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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.
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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
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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
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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.
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India: time for an upgrade?
28 April 2017
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