India's rating could return to junk status

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India's hard-won investment-grade foreign debt rating is in danger of being cut back to junk status as slowing economic growth, rising inflation and growing debt wreak havoc on the country's finances.

The balance is tilting towards a downgrade by at least one of the big three rating agencies in 2008, especially as the government has been weakened by the loss of a coalition partner and will not want to antagonise voters with any belt-tightening measures.

In the past four years, the three rating agencies have raised India to investment grade on the strength of its external financial ratios, improving budget deficit and robust growth.

The external position remains strong, but analysts are worried that domestic problems and a flight of capital could combine to bring down the country's credit standing.

"Undoubtedly, the downside risks have grown on account of high oil prices and an inadequate reaction from the government," Moody's rating analyst Aninda Mitra said.

Earlier in July, Standard & Poor's said the rising cost of subsidies, debt write-offs and public sector wage rises had increased the risk of a downgrade of India's BBB-minus rating, the lowest investment-grade rating.

The Indian economy has expanded by 9 per cent or more in the past three years. In the fiscal year to next March the central bank expects a slowdown to 8.0-8.5 per cent, with investment banks and rating agencies forecasting less than 8 per cent.

Annual inflation, as measured by the wholesale price index, is at 11.91 per cent, its highest in 13 years.

On top of that, a widening fiscal deficit -- strained by higher interest payments, civil service wages, loan waivers and subsidies -- is making markets nervous.

"The budget deficit in India is likely to blow out. We have a forecast of 3.5 per cent of GDP this year, and the risk is on the upside," said Robert Prior-Wandesforde, an economist with HSBC.

"Add in the state governments and off-budget items and you would get around a 10 percent deficit number," he said.

POLITICAL CONSTRAINTS

Indian policy makers are hamstrung by political constraints at a time when fiscal discipline is sorely needed.

"Political developments in India, in particular a new coalition, suggest the government will be forced to maintain a lighter hand on the economic levers," Societe Generale said in a client note.

"The risk of an early election is likely to see the government step back from electorally unpopular tightening measures," the bank added.