India's Election Is Pivotal For Its Sovereign Creditworthiness

Primary Credit Analysts: KimEng Tan, Singapore (65) 6239-6350; kimeng.tan@standardandpoors.com Takahira Ogawa, Singapore (65) 6239-6342; takahira.ogawa@standardandpoors.com Secondary Contact: Agost Benard, Singapore (65) 6239-6347; agost.benard@standardandpoors.com

Table Of Contents
Policy Inaction Has Contributed To Weakening Credit Metrics Little Clarity On Policy Orientation Of The Next Government Hurdles To Stronger Sovereign Credit Fundamentals

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

APRIL 15, 2014 1

1296227 | 300510290

India's Election Is Pivotal For Its Sovereign Creditworthiness

The current Indian parliamentary elections could have a significant impact on institutional and governance settings in the country over the next few years. The winners of the election and the composition of the next national government remain unclear. However, the new government's policy decisions and their impact on economic growth prospects and fiscal health will have important implications on the government's credit metrics and its sovereign ratings. In our view, India's sovereign credit metrics have weakened over the past few years. Standard & Poor's Ratings Services' negative outlook on its 'BBB-' long-term sovereign rating since April 2012 reflects the weakened credit profile. During this time, the government made limited responses through its policies to fight the slowing economic growth. It achieved some progress, particularly in raising subsidized fuel prices and having greater clarity on monetary policy. However, the impact came late and has not been strong enough to reverse the slide in credit support for the government. Overview India's sovereign credit metrics have weakened over the past few years. Policy changes that improve fiscal stability and growth prospects could stabilize or reverse the slide in credit support. The shape of the next government to be decided in the current elections will determine the likelihood of these policy changes.

The lack of decisive policy action partly reflected the distraction of a number of high-profile corruption allegations against the United Party Alliance government. The defections of a few smaller parties to the opposition ahead of the national elections this year also weakened the government's policymaking capacity. The national elections this year also reduced the government's appetite for new reforms. Perhaps reflecting these developments, a number of governance indicators declined recently (see chart 1).

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

APRIL 15, 2014 2

1296227 | 300510290

India's Election Is Pivotal For Its Sovereign Creditworthiness

Chart 1

Policy Inaction Has Contributed To Weakening Credit Metrics

India's lack of clear and decisive policy direction in recent years is partly responsible for its slipping economic growth and the increasing impact of commodity price fluctuations on its public finances. After an 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 appeared to be the weakest component of recent GDP growth, with possible negative implications for future growth (see chart 2).

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

APRIL 15, 2014 3

1296227 | 300510290

India's Election Is Pivotal For Its Sovereign Creditworthiness

Chart 2

The central government's fiscal flexibility has also diminished due to inadequate measures to counter rising commodity prices, in our view. Government spending on subsidies has increased sharply since the mid-2000s (see chart 3). The steep increase has reversed somewhat with softer crude oil prices in 2013 and allowed increases in domestic fuel retail prices. Nevertheless, the current share of subsidy in total central government spending remains well above that before fiscal 2009. In addition, the current government's move to expand food subsidies in 2013 could have increased subsidy spending further.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

APRIL 15, 2014 4

1296227 | 300510290

India's Election Is Pivotal For Its Sovereign Creditworthiness

Chart 3

The combination of slower growth and rising subsidy burden in India could undermine sovereign rating support further. If slow growth continues, revenue growth could also decelerate. And as developed economies' growth regain traction, both interest rates and commodity prices are likely to rebound. The resulting increases on interest payments (a major government expenditure for the heavily indebted Indian government) and subsidies could further squeeze the country's already-limited budgetary space. India's growth prospects may weaken further if the government reacts to a future budget squeeze by cutting capital expenditure, which is at relatively modest levels for a low-income economy at the current level of growth (see chart 4). The country's infrastructure is already a limiting factor on growth.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

APRIL 15, 2014 5

1296227 | 300510290

India's Election Is Pivotal For Its Sovereign Creditworthiness

Chart 4

Little Clarity On Policy Orientation Of The Next Government

There is still little visibility if the next Indian government will enact policies that could reverse the deterioration in credit metrics. Policy orientation is typically determined by the winning party as well as the shape of the ruling coalition government. In our view, the current political landscape in India suggests that no single party could win an outright majority. Opinion polls have suggested that the Bharatiya Janata Party (BJP) is in the lead during the current election. The Party's manifest suggests that it plans to boost economic prosperity through infrastructure investments and productivity improvements. The incumbent Indian National Congress, meanwhile, intends to increase entitlement and the use of price support mechanism to improve distribution of the national wealth. But a number of factors could potentially create unexpected election outcomes. One is the large number of young voters who are going to the polls for the first time. The Election Commission estimated that the young ones account for more than 20% of eligible voters this year. Their political preferences, to be revealed for the first time in a national election this year, could produce some surprises.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

APRIL 15, 2014 6

1296227 | 300510290

India's Election Is Pivotal For Its Sovereign Creditworthiness

One possible result is a coalition with a relatively weak leading party at its core. The recent prominence of the new Aam Aadmi Party and the popularity of regional parties increase the likelihood of such a coalition. In this scenario, the leading party would be in a weak position to push the policy agenda even if it is in favor of policies that could augment sovereign credit fundamentals. Moreover, policy coherence could suffer if the leading party has to band together a large number of other political parties to form the next government.

Hurdles To Stronger Sovereign Credit Fundamentals

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. Second is whether the government can reduce the vulnerability of its finances to shocks such as commodity price increases. Yet another question is whether it can return the economy to stronger real GDP growth. Policy uncertainty has been a reason for the weak investment trends of recent years, in our view. It also appeared to have sparked capital outflows, which tightened financing conditions and further crimped investments. In our view, government measures that suggest a more consistent and business-friendly policy environment are likely to lift investor confidence and spur an investment recovery. The Indian government is likely to be able to boost its fiscal stability only with more policy reforms. Although its budget deficit for fiscal 2014 declined, it was because of several one-off measures and payment delays. The structural budgetary position remains vulnerable to shocks. Sustained budgetary improvements would require further changes. Continued commitment to reducing fuel subsidies is one. Although the government raised diesel prices toward market prices, it has stopped a further increase in April 2014. 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. Returning economic growth to a sustained level of above 6% is yet another key policy hurdle. 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. India's economic malaise is a complex issue with intertwining factors. Given the uncertainties on its voter demographics, policy direction, and the commitment and strength of the next government toward implementing reforms, strengthening the sovereign credit fundamentals would take a multi-prong approach. And it could be a long road ahead. Meanwhile, the negative outlook on the long-term sovereign rating 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.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

APRIL 15, 2014 7

1296227 | 300510290

India's Election Is Pivotal For Its Sovereign Creditworthiness

Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

APRIL 15, 2014 8

1296227 | 300510290

Copyright 2014 Standard & Poor's Financial Services LLC, a part of McGraw Hill Financial. All rights reserved. No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor's Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an "as is" basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT'S FUNCTIONING WILL BE UNINTERRUPTED, OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages. Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P's opinions, analyses, and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw, or suspend such acknowledgement at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal, or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof. S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain nonpublic information received in connection with each analytical process. S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription) and www.spcapitaliq.com (subscription) and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

APRIL 15, 2014 9

1296227 | 300510290