, and growing bottlenecks in key sectors (including lack of reforms to archaic land acquisition laws that hinder investment) has undermined business confidence. And infrastructure problems, combined with growing shortfalls in the production of coal and other fuels, have dampened investment prospects. For example, various regulatory and other obstacles have delayed a proposed $12 billion investment in the steel sector by Korean steelmaker POSCO--potentially the biggest foreign investment project in Indian history--by more than seven years. Other steel projects have also faced extensive delays because of land acquisition hurdles and other issues. Recent setbacks in economic policy have also hurt investor sentiment. Strong opposition from within the Congress party-led ruling coalition, as well as from opposition parties, recently forced the government to reverse its decision to raise the cap on foreign direct investment (FDI) in multibrand retail to 49% of total ownership from 26%. Similarly, pressure from a coalition ally of the governing Congress party caused the government to roll back a 10% hike in passenger train fares and forced the Railway Minister to quit. (Passenger fares have been flat for many years despite substantial growth in personal income and high inflation.) In addition, recent announcements by the government on taxation matters, such as the retrospective implementation of taxation on the offshore transaction of assets in India, have raised concerns among foreign portfolio and direct investors. (The Finance Minister later clarified his statements and announced that some of the measures against tax avoidance would not take effect until the next fiscal year, starting in April 2013.) Such incidents have raised the perception of risk among both foreign and domestic investors and could reduce India's growth prospects in the coming years.
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sovereign rating. Recent Rating Activity On April 25, 2012, Standard & Poor's affirmed its 'BBB-' long-term sovereign credit rating on the Republic of India but revised the outlook on the rating to negative from stable. The outlook revision reflected at least a one-in-three chance of a downgrade in the next two years if India's external position continues to deteriorate, its GDP growth prospects diminish, or if progress on fiscal reforms remains slow. Among the four 'BRIC' countries, India currently has the lowest credit rating and is the only one with a negative outlook. Russia and Brazil have 'BBB' long-term foreign currency ratings and China has an 'AA-' rating, and all three have stable outlooks. China was the first BRIC sovereign to receive an investment-grade rating from Standard & Poor's (when we assigned our initial rating in February 1992), followed by Russia (in January 2005), India (in January 2007), and Brazil (in April 2008), due to upgrades. The pace of economic growth is decelerating in all the BRIC countries this year. Given their large domestic markets, these countries are better able to sustain growth through domestic demand than other smaller, open economies that are more dependent on global growth. Nevertheless, sluggish growth in the U.S. and economic problems in Europe will slow economic growth in the BRIC countries for at least the remainder of 2012.
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Chart 1
GDP is expected to grow about 6.5% in fiscal year 2012-2013, similar to the rate in fiscal 2011-2012. Both savings and investment rates (as a share of GDP) rose impressively, in step with GDP growth, until fiscal 2007-2008, before declining modestly in subsequent years (see chart 2). The public sector savings rate has historically been low, but it rose to 5% of GDP in fiscal 2007-2008 as the government narrowed its fiscal deficit, before dropping precipitously in recent years. The combination of fiscal strain and lower corporate profitability could reduce both public and private sector savings rates in coming years. Lower savings would translate into lower investment and a higher current account deficit. The result would be either lower GDP growth or a higher external deficit that makes the country more vulnerable to external shocks.
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Chart 2
Relatively low or negative real interest rates for much of the recent past, along with high nominal GDP growth, have helped the government to contain its debt burden (see charts 3). However, the central government will have trouble reaching its fiscal deficit target of 5.1% of GDP for the current year, in our view. The government may find it hard to meet its goal of capping explicit budget subsidies at 2% of GDP, given strong political opposition to raising administered prices of fuels and fertilizers. An increase in administered prices, which artificially contain inflation, might contain subsidy spending. However, it would complicate the central bank's already difficult balancing act of containing inflation while avoiding a sharp slowdown in GDP growth due to tighter monetary policy. Inflation peaked at 12.4% in 2009 (as measured by the wholesale price index) and remained high at 9% in 2011. We expect inflation to dip slightly this year. India's general government deficit (which includes both the central and state governments) could hover around 8% of GDP in fiscal 2012-2013, close to an estimated 8.5% the previous year. General government debt is likely to remain above 70% of GDP in the coming year, based on Standard & Poor's method for calculating the debt burden. Interest payments will likely consume about 25% of general government revenues.
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Chart 3
Rapid economic growth, along with domestic capital markets that largely fund the government's debt, have helped to contain India's fiscal vulnerabilities despite large fiscal deficits. However, a potential structural slowdown in GDP growth would dampen government revenues, boosting the fiscal deficit and possibly reversing a recent improvement in the general government debt burden. India's external profile has worsened modestly in recent times. Its foreign currency reserves cover around six months of current account payments--down from eight months in 2008 and 2009. The current account deficit widened to an estimated 3.7% of GDP in fiscal 2011-2012 from 2.6% the previous year and may remain close to 4% of GDP this year. India's gross external financing needs are projected to rise to 92% of current account receipts, plus international reserves, in the current fiscal year--up from 88% last year. These recent developments are not serious enough, in our view, to lower the sovereign's creditworthiness. However, as the negative outlook indicates, we would consider lowering the credit rating if the government's policy response to these challenges, and potentially other unexpected shocks, is too little or too late. Under such a negative scenario, there is an added risk that the government may further regulate the economy to reduce rising short-term threats to stability.
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India has also followed a calibrated opening of the capital account, starting with direct investment and portfolio equity flows and cautiously loosening access to external debt flows. The strategy has helped to avoid vulnerabilities that can arise from a sudden full opening of both the current and capital accounts, reducing the risk of rapid capital inflows and sudden stops. Recently, however, the fiscal deficit has been growing again, and domestic interest rates have increased, while both investment and GDP growth have decelerated. The government has recently raised some of the caps on external borrowing by the private sector to ease access to funding and encourage more investment, and it has upped the caps on foreign purchases of local currency sovereign debt as well. The country's external debt remains manageable, and foreign exchange reserves are high (more than $250 billion), which contains the short-term risk of greater foreign debt inflows. However, a sudden external shock could cause external liquidity to drop. This could prompt the government to impose more controls on both capital and current account transactions to contain the immediate risk and potential damage.
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attitudes toward future economic policies. The gap between provisions of private goods (such as consumer durables) and public goods (such as roads, basic education, and sewage systems) has grown: For example, only 50% of the population has access to a latrine facility, but 63% have a telephone connection and 47% own a television, according to the 2011 census. Indian parents, both rich and poor, have been shifting their children out of government-run schools in search of better education in private schools. This trend, which started in urban areas, has now grown in the countryside as well.
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The Congress Party-led coalition government was reelected in 2009 with a majority in the lower house after parting ways with its former allies in the Communist party. The reelection, along with the presence of a prime minister with impeccable reformist credentials, raised expectations for rapid economic reform. In fact, the current government has been unable to advance economic reform for various reasons, including internal strife, uncooperative coalition allies, and an obstructionist opposition. Much media commentary about India has focused on the opposition to reform from small parties that are aligned with the Congress. Coalition partners have sometimes blocked reformist policies promoted by the Congress party's government leadership. However, this is, in our view, a partial explanation for the failure of the government to advance with economic reform, as it overlooks internal divisions within the Congress itself. This explanation also downplays the Congress party's inability to convince either the BJP (Indian People's Party) or other smaller opposition parties to support its reform legislation; the previous BJP-led coalition government managed to gain the consent of enough opposition parties to implement economic reforms during 1998-2004. Much of the unfinished reform agenda (such as introducing a national goods and services tax, raising caps on FDI in insurance and multibrand retail, pension reform, and privatization) was originally introduced by the BJP when it was in power. Hence, many analysts in India cast blame on the BJP for abandoning its own economic policies and opposing economic reforms of the current government for partisan reasons only.
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The unusual division of roles and political power inside the central government has likely contributed to poor discipline and cohesion within the Cabinet and government as a whole. For example, a senior Cabinet minister of Singh's own political party publicly criticized the government's recent decision to raise administered fuel prices. Singh was arguably more effective in his term as finance minister in the Congress minority government under Prime Minister Narasimha Rao, which liberalized the economy in the early 1990s, than he has been as prime minister since 2004. The difference is likely due to Rao's political support for Singh when he proposed dramatic steps to open the economy. Singh appears to lack that level of support from his own party today.
The Government's Response To Possible Scenarios Will Influence India's Credit Quality
The political context (and not lack of willingness among key economic policymakers in the central government and the central bank) may limit the government's ability to act decisively and quickly to manage an eroding economic environment and possible external shocks. Under one possible scenario, the government could take modest steps to contain the growth in spending in fiscal 2012-13, especially on subsidies. GDP growth could remain close to official projections (exceeding 7%), perhaps sustained by the central bank's recent interest rate cuts. The government could make modest progress in reducing its structural fiscal deficit and with pushing through some reforms and administrative measures that encourage investment and reverse the recent drop in confidence in the private sector (both local and external). Moderating oil prices could reduce the current account deficit and stabilize the recent erosion in India's external position. We would likely maintain the sovereign credit rating at its current level under such a scenario. Under a more pessimistic scenario, political problems could prevent the government from containing the growth in current spending, and lower-than-projected GDP growth could result in revenue shortfalls. Politically inspired spending programs could further widen the fiscal deficit. Lack of progress in alleviating bottlenecks in key sectors of the economy could lower both domestic and foreign investment levels. Fiscal slippage, combined with persistently high inflation, could further weaken investor confidence. Both the government's debt burden and fiscal flexibility could continue to erode, in step with rising external vulnerability because of higher trade and current account deficits. India's credit quality would suffer under such a scenario, and a downgrade could result.
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In addition, the recent years of unprecedented prosperity have created a growing middle class, a stronger private sector, and rising aspirations among the general population. The growing political clout of those political constituencies that stand to benefit from more economic reform augurs well for the direction of long-term economic policy. India's next national elections will take place by May 2014. From a political angle, the time-frame for significant economic reform is likely to be limited to the rest of 2012 and at best early 2013, before the election campaign takes priority. The central government is likely to advance during that period with introducing a new direct tax code and take steps toward gaining consensus for the proposed goods and services tax (GST) among the states. The last central government budget eased the path toward the GST by expanding the tax net to include a wider array of services. The government is scheduled to set up the technical platform later this year for administering and collecting the GST. The tax might not go into effect before the next national elections, but it is likely to happen eventually, given the heavy commitments the leading political parties and state governments of all political stripes have made. The government took steps recently to loosen rules for portfolio investment in the Indian market, indicating its desire to sustain external inflows. It may take similar modest steps to encourage FDI as well, helping sustain external funding.
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