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.

The fate of the ruling coalition hinges on a confidence vote next Tuesday. A defeat could mean an early election.

Earlier this week, Fitch Ratings lowered the outlook on India's BBB-minus local currency rating to negative from stable but maintained the stable outlook for its foreign currency rating, also at BBB-minus.

This is symptomatic of the dichotomy that is emerging between India's domestic and external balance sheets.

"The external position is reasonably comfortable," said Yang-Myung Hong, an analyst with Lehman Brothers, referring to government borrowing of $56 billion out of total external debt of $221 billion, compared with currency reserves of $312 billion.

"The bigger issue is the fiscal and current account situation," he said, predicting that Fitch would downgrade India's local debt rating to BB-plus this year.

While S&P, like Fitch, rates India's foreign and domestic debt at BBB-minus, Moody's rates its domestic debt two notches lower than its foreign rating.

"We have maintained for a long time that with a debt-to-GDP ratio of nearly 80 per cent and debt-to-revenue ratio of 350 per cent, local currency ratings should not be investment grade," Mitra of Moody's said.

A local ratings downgrade would reflect domestic fundamentals but could scare foreign investors.

"Foreign investors will look at the local currency rating as well. It is an indicator of the budgetary position of the government," said Irene Cheung, head of sovereign debt research at ABN AMRO.

A lower rating would also raise borrowing costs for Indian companies, eroding profits and putting more pressure on stocks.

Foreign funds have already cut their investments in Indian debt and stock markets by $6.3 billion this year to $31.2 billion. A downgrade is likely to speed the outflow.