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S&P-Report-Will India Be the First BRIC Fallen Angel_June2012

S&P-Report-Will India Be the First BRIC Fallen Angel_June2012

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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

Standard & Poors | RatingsDirect on the Global Credit Portal | June 8, 2012

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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.

Standard & Poors | RatingsDirect on the Global Credit Portal | June 8, 2012

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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.

Standard & Poors | RatingsDirect on the Global Credit Portal | June 8, 2012

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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.

Standard & Poors | RatingsDirect on the Global Credit Portal | June 8, 2012

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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.

Standard & Poors | RatingsDirect on the Global Credit Portal | June 8, 2012

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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.

Standard & Poors | RatingsDirect on the Global Credit Portal | June 8, 2012

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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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Standard & Poors | RatingsDirect on the Global Credit Portal | June 8, 2012

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