In focus: India- Rating upgrade validates important reforms

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1 In Focus: Occasional Treasury Research Group For private circulation only In focus: India- Rating upgrade validates important reforms Moody s has upgraded India s sovereign credit rating by one notch to Baa2 from Baa3 in recognition of substantial reform measures undertaken. Debt trajectory expected to be sustainable over time. Moody s Investors Service raised the Government of India's local and foreign currency issuer ratings to Baa2 from Baa3 and changed the outlook on the rating to stable. This is the first sovereign rating upgrade for India since The rating agency cited continued progress in economic and institutional reforms as the factor underlying the upgrade. This takes cognizance of several structural shifts that have happened in the economy. The reforms have been two pronged and have addressed the objective of harnessing India s long term growth potential in a holistic manner. The parallel implementation of economic and institutional reforms have instilled confidence in long term growth and public debt trajectory. So much so, that the agency has also remarked that India s growth potential over the longer term is higher than its rating cohort. They have taken cognizance of this robust potential and our economic resilience in the form of various levers such as adequate forex reserves and higher financialisation of private savings. This development is very heartening and is well deserved. November 17, 2017 Kamalika Das Recognition of recent reform endeavours Economic reforms Moody's believes that the reforms implemented to date by the NDA government will advance the objective of improving the business climate, enhancing productivity, stimulating foreign and domestic investment, and ultimately fostering strong and sustainable growth. The reforms are also expected to complement the existing shockabsorbance capacity provided by India's strong growth potential and improving global competitiveness. The reforms cited by Moody s include Goods and Services Tax (which will promote productivity by removing barriers to interstate trade) Demonetisation Unique Identity (Aadhaar) biometric system, and Targeted delivery of benefits through the Direct Benefit Transfer (DBT) system All the above are intended to achieve an overall formalisation of the economy. Other important measures such as planned land and labour market reforms, which rely to a great extent on cooperation with and between the States, would be a huge positive when they come to fruition. Sumedha DasGupta Strong institutional reforms applauded sumedha.dasgupta@icicibank.com For a long term self-reinforcing virtuous growth trajectory, it is not enough to only act on economic reforms. This needs to be effectively complemented with stronger institutions which are independent of individual or group influences. Recent reforms have ensured that greater policy credibility has now emerged for both fiscal and monetary policy. Renuka Khadke renuka.khadke@icicibank.com Illustratively, the recently enacted Fiscal Responsibility and Budget Management (FRBM) Act and the formalisation of a Monetary Policy Committee to target inflation will enhance transparency in fiscal and monetary policy actions hereon. Please see important disclaimer at the end of this report Significant importance given to country s debt trajectory Moody s acknowledged that continued progress on economic and institutional reforms would enhance India s large and stable financing base for government debt, and will likely contribute to a gradual decline in the general government debt burden over the medium term. In the meantime, while India's high debt burden remains a constraint on the country's credit profile, Moody's believes that the reforms put in place have reduced the risk of a sharp increase in debt, even in potential downside scenarios. This acknowledgement of the debt trajectory of India being sustainable is a key reason for the rating upgrade, since it has been a severe constraint on the credit rating till date.

2 In affirming India s credit rating at the lower Baa3 category in November 2016, Moody s had sounded cautious on the efficacy of the reforms introduced by the Modi government. The agency had said that although economic and institutional reforms introduced since the positive outlook was assigned would enable India's growth to outperform its peers over the medium term, the reform effort to date had not yet achieved the conditions that would support an upgrade to Baa2. The particular emphasis was on the fact that these reforms had not yet engendered any acceleration in private investment to support high, stable growth, without which the government's debt burden -- a key constraint on the rating -- would probably remain high for a sustained period. General government debt for India stood at ~68% of GDP in FY2017, which was significantly higher than the Baa median of 44%. However, the impact of the high debt load was already mitigated somewhat by the large pool of private savings available to finance government debt. In addition, measures which increase the degree of formality in the economy, broaden the tax base (as with the GST), and promote rational and efficiently targeted expenditure (as with the DBT system), will support the gradual improvement in India's fiscal metrics over time. Moody's expects India's debt-to-gdp ratio to rise to 69% in FY2018, as nominal GDP growth has slowed following demonetization and the implementation of GST. However, recent reforms imply that the high level of public indebtedness (which is India's principal credit weakness) will remain stable, and will ultimately decline. An oft used indicator in judging public debt sustainability trajectory is the interest rategrowth differential. The more negative this indicator, the better it is for the country s long term debt sustainability prospects. While this may have deteriorated over the past fiscal on account of temporary reform related shocks to the system, however, over the long run, we remain very well placed to move to a significantly higher growth path which will further cement our debt trajectory, even if in absolute terms it should seem high now (refer to Annexure III for details). On the banking sector front, the formalisation of the Insolvency and Bankruptcy Code and the recent announcement of bank recapitalisation plan will act as catalysts for speedier resolution of banking sector stress. This was an important consideration and has been highlighted by Moody s in its rating rationale. Impact on corporates The move is also good for capital flows into the country as a large part of international capital allocations are rating linked. This is also a huge positive for Indian corporates, since their credit risk premium will now be lower and enable them to access cheaper credit overseas. This will also augment their earnings potential and incentivize them to undertake fresh investment. Further, as a clear boost to confidence and sentiment has been shown by international agencies it is now possible that new investment players such as global pension funds would find it attractive to invest in a politically stable, low risk democracy like India. Further challenges need to be addressed expeditiously The rating agency has also recognized that there persist certain inherent challenges in the system which need to be addressed over time. These include the teething problems with the implementation of the GST, ongoing weakness of private sector investment, slow progress with resolution of banking sector asset quality issues, and lack of progress with land and labour reforms at the national level However, Moody's expects that over time at least some of these issues will be addressed, resulting in a steady further improvement in India's institutional framework. Risks to the rating include a material deterioration in fiscal metrics and the outlook for general government fiscal consolidation. The rating could also face downward pressure if the health of the banking system deteriorated significantly or external vulnerability increased sharply. 2

3 In conclusion, these will cumulatively help propel our country to a stable, sustainable and higher growth trajectory in the coming years and instil confidence in all stakeholders including foreign investors. Moody's expects real GDP growth to moderate to 6.7% YoY in FY2018, and improve to 7.5% YoY in FY2019 as disruption fades, assisted by recent government measures to support SMEs and exporters with GST compliance. We expect growth to play out in a similar manner, picking up sharply in FY2019. For the current fiscal, we believe that it may be difficult for the Government to adhere to the budgeted fiscal deficit target of 3.2% of GDP, with some minor slippage possible. However, the Government s intended glide path for fiscal consolidation is unlikely to be sacrificed under any circumstance, and hence we believe that the fiscal deficit next year will be lower supported by better revenues and improved growth prospects. 3

4 APPENDIX I. Peer comparison with earlier and current peer countries Earlier peers of India (Baa3 category) Earlier peers (Baa3) Country Outlook Hungary Indonesia Positive Kazakhastan Romania South Africa Negative Source: Moody s Investor Service Current peers of India (Baa2 category) Current peers (Baa2) Country Outlook Bulgaria Colombia Italy Negative Oman Negative Panama Positive Phillippines Spain Uruguay II. Non-resident holding of general government debt for peer countries Country Bulgaria Nonresident Holding of General Government Debt, 2017 (percent of total) N/A Colombia 30.9 India 5.7 Italy 32.0 Oman Panama III. Debt sustainability metric N/A N/A Philippines 28.1 Spain 45.3 Uruguay 38.4 Source: IMF Fiscal Monitor The hypothesis is that while moderate debt levels are acceptable, high debt levels can lead to a situation where the dynamics of the debt accretion path become unsustainable and the debt to GDP ratio may not converge to a finite level. Hence, our analytical framework allows us to identify a debt limit up to, which the historical fiscal track record allows the country to converge to a stable debt path. The difference between this threshold and the current debt is defined as fiscal space. (Jonathan D. Ostry, Atish R. Ghosh, Jun I. Kim, Mahvash S. Qureshi, September 1, 2010, IMF Staff position note, Fiscal Space- Moody s, Mark Xandi, Xu Cheng, Tu Packard, December 2011). The underlying model for the primary balance reaction function is defined as follows: Primary deficit as % of GDP= constant+ debt to GDP ratio (-1) + {debt to GDP ratio (-1)} 2 +{debt to GDP ratio(-1)} 3 +output gap + expenditure gap +dependant population ratio. 4

5 Primary balance, (r-g) A B C Debt to GDP ratio The above schematic is described by the equation below: dd t/d t = (r t g t)*d t - PB t D: Debt as % of GDP, r: nominal interest rate; g: nominal GDP growth rate, PB: Primary balance as % of GDP For point A the system is in stable equilibrium, which implies that the debt trajectory does not explode. Point C on the other hand signifies the threshold level beyond which the path would explode. Carrying the analysis forward, we also make indicative calculations about the survival rate [1] of the economy, which will give a sense about the level of yields beyond which, given a certain level of GDP growth, the debt path is unsustainable. This interest rate directly corresponds to the level of debt, which is the first threshold beyond which the path may potentially become unsustainable (Point B). IV. Other Indian entities upgraded to Baa2 from Baa3 by Moody s Bharat Petroleum Corporation Limited (BPCL) Hindustan Petroleum Corporation Ltd. (HPCL) Indian Oil Corporation Ltd (IOCL) Petronet LNG Limited (PLL) Export-Import Bank of India (EXIM India) HDFC Bank Limited (HDFC Bank) Indian Railway Finance Corporation Limited (IRFC) State Bank of India (SBI) [1] Survival rate is the highest nominal long-term sovereign interest rate a country can survive without getting trapped in a vicious debt cycle 5

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