Indian Credit Downgrade

India Gets Downgrade Warning

S&P Cuts Outlook to Negative as New Delhi Wrestles With Political Gridlock and Economic Hurdles

WSJ,

25 April, 2012

The clouds gathering over India's economy darkened on Wednesday when Standard & Poor's cut its outlook on India's long-term debt to negative and warned of a possible credit downgrade, a surprise move that challenges the nation's image as a surging economic force.

Indian workers unload goods from a Pakistani truck this month, as the neighbors and rivals seek to improve relations by easing trade.

The shift steps up pressure on New Delhi to cut spending and take steps to attract more foreign investment at a time when the ruling coalition is struggling with a downshift in economic growth—and faces political opposition to any efforts to push through overhauls before the next national elections in 2014.

S&P highlighted what it said was political gridlock that will prevent the Congress party-led government of Prime Minister Manmohan Singh from carrying out reforms to rein in its fiscal deficit. The party, hobbled by scandals and infighting in its coalition, has been unable to push through changes that would attract fresh investment, increase productivity and curtail spending on welfare and subsidies.

S&P maintained India's credit rating at triple-B-minus, the lowest investment-grade rating, but said there was a one-in-three chance that it could be downgraded to "junk" status over the next two years "if the external position continues to deteriorate, growth prospects diminish, or progress on fiscal reforms remains slow in a weakened political setting."

Moody's and Fitch, the other major ratings firms, have also assigned India their lowest investment-grade ratings, but have not joined S&P in its negative outlook. Moody's said last week it saw no immediate threat to India's rating.

The shift by S&P is a startling turnabout for a nation that until recently was a darling of foreign investors. As European governments struggled with ratings downgrades that drove up their borrowing costs, India, with its strong growth and young population, has been seen as an attractive destination for investors looking for better returns.

But India's economic growth slowed to 6.9% in the year that ended March 31 after back-to-back years of 8.4% expansion. Last week, the central bank cut a benchmark interest rate for the first time in three years in a bid to stimulate business spending.

India's trade deficit ballooned to $185 billion in the fiscal year, a 56% jump over the previous year, as oil and gold prices shot up. The current-account deficit—the difference between total exports and imports of goods and services—is about 4% of GDP, Indian officials say. That is pressuring the rupee, which fell 18% against the dollar in the past year.

Commerce Secretary Rahul Khullar said in an interview on Wednesday that India faces a huge challenge securing the tens of billions of dollars in foreign capital it needs to finance its current-account gap. He said European banks that have traditionally financed Indian debt could cut back lending amid the Continent's economic woes, raising pressure on India to attract other foreign capital.

"That's the real problem," Mr. Khullar said. "Where is the capital going to come from?"

India has frightened foreign investors with tax proposals that would increase capital-gains liabilities for foreign companies—in some cases with retroactive effects potentially back to 1962.

Net foreign capital investment in India dropped to $387 million in March from $7.2 billion in February after the government unveiled the proposals. So far in April, there has been a net outflow of about $27 million..

India's budget deficit, a concern noted by S&P, touched 5.9% of gross domestic product in the year that ended March 31, wider than the government's 4.6% target. The government spends about $57 billion a year on major subsidies to ensure low prices of fuel, fertilizer and food-grains, an effort to insulate impoverished consumers from rising global commodity costs.

While subsidies and welfare spending have sent India deep into the red, reducing them would be politically costly for the ruling coalition. India has targeted a reduction in the fiscal deficit to 5.1% of GDP this year, ending March 31, 2013.

"Lack of leadership as well as pressures from coalition parties make it difficult to foresee a proactive approach to fiscal-deficit reduction and reforms more broadly," said Seema Desai, India analyst for the risk-advisory firm Eurasia Group.

Finance Minister Pranab Mukherjee said on Wednesday that the government would continue to take steps to "ensure that the fiscal deficit is retained at the projected level, and we should continue to work for higher growth."

While ratings firms have had huge influence on countries' economic prospects in recent years, the shift in S&P's outlook isn't likely to have a significant immediate impact on India's government-bond market, which has relatively little foreign participation, or bring a significant jump in international borrowing costs for Indian firms, analysts say.

A sovereign-credit rating downgrade for India, however, could lead to downgrades for its companies, driving up their borrowing costs and shrinking access to credit.

On Wednesday, the rupee rose against the dollar but lost some gains after the S&P announcement, trading at 52.54, versus 52.68 on Tuesday. The Bombay Stock Exchange's Sensitive Index, India's bellwether, closed 0.33% lower at 17151.29.

S&P's shift on India contrasts with ratings firms' views of several other emerging markets whose credit profiles have improved with better economic fundamentals and a flood of foreign investment. Indonesia gained investment-grade ratings from two of the three big firms in the past six months, for instance, and S&P raised its outlook on the Philippines to positive in December.

Mr. Khullar, the commerce secretary, said he is hopeful India can reduce its trade deficit to $150 billion in the year that began April 1. That depends on global oil prices stabilizing, as India's energy demand shows no sign of letting up. Consumption of refined fuel products rose 4.9% in the last fiscal year, its highest pace in four years, on the back of growth in vehicle sales and demand for diesel-powered generators to cope with power outages, according to data released Wednesday.

Mr. Khullar said India must urgently increase domestic supplies of coal, fertilizer and other items that it is importing in large quantities. Coal imports alone jumped 80% to $17.7 billion in the last financial year, he said.

"If you're going to see growth rates in your imports of that order, the required growth rate for exports is so high that it's simply unattainable," he said.

Gold imports are also pinching India. Gold and silver imports were up 44.4% to $61.5 billion in the year ended March 31. The government has raised the import duty on gold in an effort to dampen demand.

Indians are big buyers of gold jewelry for weddings and other occasions; gold is also seen as a safe investment amid economic uncertainty and inflation, analysts say.

Rajesh Solanki, a jewelry dealer in Mumbai's Zaveri Bazaar—one of the city's bustling jewelry hubs—says sales boomed last year.

"People wouldn't think twice about buying large quantities of jewelry. Everybody was expecting prices to rise and, therefore, it was the best investment. Customers were afraid that they would miss the bus," he said.

About 70% to 80% of the demand was for jewelry and the rest was for bars and coins, he said.