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S&P Cuts India Outlook; Investment Rating In Peril

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Finance Minister Pranab Mukherjee said there was "no need for panic" after the rating agency Standard & Poor's downgraded the country's outlook from stable to negative on Wednesday. The downgrade of India's rating reflects the toll that hefty fiscal and current account deficits and political paralysis are exacting on Asia's third-largest economy. And more, the agency said there is a one in three chance of a downgrade to India's credit rating if external conditions continue to deteriorate.

"There is no need for panic," Mukherjee told reporters. "The situation may be difficult, but we will be surely able to overcome (it)." India is likely to pass some financial reforms in the current session of Parliament, which started on Monday, he added.

A Finance Ministry official said India will take "corrective measures." However, the official, who declined to be named, did not elaborate on the measures.

Following downgrading of India outlook, S&P also revised the outlooks on its long-term counterparty credit ratings on 11 financial institutions to negative from stable. The banking industry country risk assessment (BICRA) score on India remained unchanged at 5.

S&P also revised its outlook on Indian IT biggies TCS, Infosys and Wipro to negative from stable. The rating agency further said it could further lower the ratings on these companies if it revised downward T&C assessment. T&C assessment will be lowered if sovereign credit rating is further lowered.

Parliamentary Affairs Minister Pawan Kumar Bansal told reporters the government hoped to get approval in the current session of parliament for the insurance amendment bill, which initially proposed to raise foreign direct investment limit to 49 per cent from the current 26 per cent.

It is unclear whether the government would be able to keep the proposed increase in the FDI limit in the final amendment.

India has no sovereign global bond issues, but a downgrade would increase borrowing costs for local companies and make it harder to refinance debt, and may have a further chilling effect on foreign investor confidence in the country in general. However, Kumar Rachapudi, Fixed Income Strategist, Barclays Capital, Singapore pointed out that while the S&P action is negative on the margin, borrowing costs for companies are dependent on their individual credit strength. So unless borrowing costs for banks goes higher significantly, this action is unlikely to translate into wider spreads in general for the economy.

"The outlook revision reflects our view of at least a one-in-three likelihood of a downgrade if the external position continues to deteriorate, growth prospects diminish, or progress on fiscal reforms remains slow in a weakened political setting," S&P credit analyst Takahira Ogawa said in a note.

The negative outlook jeopardises India's long-term rating of BBB-, the lowest investment grade rating, and sent Indian bonds, stocks and the rupee lower.

Indian bond yields rose, while the rupee and stocks remained under pressure after Standard & Poor's cut India's outlook, with traders predicting pressure on the central bank to step in to prevent further falls in markets.

Indian markets have already been battered in recent weeks by the issues spotlighted by S&P in downgrading the country's outlook to negative, with the rupee recently at three-and-half-month lows, and bond yields near their December 2011 highs.

That explained the relatively muted falls on Wednesday, after initially bigger knee jerk reactions, as S&P cited well-flagged market risks such as India's widening current account and fiscal deficits, a slowdown in reforms, and the weaker economic outlook.

The high cost of oil along with soaring gold imports drove India's current account deficit to its widest in eight years in the 2011-12 fiscal year which ended in March, according to government forecasts, or 4 per cent of gross domestic product (GDP), up from 2.6 per cent in the previous fiscal year. Fiscal deficit, meanwhile, swelled to about 5.9 per cent of GDP in the fiscal year that ended in March, far above the government's 4.6 per cent target.

Many economists believe New Delhi will have a tough time hitting its target of cutting the deficit this fiscal year to 5.1 per cent of GDP, given a hefty subsidy burden and a weakened government that has failed to push through significant reforms.

The deficit burden is exacerbated by a sharp slowdown in growth, with the Indian economy expanding at just 6.1 percent in the December quarter, the weakest in nearly three years.

On top of all these challenges, uncertainty about the taxation of foreign investors has most recently raised fears about slowing capital inflows.

Traders said that markets would continue their recent falls unless the Reserve Bank of India steps in with debt purchases or by intervening in the currency markets, though the central bank may not be in a position to act decisively.

Just A Notch Above Non-Investment Grade
S&P reaffirmed its BBB- long term rating on India. Moody's rating agency has a Baa3 rating on the country, while Fitch is at BBB-. All are just one notch above non-investment grade or "junk" status. Moody's in December issued a stable outlook for India.

Nomura, however, sees a "low likelihood" of an actual ratings cut for India after S&P lowered its outlook to negative. "We expect the economy to see some cyclical rebound in the near term, the debt-to-GDP ratio is likely to remain stable, and the fiscal deficit should not worsen substantially," Nomura said.

However, Nomura warns the "only" risk to its call is a material decline in India's FX reserves.

"The writing was on the wall given the country's weakening debt profile and sluggish investment climate," said Radhika Rao, an economist at Forecast Pte in Singapore.

"With the coveted investment grade now at risk, one can only hope this acts as a wake-up call for the government," Rao said.

Foreign investors have become net sellers in Indian debt and equity markets this month, although for the year-to-date inflows remain positive.

General elections looming in 2014 are expected to limit the prospects for significant reforms that would improve the investment climate and India's fiscal position.

Big Subsidy Bill
India imports most of its oil and then subsidises fuel to consumers, a double exposure to global energy prices that led to a balance of payments crisis in 1991.

Meanwhile, a series of policy moves, including one that would retroactively tax indirect investments and another that targets tax havens used by foreign portfolio investors, has further soured already-weak investor sentiment.

India's 10-year bond yield rose 4 basis points to 8.63 percent soon after the S&P move, while the ailing rupee weakened and stocks fell, although markets recovered some of their losses.

Spreads on Indian bank bonds widened by 5-10 basis points after the outlook revision, with ICICI Bank's 2020 issue trading at 400 bps above U.S. Treasuries.

"This action should at least now push the government into action by announcing new reforms or look to implement the already announced ones. Until then, we will see markets, including the currency, remaining under pressure," said Arun Singh, senior economist at Dun & Bradstreet in Mumbai.