Will ratings on India withstand triple whammy: S&P

MUMBAI: India's credit profile has worsened in the past twelve months but Standar & Poor���s believe the upside and downside risks to its 'BBB-' rating are currently balanced. This assumes, however, that the reasons for credit deterioration are temporary.

If we conclude that they are longer lasting, the ratings on India could be lowered again to speculative grade. S&P has raised its sovereign credit ratings on India to 'BBB-/Stable/A-3' from 'BB+/Positive/B' on January 30, 2007.

Fiscal Deficit Under Pressure

One of the main, and unexpected, sources of concern for the Congress-Party-led United Progressive Alliance government is the hike in global oil and food prices. S&P originally estimated the consolidated general government deficit (including state government deficits, oil and fertilizer subsidies, and other off-balance-sheet expenses) at 6.5% of GDP in fiscal 2008 (ending March 31, 2009). With the impact of additional expenditure measures such as farmer debt relief, higher oil and fertilizer prices, and the partial implementation of Sixth Pay Commission salary increases, S&P now estimates the deficit could exceed 9% of GDP.

Similar to Indonesia and Malaysia, India's fiscal position has been hurt by the growing gap between administered domestic fuel prices and rapidly rising global oil prices. Despite its June 2008 decision to increase the retail price of fuel by about 10%, the government will also partially finance state-owned oil-marketing companies' losses by issuing Rs 946 billion (1.8% of GDP) in oil bonds in fiscal 2008-2009. This is 8.4 times the Rs 113 billion in bond issuance for fiscal 2007-2008.

There is a similar system for financing fertilizer producers' losses. The government announced a 10%-27% reduction in the prices of complex fertilizers on June 18, 2008, and the government subsidy to fertilizer producers could reach Rs 950 billion (1.8% of GDP) by the end of fiscal 2008-2009. As Rs 310 billion is already budgeted, the net additional cost would be INR640 billion (1.2% of GDP).

Some of the government's political decisions will also increase its fiscal burden. In March 2008, the finance minister announced a plan to relieve farmers of Rs 717 billion in bank and credit union debt (1.4% of GDP, of which 0.5% of GDP is expected for fiscal 2008-2009). Funding details for this project have not yet been announced nor has any comment been made on whether possible moral hazard created by this relief would impact on currently solvent debtors' willingness to service their debt.

The Sixth Pay Commission's recommendations to increase by 40% the basic salary and pension (including the family pension) for government workers will also have a significant impact on government spending. It's the government's call if, when, and to what extent the recommendations are implemented: The Fifth Pay Commission's 1994 recommendations were only implemented in 1997. Given the political cycle, however, the government is expected to implement at least some of the new recommendations in fiscal 2008-2009. The central government's 2.9 million employees stand to cost an additional Rs 230 billion (0.4% of GDP) or higher for fiscal 2008-2009, depending on the extent and timing of the wage and pension increases. Full implementation (which is unlikely) would cost Rs 1.26 trillion (2.4% of GDP). The state governments, which employ 7.2 million people, are expected to follow suite and increase their expenditure by 1.5%-3.0% of GDP.

If the Sixth Pay Commission's recommendations are partially implemented as described above, and S&P assumes most of those additional expenditures are financed by government borrowing, there is a risk that the general government fiscal deficit could reach 9.0%-11.0% of GDP in 2008-2009.

Factors Affecting India's Fiscal Deficit And Level Of Impact On Expenditure

N.A.--Not available. N/A--Not applicable. INR--Indian rupees *Sixth Pay Commission's recommendation, assuming lower end of implementation (ie. central government only). ��Farmers' debt relief, assuming one third of total plan will be implemented in fiscal 2008-2009. ��Of total cost, INR310 billion is the budgeted subsidy. **Nominal GDP is INR53,037.7 billion (government���s projection for fiscal 2008-2009).

In the short term the rating will depend on the government's ability to manage the fiscal challenges that threaten to undermine recent public-finance gains. Continued strong GDP growth should provide buoyant tax revenues this year, partly covering additional spending pressures. Higher inflation might lead to nominal GDP increasing more than the government has projected, which will in turn lead to lower fiscal-deficit-to-GDP ratios than those calculated in the table above. The government is also making an effort to control expenditure: It has issued a circular to all ministries detailing relevant measures and curtailing additional outlays to those already budgeted.

However, there is a risk that the expected increase in government spending will greatly outweigh any potential revenue gains, leading to a higher fiscal deficit compared with budgeted numbers. A sharp increase in the budget deficit is likely to be protracted in the medium term and threatens to reverse the recent trend of a declining general government debt (as measured by debt to GDP). This would result in weaker creditworthiness.

S&P acknowledges the dilemma faced by the government. If it addresses the immediate pressure on its fiscal position by increasing administrated fuel and food prices this may prompt civil discontent. Higher food prices, in particular, would have a disproportionate impact on the poor. Civil discontent could weaken public support for prudent fiscal policy and derail fiscal consolidation in the medium term.

The leftist parties also withdrew their support from the UPA on July 10, 2008, which could complicate the early implementation of fiscal-discipline measures. The withdrawal was prompted by the UPA's move toward a nuclear treaty with the U.S., despite leftist opposition. The UPA's chances of winning parliament's vote of trust, which is expected later this month, have increased with the support of the Samajwadi Party, although there is still a possibility that the government will fall. If the government survives, on the other hand, there is the prospect of a better relationship with U.S. through the ratification of the nuclear treaty, which could benefit India's economy in the medium to long term. The government's weak position in parliament, however, continues to constrain its capacity to maintain fiscal prudence in the lead-up to the general elections. If the government falls, a caretaker government will hold a general election within six months.

Credit Trends

Medium-term prospects for structural reform are also mixed. The next general elections are due by May 2009. The UPA government, which is in a minority position in parliament, has been unable to vigorously advance its reform agenda because of strong opposition from leftist-party allies. These proposals range from pension reform to the privatization of various entities and the liberalization of labor laws, but the momentum of economic reform has slowed considerably in recent years despite rapid GDP growth. If further steps toward strong growth are not taken, however, the economy is likely to decelerate--especially if high inflation leads to higher real interest rates and weakening investment demand and consumer borrowing. While the two largest political parties (Congress and the Bharatiya Janata Party) share a broadly similar approach to economic policies, the strength of the next government's electoral mandate and the composition of the coalition will be important factors in determining the government's ability to implement economic reforms and thus maintain high growth.

The current government has presented budgets that appear to respect India's Fiscal Responsibility and Budget Management Law (FRBM). This law seeks to eliminate the central government's revenue deficit (that is, excess of current expenditures over current revenues) and to reduce the overall fiscal deficit. Recent events, however, have undermined the credibility of the FRBM. The government has resorted to greater quasi-fiscal off-budget spending--such as issuing bonds to cover losses in oil companies and fertilizer companies--and thus effectively loosening fiscal policy while still adhering formally to the FRBM's targets. The resulting loss of a meaningful framework for long-term fiscal policy may prove costly for India, potentially undoing the fiscal gains that contributed to India's rise to an investment grade rating in January 2007.

Inflation A Key Challenge

Inflation is now the Reserve Bank of India's (RBI) biggest challenge. The Wholesale Price Index (WPI) recorded higher than 11% growth year-on-year in early June for the first time in 13 years. The recent rise in inflation reflects both supply shocks (such as higher prices for food and energy) and the underlying inflationary pressures associated with a fast-growing economy. While the government's recent decision to increase the domestic price of fuel is welcome from a fiscal perspective, it was only a partial measure since price controls still disguise the true extent of inflationary pressure on the economy. There is a possibility that the RBI will further increase its policy rates despite having increased the repo rate by 50 basis points (bps) to 8.50% on June 24, 2008, less than two weeks after it had increased it by 25 bps to 8.00%. Simultaneously, the RBI increased the cash reserve rate to 8.75% on June 24.

There is a possibility that the WPI rate might come down after the harvest later in the year. However, even if the monsoon is favorable there is a risk that inflation levels will remain high due to base effects. Higher inflation has already started to push up bond yields. If inflation expectations result in investors demanding higher premiums for fixed-income securities, investment and consumption could suffer. As the public sector is the largest borrower in the domestic bond market, the government's cost of funding would also increase, which would also hurt its fiscal balance.

Current account deficit may continue increasing in the medium term India's current account deficit is likely to reach $35 billion (2.5% of GDP) in calendar 2008--higher than $25 billion (or 2.2% of GDP) in 2007--due mainly to higher oil prices and still-strong demand for external goods and services.

There is a possibility that the upward trend will persist over the medium term. For a low-income country with strong growth prospects, it is natural that it receives savings from the rest of the world. However, if investment doesn't improve the nation's productive capacity and ultimately increase its export sector, India's current account deficit would detract from its creditworthiness. India is currently operating from a position of external strength having built up $303 billion in foreign currency reserves as of May 9, 2008, which is equivalent to more than 10 months of current account payments. The country will remain in a net external creditor position in 2008. As such, the widening current account deficit for this year and next is unlikely, in itself, to pose a threat to India's sovereign credit ratings.

Conclusion

We are seeing increasing risks to India's 'BBB-' rating from rising fiscal deficits (from already high levels by international standards), rising inflation, and, to a lesser extent, widening current account deficits. These risks, however, are still mitigated by India's deep domestic markets, which allow it to finance large fiscal deficits without recourse to external funds, and by its strong external liquidity. The coming weeks and months will be critical as national elections approach. Political compulsions may make it difficult for the government to take timely measures to staunch fiscal or monetary slippages. Failure to respond adequately to negative developments as they arise in this pre-election period could point to a sustained deterioration in macroeconomic stability and thus increase the probability that the government's ratings could be lowered to speculative grade.