India's step-wise reforms set in motion, but weak investment and banking risk may act as speedbreakers

India Infoline News Service | Mumbai | September 20, 201617:16 IST

Moody's points out that banking sector risk will also remain a constraint on India's sovereign ratings.

Moody's Investors Service says that the credit implications of India's (Baa3 positive) reforms will materialise in the medium term, fostering a more stable macroeconomic environment conducive to fiscal consolidation. In the nearer term, challenging budget targets could lead to significant spending cuts late in the fiscal year, especially since in the first four months of the fiscal year, 74% of the whole year's budget target has already been reached.

Moreover, structural hurdles will continue to constrain private sector investment and growth. The banking sector will continue to pose contingent liability risks to the government over the near to medium term.

The conclusions were expressed by Marie Diron, a Senior Vice President with Moody's Sovereign Group, and Aditi Nayar, a Senior Economist with ICRA Ltd, Moody's affiliate in India. They were speaking at a joint Moody's-ICRA sovereign and macro-economy briefing in New Delhi on September 20.

"From ICRA's perspective, we expect India's growth-inflation dynamics to display mixed trends during the fiscal year ending 31 March 2017 (FY2017)," says Nayar.

"Specifically, growth of gross value added (GVA) at basic prices is set to improve to 7.7% from 7.2% in FY2016 on the back of domestic consumption demand, amid a hardening of CPI inflation to an average of 5.1% from 4.9% over the same period," adds Nayar.

"In Moody's view, over time, the multi-pronged but step-wise approach to reform will contribute to stable robust growth, moderate inflation and narrower budget deficits. In particular, the cementing of the monetary policy framework with the objective of maintaining inflation at moderate levels is credit positive. Moody's expects continuity in monetary policy" says Diron.

"Meanwhile, a few fiscal measures entail some, although limited, immediate savings for the government, including through subsidy reform and more moderate increases in Minimum Support Prices (MSP) than in the past," adds Diron. "The implementation of the goods and sales tax (GST) — which Moody's assumes will become effective in 2017 will enhance revenue collection for the government over time, through better tax compliance and higher profits, as businesses save on tax administration costs."

Moreover, Moody's points out that some measures, if effectively implemented, will bolster India's growth potential, including an easing of restrictions on Foreign Direct Investment (FDI) that could foster productivity growth in some sectors; the bankruptcy law, which, if credible, would enhance investor confidence; improved access to bank accounts; and measures aimed at easing business starts.

However, these reforms will ease rather than remove some of the hurdles to robust and sustained investment, and therefore growth in India. In the nearer term, private investment will remain weak as corporates in investment-intensive sectors are burdened by elevated debt levels. In addition, the economy will remain vulnerable to fluctuations in monsoon rains, because of the only partial irrigation of crops and gradual progress in food storage and transport infrastructure. In general, infrastructure gaps will continue to constrain investment and the rise in FDI will not make up for muted domestic investment.

With the sequential dip in growth of GVA at basic prices and GDP in Q1 FY2017 to 7.1% and 7.3%, respectively results which were in line with ICRA's expectations ICRA maintains its forecast of a pick-up in economic growth in FY2017, with GVA growth of 7.7% and GDP expansion of 7.9%, compared to 7.2% and 7.6% in FY2016.

The staggered implementation of pay revisions by the central government and a number of state governments, as well as the improved outlook for the rural economy post-monsoon, portend that consumption will continue to drive economic growth in FY2017.

However, fiscal constraints will limit the space available for direct infrastructure investment by the central government in FY2017. In addition, the mixed global growth outlook will prevent merchandise exports from emerging as a major growth driver in the near term.

In terms of the monetary policy framework, the Government of India has notified a CPI inflation target of 4%, within a tolerance band of 2%-6% until March 2021. Such a scenario would help to anchor inflationary expectations. In addition, a favourable base effect as well as improved crop sowing dynamics will ensure that CPI inflation remains within this tolerance band in the near term.

However, higher global food prices and the anticipated improvement in domestic demand after the implementation of revised scales for the Central Government employees and pensioners pose modest risks to the inflation trajectory.

Without taking into account the impact of the eventual increase in allowances based on the recommendations of the Seventh Central Pay Commission, because the timing of the implementation is unclear ICRA expects that CPI inflation will record a mild hardening to about 5.1% in FY2017 from 4.9% in FY2016.

Moody's points out that banking sector risk will also remain a constraint on India's sovereign ratings. While bad asset recognition is a first step, the measure does not strengthen the resilience of banks, and therefore does not reduce the contingent liability risks for the sovereign. Moody's estimates that the fiscal costs of equity injections in public sector banks are manageable, although they are larger than currently budgeted and will add to the government's challenge in meeting its fiscal targets.


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