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Economic Research: India's COVID-19 Recovery Will Be Key To The Sovereign Ratings

The COVID-19 crisis has hit the Indian economy hard. S&P Global Ratings has revised the country's real GDP growth forecast for fiscal 2021 (ending March 31, 2021) for the country to negative 5%, versus a pre-outbreak expectation of 6.5%. The health crisis will also challenge important reform work that the government has been implementing to liberalize and energize the national economy. We expect the speed of India's post-crisis recovery to have long-term implications for the sovereign credit rating (BBB-/Stable/A-3).

In our base-case scenario, India's economy will strongly recover following the deep contraction in this fiscal year; we forecast real GDP growth at 8.5% in fiscal 2022. India's wide range of structural trends, including healthy demographics and competitive unit labor costs, work in its favor. Economic reforms, if executed well, would support this outcome. With a recovery of this magnitude, India's 10-year weighted average real GDP per capita growth will likely stay well above the average of its peers.

Nevertheless, risks include a serious local epidemic, enduring financial and corporate distress in India, and long-lasting global economic malaise. Such risk scenarios may involve a comprehensive review of our assumptions of the sovereign. Expectations for a strong rebound may change if this crisis has a more chronically debilitating effect on Indian growth than we now assume.

Our ratings on the Indian sovereign reflect the country's weak fiscal and debt settings. India's fiscal deficit should rise sharply this year as the government spends more to address the pandemic despite weaker revenue generation. Its fiscal position should return to trend once a global recovery takes hold (see "India 'BBB-/A-3' Sovereign Rating Affirmed; Outlook Stable," June 11, 2020).

The government announced an Indian rupee (INR) 20 trillion (US$264.8 billion) stimulus package in May 2020. This is a big number but direct government spending will be less than 1% of GDP. Most of the aid will come in the form of government guarantees, and credit and liquidity support provided by the banking sector and the Reserve Bank of India (RBI).

India's external settings continue to support our rating, owing largely to the country's modest external debt stock. As a large net importer of energy, low oil prices benefit the country's terms of trade, likely leading to a lower current account deficit over the next few years. India's external position should remain stable barring a collapse in exports, a steep decline in the central bank's foreign-exchange reserves, or a sustained rise in the current account deficit.

These factors are unlikely to change dramatically in the next 12 months. However, pandemic-related risks, especially to India's growth trajectory, could exert downward pressure on the rating if the post-pandemic recovery is weaker than we expected.

Immediate Policies Focus On Containment And Mitigation

India's economic reopening will require momentous coordination between the public and private sectors. The country will find it difficult to resume production following an extended period of government-mandated, nationwide lockdown introduced in March 2020. Economic activity will likely only meaningfully improve around the end of calendar 2020.

The beleaguered state of the Indian economy this year poses serious challenges to the government's already stretched fiscal position. The strains also complicate the implementation of reforms that we believe are critical to sustaining strong growth over the long run.

India's economy entered the COVID-19 crisis on a weak footing. Real GDP growth fell to an 11-year low of less than 5% in fiscal 2020, far from the cyclical high of 8.3% achieved in fiscal 2017. Myriad domestic problems have weighed on growth over recent years, including a moribund banking sector, weak investment and consumer sentiment, and labor market fragility.

Fresh reforms may be required to arrest these trends. The government needs such initiatives, including improvements to India's physical infrastructure, to raise the investment potential and competitiveness of the economy. However, the COVID-19 outbreak has challenged authorities' capacity to tackle economic reforms over the coming quarters.

The Crisis Undermines India's Already Weak Fiscal Settings

Exacerbated by lower growth, India's general government fiscal deficit should rise to a multiyear high of 11% of GDP in fiscal 2021. The Indian government's stimulus package announced in May 2020 includes limited direct spending from the central government. The effect will likely be less than 1% of GDP. However, revenue generation this year will be very weak, in our view, and this will account for the bulk of the rise in the overall deficit.

Reforms undertaken by the administration of Prime Minister Narendra Modi over recent years to establish the infrastructure for direct benefit transfers, where the state distributes cash directly to those in need. This allowed the government to deliver stimulus funds to more than 300 million at-risk individuals following the introduction of its first stimulus package in March. This helped avert a much more dire humanitarian crisis.

The government's more recent measures are generally targeted at supporting firms facing acute stress related to the pandemic. These include non-bank financial institutions (NBFIs), power distribution companies (discoms), and micro, small, and midsize entities (MSMEs). The government is aiming to provide credit and liquidity support to these firms to limit structural damage to the economy.

The government provides guarantees on MSME and NBFI credit, a special liquidity scheme for NBFIs, and on an INR900 billion liquidity injection into discoms. These will add to the general government's stock of contingent liabilities. However, we assess the overall fiscal effect as limited, relative to the scale of the government's direct deficit and debt stock.

Chart 1


The key question is just how deeply the health crisis and government containment measures will affect the economy. Fiscal 2021 will likely be the fourth successive year of decelerating economic growth.

The crisis presents a dilemma for policymakers: lock down the country indefinitely, exacerbating poverty, or reopen the economy and risk a higher infection and death toll. In view of the severe economic toll wrought by strict containment measures so far, the government is moving toward reopening the economy to protect jobs and incomes, and prevent more lasting economic damage.

Social Conditions Hinge On Labor Markets

India has experienced some prominent incidents of social unrest over the past two years related to high-profile legislative decisions taken by the government. However, these decisions probably have not materially dented support for the ruling Bharatiya Janata Party.

Lockdown policies and their disproportionate effect on India's huge informal sector pose a more serious political challenge, particularly if labor markets fail to heal quickly.

To contain the virus, the government has had to address the threat of widespread outbreak among workers in the informal economy, who often live and work among dense networks of people. But even if this is achieved, policymakers will find it challenging to swiftly restore both the informal and formal labor markets as India emerges from lockdown. Should unemployment remain elevated for a long time, pockets of social unrest could emerge, dampening India's investment and growth.

Critical Structural Reforms May Be Deferred

The pandemic has challenged the Indian government's capacity to implement initiatives needed for growth. These include measures to alleviate high rates of structural unemployment, financial sector reforms, and a general easing of business regulations and trade barriers.

The Modi administration has over the past few years introduced economy-boosting policies, including cuts to corporate taxes (announced in 2019). But the COVID-19 crisis will challenge the government's capacity to roll out more painful reforms that are more easily digested during periods of economic strength.

Chart 2


Increased flexibility in labor regulations in the formal economy may encourage firms to bring in workers from the much larger informal labor base. This may raise India's productivity while burnishing its credentials as a destination for foreign investment, especially relative to regional peers such as Indonesia, Vietnam, and the Philippines.

The liberalization in recent months of labor market regulations in Uttar Pradesh, Gujarat, and Madhya Pradesh states may help the government's investment case. These developments are aimed at mitigating the huge stress faced by employers and laborers in the face of the aforementioned containment measures. Should these initiatives become more permanent and broad-based, it would be an important step toward a less restrictive, and more competitive labor market framework.

The central government has stepped up its encouragement of a more enduring liberalization of labor market regulations, as well as for the broader adoption of more flexible employment conditions, such as contract work. We anticipate further developments on this front.

The government also wants to improve the country's middling physical infrastructure, but a lack of money has held back progress. These constraints will likely worsen in the aftermath of the pandemic, with a higher fiscal deficit this year pushing the government's debt burden higher still. The crisis has limited the government's capacity to create productive infrastructure, increasing its reliance on the private sector to build via public-private partnerships.

Foreign direct investment will have an important role to play in boosting the productive capacity of India without straining the government's balance sheet. Over the past few years, the government has gradually liberalized foreign participation in the economy, and the state has approved investment into most sectors. More recently, the government has liberalized its capital account by lifting caps on foreign participation in government bond markets.

Telecoms Ruling, RCEP Retreat May Stanch Foreign Investment

Recent developments in the telecoms sector may cause lasting concerns among foreign investors. A February 2020 ruling by the Supreme Court of India confirmed that telecoms--including Vodafone Idea Ltd. and Bharti Airtel Ltd.--must immediately pay overdue levies and interest amounting to about US$13 billion, despite efforts by the government to stagger the payments. As a partially foreign-funded venture, Vodafone Idea may be forced to exit the Indian market entirely in light of its own US$4 billion levy. These developments highlight the financial stresses and regulatory uncertainties facing major telecoms in the country. This may discourage firms across sectors from investing.

The Indian government's pullout from the Regional Comprehensive Economic Partnership (RCEP) negotiations earlier this year may also hamper investor sentiment. Indian officials said RCEP--a proposed free-trade pact primarily involving South and Southeast Asian nations--threatened India's manufacturing and agricultural sectors. Nevertheless, the withdrawal may make Indian goods less competitive in the global market. Additionally, free-trade agreements such as RCEP often act as stepping stones for structural reforms, which are good for growth.

Financial Sector Enters Crisis On A Weak Footing

Prior to the onset of the pandemic, the Indian banking sector was showing signs of improvement. This was particularly true for troubled asset resolution and governance, spurred by introduction of the Insolvency and Bankruptcy Code in 2016. Much of the current weakness in the financial system is due to a legacy of poor practices. The code has forced lenders to fully account for their nonperforming assets, and to take painful steps to repair their balance sheets.

The industry's nonperforming loans ratio moderated in fiscal 2020, and profitability improved. Sector-wide asset quality is still weak compared with that of regional peers. Over the past few years, the government has injected funds into the public banking sector to boost capital and support lending. The injections have added to the government's fiscal deficit and debt stock.

Indian banks still did not enter the crisis from a position of strength. And although they have been on the recovery path for the past 12-18 months, the acute economic downturn will defer the improvement by a year, in our opinion.

In the interim, we expect Indian banks' asset quality to deteriorate, credit costs to rise, and profitability to decline. Should these conditions prevail beyond fiscal 2021, continued risk aversion, particularly from the more selective private sector banks, could stymie credit growth. This would put yet another brake on the economic recovery.

Out Of Crisis, An Opportunity?

The pandemic remains in its early stages, and the scale and duration of the crisis remains highly unpredictable. The same can be said for India's social, health, and economic progress. Should containment measures against the virus prove successful, the government would likely be in a position to consolidate its already solid support, solidifying political and social stability. Likewise, the economy may regain its footing quickly, thus stabilizing investor and consumer sentiment.

Low energy prices, which should persist for some time, will benefit the Indian economy more than most. With the resulting political capital, hard hitting economic reforms could return to the agenda. This would hand the government a fresh opportunity to address the economy's structural weaknesses. Amid the crisis, the government has also shown itself willing to implement broad-based reforms alongside its economic stimulus measures.

New measures include a major reclassification of MSMEs to allow for much broader categorization in the segment, sweeping agricultural market reforms that will allow farmers to sell their produce into more markets across the country, and raising the foreign investment ceiling in the defense sector to 75%.

In tandem with the central government's push toward wider adoption of more flexible labor market standards, and officials' augmented rhetoric on the privatization of non-strategic government-related entities, these developments suggest that the government remains cognizant of the urgency for reforms.

In our view, India's economic outlook remains bright, so long as emerging weaknesses are addressed before growth rates fall much further. The course of India's pandemic will play an important role in determining the strength of its economic recovery.

Recommended Reading

This report does not constitute a rating action.

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Ruchika Malhotra, Singapore (65) 6239-6362;

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