June 8, 2012

Will India Be The First BRIC Fallen

Angel?
Primary Credit Analysts:
Joydeep Mukherji, New York (1) 212-438-7351; joydeep_mukherji@standardandpoors.com
Takahira Ogawa, Singapore (65) 6239-6342; takahira_ogawa@standardandpoors.com

Table Of Contents
Business Confidence Has Taken A Hit
Is Economic Policy At A Turning Point?
Recent Economic Developments Point To Slowing Growth
Will India's Economic Policy Take A Few Steps Backward?
Perceptions Of Poor Governance Could Undermine Economic Reform
Populist Solutions May Be Tempting
Political Roadblocks Have Delayed Economic Reforms
Divided Leadership At The Center May Be The Biggest Hurdle
The Government's Response To Possible Scenarios Will Influence India's
Credit Quality
The Country Is Better Positioned To Weather Setbacks Than In The Past
Global Perceptions Of India Are Changing

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Slowing GDP growth and political roadblocks to economic policymaking could put India at risk of losing its
investment-grade rating. Standard & Poor's Ratings Services revised its outlook on India's 'BBB-' long-term
sovereign credit rating--which is one notch above speculative-grade--to negative from stable in April of this year
because of lower GDP growth prospects and the risk of erosion in its external liquidity and fiscal flexibility. The
negative outlook also reflects the risk that Indian authorities may be unable to react to economic shocks quickly and
decisively enough to maintain its current creditworthiness.

Economic growth has slowed in India in recent months, as it has in much of the world, and the country has suffered
mild erosion in its economic profile, with widening trade and current-account deficits. Its central government's fiscal
deficit exceeded official projections for the year ended March 31, 2012, reaching 5.9% of GDP. In addition,
inflation remains stubbornly high despite the Reserve Bank of India's tightening policies in 2011 (although the
central bank recently reversed its interest rate policies to help sustain GDP growth).

Overview

• The revision of our outlook on India to negative reflects mild erosion in India's external and fiscal profiles and lower GDP growth
prospects.
• A return to recent high growth rates will depend on further fiscal reform and steps to improve the country's investment climate.
• A tougher political setting for economic policymaking raises the risk that Indian authorities may not be able to react to negative
shocks quickly and adequately to avoid a loss of creditworthiness.
• It remains to be seen whether the government would react to potentially lower growth and greater vulnerability to economic
shocks by further liberalizing the economy or, conversely, by rolling back some of its earlier liberalizing policies, which had
expanded the role of market forces and the private sector.

India's GDP growth fell to an estimated 5.3% year-over-year in the first quarter of calendar 2012, from 6.1% in the
previous quarter. The biggest contributors to growth in the last fiscal year were sectors such as real estate and
financial and government services, with manufacturing, infrastructure, and agriculture showing lower growth. The
Indian rupee has declined about 20% against the U.S. dollar over the past year.

In our view, setbacks or reversals in India's path toward a more liberal economy could hurt its long-term growth
prospects and, thus, its credit quality. How India's government reacts to potentially slower growth and greater
vulnerability to economic shocks may determine, in large part, whether the country can maintain its
investment-grade rating, or become the first "fallen angel" among the BRIC nations (which include Brazil, Russia,
India, and China).

Business Confidence Has Taken A Hit

Local business confidence in India has deteriorated for various reasons, including perceptions of "policy paralysis"
within the central government. India was able to boost public and private investment in infrastructure in recent
years, sustaining high GDP growth of around 8%-9% during the three years leading up to the recent global

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slowdown (in 2008). However, a perceived slowdown in government decision-making, failure to implement
announced reforms, and growing bottlenecks in key sectors (including lack of reforms to archaic land acquisition
laws that hinder investment) has undermined business confidence. And infrastructure problems, combined with
growing shortfalls in the production of coal and other fuels, have dampened investment prospects.

For example, various regulatory and other obstacles have delayed a proposed $12 billion investment in the steel
sector by Korean steelmaker POSCO--potentially the biggest foreign investment project in Indian history--by more
than seven years. Other steel projects have also faced extensive delays because of land acquisition hurdles and other
issues.

Recent setbacks in economic policy have also hurt investor sentiment. Strong opposition from within the Congress
party-led ruling coalition, as well as from opposition parties, recently forced the government to reverse its decision
to raise the cap on foreign direct investment (FDI) in multibrand retail to 49% of total ownership from 26%.
Similarly, pressure from a coalition ally of the governing Congress party caused the government to roll back a 10%
hike in passenger train fares and forced the Railway Minister to quit. (Passenger fares have been flat for many years
despite substantial growth in personal income and high inflation.)

In addition, recent announcements by the government on taxation matters, such as the retrospective implementation
of taxation on the offshore transaction of assets in India, have raised concerns among foreign portfolio and direct
investors. (The Finance Minister later clarified his statements and announced that some of the measures against tax
avoidance would not take effect until the next fiscal year, starting in April 2013.) Such incidents have raised the
perception of risk among both foreign and domestic investors and could reduce India's growth prospects in the
coming years.

Is Economic Policy At A Turning Point?

These developments raise larger questions: Are the recent years of rapid economic growth over? India enjoyed GDP
growth averaging 8.7% during 2004-2008 and 7.8% during 2009-2011. Will India return to a lower level of trend
growth over the next three to five years, or can it recover to levels close to its impressive growth rates of recent years
(adjusted for cyclical factors, such as global growth trends)?

Moreover, is there a risk that India will go backwards in its economic policies and undo some of the progress it had
made to liberalize its economy since the early 1990s? The government could react to lower GDP growth and greater
vulnerability to economic shocks by tightening fiscal policy and liberalizing the economy. Or, it could potentially
roll back some of the policies that had opened the economy and created a greater role for market forces and private
investment.

Indian officials have consistently stated that while economic reform may be slow because of the political realities of
a largely poor, diverse, and democratic country, it could only go forward. But is there a risk that economic
liberalization may not just stall, but could even recede?

Such a retreat might be in line with the more interventionist economic policies many developed countries pursued in
response to the recent global economic crisis. However, India's economic conditions differ greatly from those of
developed countries, and its economic performance has been remarkably successful since liberalization began.
Failure to advance with more liberalization might reduce India's long-term growth potential and thus hurt its

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sovereign rating.

Recent Rating Activity

On April 25, 2012, Standard & Poor's affirmed its 'BBB-' long-term sovereign credit rating on the Republic of India but revised the
outlook on the rating to negative from stable. The outlook revision reflected at least a one-in-three chance of a downgrade in the
next two years if India's external position continues to deteriorate, its GDP growth prospects diminish, or if progress on fiscal reforms
remains slow.
Among the four 'BRIC' countries, India currently has the lowest credit rating and is the only one with a negative outlook. Russia and
Brazil have 'BBB' long-term foreign currency ratings and China has an 'AA-' rating, and all three have stable outlooks. China was the
first BRIC sovereign to receive an investment-grade rating from Standard & Poor's (when we assigned our initial rating in February
1992), followed by Russia (in January 2005), India (in January 2007), and Brazil (in April 2008), due to upgrades.
The pace of economic growth is decelerating in all the BRIC countries this year. Given their large domestic markets, these countries
are better able to sustain growth through domestic demand than other smaller, open economies that are more dependent on global
growth. Nevertheless, sluggish growth in the U.S. and economic problems in Europe will slow economic growth in the BRIC countries
for at least the remainder of 2012.

Recent Economic Developments Point To Slowing Growth

Standard & Poor's raised India's long-term sovereign credit rating to 'BBB-' in January 2007, making India the
poorest sovereign (in terms of per capita GDP) to receive an investment-grade rating. One of the key elements
contributing to the upgrade, and sustaining the current rating, was India's ability to achieve comparatively high rates
of economic growth. Favorable long-term growth prospects and a high level of foreign exchange reserves support
the country's sovereign rating, while large fiscal deficits, a high debt burden, and a lower-middle-income economy
constrain it.

India's economy expanded roughly 8%-9% in the three years before the recent global financial crisis (see chart 1).
According to data from India's Planning Commission, rapid growth contributed to a decline in the poverty rate to
29.8% in 2010 from 37.2% in 2005, implying a drop of 40 million people in the absolute number of the country's
poor. Per capita income doubled during those five years. In addition, the total fertility rate (the average number of
children a woman conceives) fell to 2.5 in 2010 from 3.2 in 2000.

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Chart 1

GDP is expected to grow about 6.5% in fiscal year 2012-2013, similar to the rate in fiscal 2011-2012. Both savings
and investment rates (as a share of GDP) rose impressively, in step with GDP growth, until fiscal 2007-2008, before
declining modestly in subsequent years (see chart 2). The public sector savings rate has historically been low, but it
rose to 5% of GDP in fiscal 2007-2008 as the government narrowed its fiscal deficit, before dropping precipitously
in recent years.

The combination of fiscal strain and lower corporate profitability could reduce both public and private sector
savings rates in coming years. Lower savings would translate into lower investment and a higher current account
deficit. The result would be either lower GDP growth or a higher external deficit that makes the country more
vulnerable to external shocks.

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Chart 2

Relatively low or negative real interest rates for much of the recent past, along with high nominal GDP growth, have
helped the government to contain its debt burden (see charts 3). However, the central government will have trouble
reaching its fiscal deficit target of 5.1% of GDP for the current year, in our view. The government may find it hard
to meet its goal of capping explicit budget subsidies at 2% of GDP, given strong political opposition to raising
administered prices of fuels and fertilizers. An increase in administered prices, which artificially contain inflation,
might contain subsidy spending. However, it would complicate the central bank's already difficult balancing act of
containing inflation while avoiding a sharp slowdown in GDP growth due to tighter monetary policy. Inflation
peaked at 12.4% in 2009 (as measured by the wholesale price index) and remained high at 9% in 2011. We expect
inflation to dip slightly this year.

India's general government deficit (which includes both the central and state governments) could hover around 8%
of GDP in fiscal 2012-2013, close to an estimated 8.5% the previous year. General government debt is likely to
remain above 70% of GDP in the coming year, based on Standard & Poor's method for calculating the debt burden.
Interest payments will likely consume about 25% of general government revenues.

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Chart 3

Rapid economic growth, along with domestic capital markets that largely fund the government's debt, have helped
to contain India's fiscal vulnerabilities despite large fiscal deficits. However, a potential structural slowdown in GDP
growth would dampen government revenues, boosting the fiscal deficit and possibly reversing a recent improvement
in the general government debt burden.

India's external profile has worsened modestly in recent times. Its foreign currency reserves cover around six months
of current account payments--down from eight months in 2008 and 2009. The current account deficit widened to an
estimated 3.7% of GDP in fiscal 2011-2012 from 2.6% the previous year and may remain close to 4% of GDP this
year. India's gross external financing needs are projected to rise to 92% of current account receipts, plus
international reserves, in the current fiscal year--up from 88% last year.

These recent developments are not serious enough, in our view, to lower the sovereign's creditworthiness. However,
as the negative outlook indicates, we would consider lowering the credit rating if the government's policy response
to these challenges, and potentially other unexpected shocks, is too little or too late. Under such a negative scenario,
there is an added risk that the government may further regulate the economy to reduce rising short-term threats to
stability.

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Will India's Economic Policy Take A Few Steps Backward?

Senior Indian policymakers remain committed to liberalizing the economy and pursuing an increasingly
market-oriented growth strategy. However, the momentum for economic reform has largely stalled in recent years as
a result of political factors. The combination of a weakening political context for further reform, along with
economic deceleration, raises the risk that the government may take modest steps backward away from economic
liberalization in the event of unexpected economic shocks. Such potential backward steps could reverse India's
liberalization of the external sector and the financial sector. They could also move India toward greater use of
discretionary rules and regulations, rather than towards a more transparent, rules-based policy framework.
Moreover, growing public criticism of the government for the poor provision of public services, as well as for
perceived corruption, could lead to backlash against liberalization itself.

For example, a growing trade deficit, along with the need to boost fiscal revenues, contributed to the government's
decision to raise minor trade barriers in its recent budget. The government raised tariffs on gold, a commodity that
had been a major source of smuggling in the past (when tariff rates were much higher). India had been reducing
import barriers considerably in recent years, aiming to reach tariff levels comparable with those of Southeast Asian
countries. However, trade liberalization has stalled in recent years, and Indian tariffs remain higher than those in
Southeast Asia and most emerging markets. The government recently tightened rules for Indian exporters in reaction
to depreciation of the rupee, requiring them to remit half their foreign exchange proceeds back to India within 15
days of sale.

A widening external deficit, combined with slower growth at home, could tempt the government to modify
industrial policies in order to tilt the playing field in favor of domestic producers at the expense of imports.
Lobbying from domestic producers could lead the government to make greater use of both trade barriers and other
rules that encourage or mandate more domestic production in key industrial sectors under the guise of "local
content" rules.

The government had been reducing its equity stake in public sector banks (which account for the bulk of loans) and
exposing them to market forces, greater competition, and pressure from minority shareholders from the private
sector. However, the government has retained majority ownership of those banks, periodically injecting public funds
into them to boost their capital levels and sustain their rapid asset growth.

A persistent slowdown in GDP growth could result in a rise in nonperforming loans (NPLs) to both public- and
private-sector borrowers. The government could respond by nudging the public sector banks to respond in a less
commercially oriented manner. The government, as the dominant shareholder, could play a role in getting
public-sector banks to restructure loans to large public-sector enterprises (such as Air India) that run into serious
financial difficulties. In addition, a potential fall in the GDP growth rate could tempt the government to use both
formal and informal means to get the banks to increase directed lending and reduce interest rates to aid borrowers in
key sectors of the economy.

India has traditionally followed a policy of cautious external liberalization, starting with liberalizing current account
transactions, along with steps to liberalize the domestic economy. Indian policymakers have sought to control the
fiscal deficit while strengthening the domestic financial system to enable both the public and private sectors to get
more funding at home before gaining full access to funding from abroad. The exchange rate has also become more
flexible, and the development of hedging products has enabled firms to better manage their foreign-exchange risk.

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India has also followed a calibrated opening of the capital account, starting with direct investment and portfolio
equity flows and cautiously loosening access to external debt flows. The strategy has helped to avoid vulnerabilities
that can arise from a sudden full opening of both the current and capital accounts, reducing the risk of rapid capital
inflows and sudden stops.

Recently, however, the fiscal deficit has been growing again, and domestic interest rates have increased, while both
investment and GDP growth have decelerated. The government has recently raised some of the caps on external
borrowing by the private sector to ease access to funding and encourage more investment, and it has upped the caps
on foreign purchases of local currency sovereign debt as well. The country's external debt remains manageable, and
foreign exchange reserves are high (more than $250 billion), which contains the short-term risk of greater foreign
debt inflows. However, a sudden external shock could cause external liquidity to drop. This could prompt the
government to impose more controls on both capital and current account transactions to contain the immediate risk
and potential damage.

Perceptions Of Poor Governance Could Undermine Economic Reform

Recent political scandals involving corruption charges have created a rising public perception of poor governance,
which could increase the risk of policy reversals. Allegations of corruption in heavily regulated sectors, such as
mining, telecommunications, oil and gas, and land acquisition, could gradually undermine public support for
pro-market policies. Practices that in many instances are favorable for business, especially politically well-connected
firms, are often misinterpreted in general public opinion as being pro-market, rather than pro-business. Hence,
public backlash against such abuses may erroneously result in a backlash against market-oriented policies.

Public perceptions about the distribution of the benefits of recent economic growth could also create obstacles for
deeper liberalization. India has been unable to follow the path of East and Southeast Asian countries that developed
a large, labor-intensive export base for textiles and other light industrial products during their years of rapid growth
and industrialization. This can be seen in the relative decline of India's labor-intensive exports and rise of
capital-intensive and skill-intensive exports, especially in services.

For example, exports of textiles, leather, and leather manufactures (all labor-intensive sectors) fell to 10.3% of total
exports in fiscal 2011-2012 from 28% in 2000-01. Rigid labor laws have constrained the growth of the textile
sector, which typically employs large numbers of unskilled workers. India accounts for about 4% of global textile
exports, compared with about 30% for China. While India's overall exports have grown rapidly in recent years, the
shifting composition of exports indicates the foregone possibility of creating more unskilled jobs through increased
trade. Rigid labor laws have limited India's ability to create more unskilled jobs in the formal sector of the economy.
Hence, its pattern of growth has created relatively more demand for skilled and semi-skilled labor compared with
the other Asian countries, and less demand for unskilled labor. The potential implications for income inequality
could create social tensions and gradually weaken public support for economic reforms.

Over the years, India has liberalized the market for many goods and services, as well as the market for capital.
However, land markets remain heavily regulated and opaque, while the formal labor market remains rigid and
small. Such rigidities impose an economic cost but also create political incentives for populism to compensate for
slower employment growth, especially for the poorest people.

Weaknesses in the provision of basic public services, such as education and health care, could also affect public

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attitudes toward future economic policies. The gap between provisions of private goods (such as consumer durables)
and public goods (such as roads, basic education, and sewage systems) has grown: For example, only 50% of the
population has access to a latrine facility, but 63% have a telephone connection and 47% own a television,
according to the 2011 census. Indian parents, both rich and poor, have been shifting their children out of
government-run schools in search of better education in private schools. This trend, which started in urban areas,
has now grown in the countryside as well.

Populist Solutions May Be Tempting

The negative consequences of poor public services and rigid land and labor markets could lead the government to
gradually undertake reforms to address the problem, or to pursue costly populist policies that deal with the
symptoms but not the causes. The government could liberalize markets for land and labor, as well as improve
accountability and transparency in education, health care, and other services. Conversely, it could boost public
spending on such services without reforming the weak delivery mechanisms, or tighten regulations and impose more
burdens on the private sector. For example, the central government recently placed extensive regulations on private
schools, including those that receive no public funding, as part of a larger reform to the education system.

Such measures might increase the government's role in the economy, either directly or indirectly, and restrict the role
of market forces in a manner that reverses the course of economic liberalization undertaken since 1992. Heavily
regulated sectors such as energy, mining, infrastructure, and financial services may be more vulnerable to such policy
setbacks. The government would be less likely to reverse liberalization in many of the real sectors of the economy,
such as industries that produce capital and consumer goods.

Rapid economic growth since the early 2000s has resulted in a substantial increase in government revenues.
However, much of the added money has gone to programs that subsidize consumption and to generous increases in
public-sector salaries. While such policies might be justified on grounds of social equity, or "inclusive growth,"
some Indian critics see them as promoting mistargeted spending on subsidies and social programs that largely bypass
the very poor. And such programs, as well as proposed new legislation to increase food subsidies, continue to rely
on the existing weak and leaky machinery of the public sector to deliver more resources.

The government may be tempted to further expand such spending programs without improving the delivery
mechanism, if economic growth were to fall faster than expected and seriously reduce the pace of job creation. Such
a government response would not only hurt the country's fiscal health but could also herald a bigger role for the
public sector in the rural economy.

Political Roadblocks Have Delayed Economic Reforms

In our view, the risks surrounding economic policy arise from the unusual political situation in the country, not
from an ideological movement against reform. There is little sign of a revival of public support for the statist
economic policies that were pursued until 1992.

India's economic reforms have always depended on a strong impulse from political parties in government and either
a tacit or open agreement of substantial segments of the opposition parties. All legislation in India must pass both
houses of parliament. A series of governments have been able to pass reform legislation since 1992, even though
none enjoyed a majority in both houses of parliament.

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The Congress Party-led coalition government was reelected in 2009 with a majority in the lower house after parting
ways with its former allies in the Communist party. The reelection, along with the presence of a prime minister with
impeccable reformist credentials, raised expectations for rapid economic reform. In fact, the current government has
been unable to advance economic reform for various reasons, including internal strife, uncooperative coalition allies,
and an obstructionist opposition.

Much media commentary about India has focused on the opposition to reform from small parties that are aligned
with the Congress. Coalition partners have sometimes blocked reformist policies promoted by the Congress party's
government leadership. However, this is, in our view, a partial explanation for the failure of the government to
advance with economic reform, as it overlooks internal divisions within the Congress itself. This explanation also
downplays the Congress party's inability to convince either the BJP (Indian People's Party) or other smaller
opposition parties to support its reform legislation; the previous BJP-led coalition government managed to gain the
consent of enough opposition parties to implement economic reforms during 1998-2004.

Much of the unfinished reform agenda (such as introducing a national goods and services tax, raising caps on FDI in
insurance and multibrand retail, pension reform, and privatization) was originally introduced by the BJP when it
was in power. Hence, many analysts in India cast blame on the BJP for abandoning its own economic policies and
opposing economic reforms of the current government for partisan reasons only.

Divided Leadership At The Center May Be The Biggest Hurdle

The crux of the current political problem for economic liberalization is, in our view, the nature of leadership within
the central government, not obstreperous allies or an unhelpful opposition. The Congress party is divided on
economic policies. There is substantial opposition within the party to any serious liberalization of the economy.
Moreover, paramount political power rests with the leader of the Congress party, Sonia Gandhi, who holds no
Cabinet position, while the government is led by an unelected prime minister, Manmohan Singh, who lacks a
political base of his own.

Many senior leaders in the party appear to oppose further economic liberalization, or are not enthusiastic about it,
in our view. Many leaders oppose steps that would reduce the discretionary powers of public officials over regulated
sectors of the economy out of self-interest, not ideology, fearing the loss of political power. Some leaders may think
that economic reforms will cost them votes, or at least will not gain new votes. Many have likely become
complacent about India's economic growth, comforted by the fact that the economy grew so rapidly for so many
years (since 2004) despite few significant new reforms. Some might attribute the recent slowing in economic growth
to global trends or cyclical domestic factors, not to the cumulative impact of stalled economic reforms.

The division of roles between a politically powerful Congress party president, who can take credit for the party's
two recent national election victories, and an appointed prime minister, has weakened the framework for making
economic policy, in our view. Manmohan Singh did not run for office in 2009 and, according to many political
analysts, appears to have less influence within the Cabinet than previous prime ministers. In fact, the Cabinet is
appointed largely by Sonia Gandhi and leaders of the allied parties, who choose their own candidates for the
Cabinet posts allocated to them within the coalition. Hence, the prime minister often appears to have limited ability
to influence his cabinet colleagues and proceed with the liberalization policies he favors (and constantly advocates in
his public speeches). For example, Singh has been unable to liberalize the heavily controlled coal sector despite
publicly advocating it for many years.

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The unusual division of roles and political power inside the central government has likely contributed to poor
discipline and cohesion within the Cabinet and government as a whole. For example, a senior Cabinet minister of
Singh's own political party publicly criticized the government's recent decision to raise administered fuel prices.

Singh was arguably more effective in his term as finance minister in the Congress minority government under Prime
Minister Narasimha Rao, which liberalized the economy in the early 1990s, than he has been as prime minister since
2004. The difference is likely due to Rao's political support for Singh when he proposed dramatic steps to open the
economy. Singh appears to lack that level of support from his own party today.

The Government's Response To Possible Scenarios Will Influence India's Credit

Quality
The political context (and not lack of willingness among key economic policymakers in the central government and
the central bank) may limit the government's ability to act decisively and quickly to manage an eroding economic
environment and possible external shocks.

Under one possible scenario, the government could take modest steps to contain the growth in spending in fiscal
2012-13, especially on subsidies. GDP growth could remain close to official projections (exceeding 7%), perhaps
sustained by the central bank's recent interest rate cuts. The government could make modest progress in reducing its
structural fiscal deficit and with pushing through some reforms and administrative measures that encourage
investment and reverse the recent drop in confidence in the private sector (both local and external). Moderating oil
prices could reduce the current account deficit and stabilize the recent erosion in India's external position. We would
likely maintain the sovereign credit rating at its current level under such a scenario.

Under a more pessimistic scenario, political problems could prevent the government from containing the growth in
current spending, and lower-than-projected GDP growth could result in revenue shortfalls. Politically inspired
spending programs could further widen the fiscal deficit. Lack of progress in alleviating bottlenecks in key sectors of
the economy could lower both domestic and foreign investment levels. Fiscal slippage, combined with persistently
high inflation, could further weaken investor confidence. Both the government's debt burden and fiscal flexibility
could continue to erode, in step with rising external vulnerability because of higher trade and current account
deficits. India's credit quality would suffer under such a scenario, and a downgrade could result.

The Country Is Better Positioned To Weather Setbacks Than In The Past

Despite its recent problems, the Indian economy remains in much better shape to muddle through the current period
of heightened global uncertainty than it was earlier, especially in the early 1990s, when it suffered a
balance-of-payments crisis. The risk to external liquidity is much lower, thanks to more than $250 billion in foreign
exchange reserves and a floating exchange rate that gives scope for adjusting to external shocks. India's financial
markets are also deeper and more sophisticated than before.

Moreover, the dynamism unleashed by years of gradual economic liberalization has strengthened the country's
productive base and created a momentum of its own. Many Indian firms have become globally competitive, both in
manufacturing and in services. India's exports continue to grow as a share of total world exports. The recent
improvement in the country's physical infrastructure, especially its roads and highways, will continue to spark new
economic activity in coming years.

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In addition, the recent years of unprecedented prosperity have created a growing middle class, a stronger private
sector, and rising aspirations among the general population. The growing political clout of those political
constituencies that stand to benefit from more economic reform augurs well for the direction of long-term economic
policy.

India's next national elections will take place by May 2014. From a political angle, the time-frame for significant
economic reform is likely to be limited to the rest of 2012 and at best early 2013, before the election campaign takes
priority. The central government is likely to advance during that period with introducing a new direct tax code and
take steps toward gaining consensus for the proposed goods and services tax (GST) among the states. The last
central government budget eased the path toward the GST by expanding the tax net to include a wider array of
services. The government is scheduled to set up the technical platform later this year for administering and collecting
the GST. The tax might not go into effect before the next national elections, but it is likely to happen eventually,
given the heavy commitments the leading political parties and state governments of all political stripes have made.

The government took steps recently to loosen rules for portfolio investment in the Indian market, indicating its
desire to sustain external inflows. It may take similar modest steps to encourage FDI as well, helping sustain external
funding.

Global Perceptions Of India Are Changing

Some observers in India possibly assume that the economy could sustain 6%-7% GDP growth in the coming years
without active reforms or more effective economic management. However, we should not exclude the possibility of
a more significant drop in trend GDP growth (perhaps to 4%-5%) if weak economic management coincides with a
bad external shock or with bad luck, such as a poor monsoon. Under such a remote scenario, India would face the
risk of stagflation if the authorities fail to coordinate fiscal and monetary policies and act decisively. Prolonged
policy incoherence resulting from a poorly managed coalition government raises the risk of a tardy response, and a
rating downgrade.

The strictly economic impact of a downgrade might be limited. India's domestic financial system can easily fund the
government's commercial debt, which is denominated in local currency. However, a potential downgrade could have
wider implications for the country.

Global perceptions of India have changed remarkably in the past decade. India evolved from a country that
appeared destined to remain poor, backward, and weak to one on a path toward prosperity, modernity, and power.
The impact of this shift in global perception, paired with the country's very real economic growth during the past
decade, altered India's global economic, political, and strategic standing. It would be ironic if a government under
the economist who spurred much of the liberalization of India's economy and helped unleash such gains were to
preside over their potential erosion.

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