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India: time for an upgrade? 28 April 2017 Economics India: time for an upgrade? DBS Group Research 28 April 2017 • India currently ranks at the lowest rung of the investment grade • Two of the three global rating agencies maintain a ‘Stable’ outlook, one is ‘Positive’ • Recent macro improvements, political stability and on-track reforms are seen as key strengths • Concerns over fiscal deficits, stressed banks and low per-capita GDP have, however, emerged as limiting factors • These constraints are unlikely to materially improve over the next 12 months, hurting the likelihood of a rating upgrade. An outlook change, however, is possible India’s financial markets are on a roll this year, with the rupee and equity markets amongst the best performers in the region. Improving fundamentals and political stability have attracted foreign investment inflows. This positive backdrop has spurred calls for a rating upgrade. Optimistic tone but eyes constraints The economy currently stands at the lowest rung of the investment grade ladder. S&P (Standard & Poor’s) raised the outlook to ‘Stable’ from ‘Negative’ in September 2014. Fitch Ratings is at ‘Stable’ while Moody’s raised its outlook to ‘Positive’ in April 2015. In recent comments, rating agencies have highlighted stable politics, strong growth, sound external balances, reforms and credible monetary policy as key strengths. Initial scepticism on demonetisation was addressed by strong OctDec16 growth and improving monetary conditions. These observations have not translated into affirmative rating action. High general government fiscal deficit, stressed banks’ balance sheets and low percapita GDP have been cited as lingering constraints. We assess these factors here and compare India with economies with the next higher rating (henceforth referred to as a control group). This is based on S&P’s classification [1]. Consolidated deficit remains high India’s general government (centre and state) fiscal deficit is higher than most of its rating peers (Chart 1). The diverging moves in the centre (narrowing) and states (widening) fiscal deficits have kept the deficit elevated at 6.5-7.0% of GDP in recent years. With states facing higher spending commitments and easing revenue growth, fiscal consolidation will take a backseat this year [2]. A high fiscal deficit has kept the general government debt-to-GDP high. It has eased from 75% of GDP in 2009 to 66% in 2014, but has backed up to 68% (Chart 2). State borrowings are expected to rise this year, underpinning the ratio. By contrast, the control group’s debt-to-GDP ratio stands at 40%. Radhika Rao • (65) 6878-5282 • [email protected] Refer to important disclosures at the end of this report. 1 India: time for an upgrade? 28 April 2017 Chart 2: General government debt levels Chart 1: General government fiscal deficits % of GDP (reverse scale) % of GDP 90 -10 85 -9 -8 80 -7 75 -6 -5 Control group -4 70 India -3 65 -2 60 -1 55 2018f 2017e 2016 2015 2014 2013 2012 2011 2010 0 Source: S&P, DBS; IN - fiscal years 50 04 06 08 10 12 14 16 Source: BIS credit statistics, DBS The ‘quality’ of consolidation is also under scrutiny as 20% India’s fiscal revenues are directed towards interest expenses compared to a moderate 9% in the control group. India’s expenditure-to-GDP ratio is nearly on par, but revenues trail at 21% of GDP vs 26% in the control group. The quantity and quality of fiscal consolidation is under scrutiny There are signs that the government will commit to further consolidation as a new fiscal framework is being considered. However, any relief over the next year or so is unlikely, limiting the scope of an upgrade. The Fiscal Responsibility and Budget Mechanism (FRBM) committee proposes lowering the debt-to-GDP ratio from the present 68% to 60% of GDP by 2022. This would be an improvement on current trends, though, at 60%, the ratio would still be higher than most peers. Hence, barring a faster-than-proposed consolidation, the fiscal position will remain a tough hurdle to leap. Improvement in per-capita GDP to be slow Rating agencies have often cited India’s low per-capita GDP as an issue. In response, India’s Finance Ministry made a strong case in the recent Economic Survey that basing any rating action on per-capita GDP trends is not ideal as it was a slow moving variable. We concur. It has taken the economy more than a decade to double per-capita GDP to USD 1730 by 2016 (Chart 3). If we assume nominal per-capita GDP growth of 7.6% (twenty-year average), it will take another decade to reach near $4000. Plus the gap vis-a-vis the peer group will only have narrowed marginally in this timeframe. Instead of using an absolute per-capita GDP measure, we believe the inflation-adjusted real GDP per-capita growth rate is a better gauge of underlying trends. Chart 3: Per-capita GDP - India vs 2cts in control group USD 9000 8000 Philippines 7000 India 6000 Colombia 5000 4000 3000 2000 1000 0 95 97 99 01 03 05 07 09 11 13 15 2 India: time for an upgrade? 28 April 2017 Chart 4: Non-performing loans Chart 5: Investment growth trails % of total advances % of GDP 40 Malaysia 36 China Control group 32 Indonesia 28 Thailand 15Y avg 24 India Investment 0 2 4 6 8 Source: Latest avail; doesnt include restructured; IMF, DBS 10 20 00 03 06 09 12 15 At the same time, weight should also be placed on reforms that are underway to raise per-capita GDP growth, including efforts to expand the labour-intensive manufacturing base, attract FDI, lift skill-training / job creation and make the agricultural sector more resilient. Instead of absolute per capita GDP, its growth rate is a better indicator of underlying strength Stressed banks’ books and muted private sector activity are sticking points Gross non-performing advances (NPAs) in public-sector banks rose from 3.0% in 2012 to 9.0% last year. The RBI’s studies point to further deterioration to 10.1% by March 2018. Including restructured advances, the ratio could exceed 13-14% from 12% currently. India’s NPA levels are higher than most peers (Chart 4). Measures are being taken to resolve these stressed assets, with more likely in coming weeks. Establishing a ‘bad bank’ is also under consideration, but would be a challenge to implement given the drain on banks’ capital position. This in turn would pressure the government to step-up capital infusion to ensure Basel III requirements are met. According to press reports, S&P estimates that banks need $45bn by 2019 to meet Basel III requirements, much higher than the planned $11bn. With other options (consolidation, M&A, risks to alternative fund-raising etc) being difficult to implement, the resolution process could stretch over a year or two. Pressure on banks’ balance sheets also reflect ongoing deleveraging. A fifth of the industry sub-sectors are in the banks’ stressed assets category, with base metals and products at over 40%. Capital formation trends remain weak, as seen by a consistent fall in the investment-to-GDP ratio (Chart 5). There are early signs of a pick-up in corporate earnings and pricing power, which should support growth going forward. What lies ahead As discussed above, material improvement in necessary areas is unlikely over the next 12 months, dampening the likelihood of a rating upgrade. A case can nonetheless be made for an upgrade in the rating outlook. Ratings typically gauge the risk of a government’s default on its local or foreign currency obligations, based on a review of factors such as political stability, income and economic structure, growth prospects, monetary flexibility, external liquidity and fiscal balances (UNCTAD, 2008). Here, the economy has made clear progress. This includes: a) healthy external position with sufficient stock of foreign reserves (11x import coverage), narrow current account of less than 2.0% of GDP for three years and moderating 3 India: time for an upgrade? 28 April 2017 short-term external debt (20% of reserves). Net FDI is now sufficient to fund the current account deficit; b) a positive growth outlook supported by improving rural incomes, higher public sector wages, lower borrowing costs and moderate inflation; c) an inflation targeting framework that ensures the RBI and government are on the same page as regards price control; d) political stability enhanced by recent state elections; e) gradual but wide-ranging reforms are underway, including financial inclusion, passage of the bankruptcy law, encouraging FDI and improving the ease of doing business. The rollout of the Goods and Services Tax in July 2017 will be an important test of the government’s ability to overhaul the tax structure. A less disruptive transition and subsequent efficiency gains would add points to India’s favour. Signs of improving tax revenues will be positive for fiscal consolidation efforts. In sum In light of this progress, an upgrade in the rating outlook appears probable over the next 12 months. This would open the door to a potential rating upgrade over the following 18-24 months. The experience of other regional economies during 2000-2010 suggest that ratings were upgraded on the back of strong growth, despite increased fiscal deficits. India could benefit similarly. Notes [1] We refer to Colombia, Panama, Philippines, Uruguay at ‘BBB’ rating (S&P) as the control group [2] DBS Group Research; India – watching state finances; 12Apr17 Sources All data are sourced from CEIC Data, Bloomberg, Indian government agencies, RBI, S&P and press reports. Transformations and forecasts are DBS Group Research. 4 India: time for an upgrade? 28 April 2017 Recent Research Rates: global rates roundup 25 Apr 17 Rates: global rates roundup 2 Feb 17 TW: Trump and Taiwan, revisited 20 Apr 17 TW: shifting into higher gear 27 Jan 17 ID: stronger rupiah a boost 20 Apr 17 SG: time to recalibrate 26 Jan 17 CNH: room to loosen controls 13 Apr 17 EZ: ECB stays defensive 24 Jan 17 IN: watching state finances 12 Apr 17 ID: looking at an S&P upgrade 19 Jan 17 SGD: neutral for a long time to come 7 Apr 17 US: pop goes the headline 18 Jan 17 SGS: FX tailwind at the limit 7 Apr 17 Asia cyclical dashboard 17 Jan 17 IN budget: stability over growth 12 Jan 17 Rates: SGS: US-dependent 10 Jan 17 IN: is oil the next headache? 13 Dec 16 IN: structural tailwinds to add to cyclical upswing 31 Mar 17 KR: is optimism justified? 29 Mar 17 IN: monetary policy on cruise control 27 Mar 17 TH: narrower C/A surplus a plus 21 Mar 17 SG: ensuring fiscal sustainability 20 Mar 17 Qtrly: Economics-Markets-Strategy 2Q17 9 Mar 17 Asia: Trump and the state of US-Asia trade 7 Mar 17 CN: the rise and rise (and rise) of the RMB 24 Feb 17 ID: next move is a rate hike 21 Feb 17 SG budget: building the future economy 21 Feb 17 CN: what to watch for as PBoC tightens 20 Feb 17 SG: upgraded 20 Feb 17 TW: Trump’s policies and Taiwan 15 Feb 17 Qtrly: Economics-Markets-Strategy 1Q17 8 Dec 16 ID: FDI much stronger than it appears 30 Nov 16 EZ: ECB challenged by higher bond yields 16 Nov 16 TW: 7 likely outcomes in 2017 15 Nov 16 Global: revenge of the demographic dividend 14 Nov 16 US: structural interest rate compression 2 Nov 16 FX: mid-quarter update 1 Nov 16 SG: down but not out 1 Nov 16 Rates: global rates roundup 31 Oct 16 TW: diversifying into Southeast Asia 21 Oct 16 CN: cyclical bottom 19 Oct 16 SG: shaping the future 6 Feb 17 3 Feb 17 IN: assessing current account improvement 18 Oct 16 FX: USD strength hits a roadblock IN budget: a balanced approach 2 Feb 17 PHgov bonds: expensive (still) 11 Oct 16 Disclaimer: The information herein is published by DBS Bank Ltd (the “Company”). 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