Risk drivers and outlook

India’s growth keeps slowing down from elevated levels and this negative trend has accelerated since the end of 2016 due to two domestic shocks. Last November’s chaotic demonetisation policy and the uncertain transition to GST (goods and services tax) last July have indeed temporarily disrupted economic activity. Poor banking sector health and high corporate debt are also playing a role in hampering growth. However, with the impact of the above shocks expected to fade in the coming months, the MLT economic outlook remains upbeat. India will continue to benefit from supportive economic conditions, particularly low oil prices, which have contributed to bringing inflation down to a 10-year low, and its large domestic market, which reduces vulnerability in an uncertain global environment. An extra boost definitely comes from political stability and the reform process, which should move forward until at least 2024, as PM Modi is the favourite for re‑election in 2019 and is expected to obtain a majority in Parliament next year. The reform and pro-business stance is reflected in an improved business environment, investor confidence (as FDI is on a sustained upward trend) and a stronger rupee. This explains why India’s commercial risk is rated in category B (on a scale from A to C).

All is not rosy, though, as three downside risks are clouding the outlook. The biggest concern comes from an ailing banking sector, especially state banks burdened with rising bad loans, for which the government plans a modest recapitalisation. Together with high corporate debt levels in some sectors, this affects credit supply (now at the lowest levels for decades) and demand and domestic investments and could eventually reduce India’s growth potential. A third risk lies in structurally poor public finances. Ongoing fiscal consolidation is expected to remain a slow process despite the noticeable impact of the recent introduction of national GST. All in all, India’s strong fundamentals, from a robust balance of payments to rather low external debt, and its positive economic outlook justify India’s classification in category 3/7 for MLT political risk. As for ST political risk, the rating is a strong 2/7 thanks to a robust and further strengthening external liquidity.

Facts & figures

Pros

  • Reformist government
  • Broad-based economy
  • Strong services industry
  • Sustainable external debt

Cons

  • Recurrent communal tensions
  • Downward trend in domestic investment ratio
  • Banking sector burdened by high and rising bad loans
  • Weak public finances

Head of State

  • President Ram Nath Kovind

Head of Government

  • Prime Minister Narendra Modi (BJP)

General elections (5-year cycle)

  • Presidential: in 2022
  • Legislative: in 2019

Population

  • 1,311.1 million

Income per capita

  • USD 1,600

Income group

  • Lower middle income

Main export products

  • Private transfers (12.7% of current account receipts), Software services (11.3%), Gems and Jewellery (7.9%), Mineral fuels (6.3%), Textiles (4.8%), Tourism (4.3%), Chemicals and plastics (4.2%)

Country risk assessment

Modi and the BJP on the way to winning a majority in Parliament 

PM Modi is increasingly leaving an imprint on the political history of India as one of the most popular political leaders of recent decades. Weakened by the minority position of his party, the BJP, in the upper house of Parliament, Modi’s recent successes in several state elections have increased the likelihood of the BJP party dominating both houses of Parliament, probably in 2018. His landslide electoral victory in Uttar Pradesh, India’s most populous state, last March was probably a turning point. It highlighted his popularity across all regions and all segments of Indian society, even in a large poor rural state such as Uttar Pradesh, and despite the very controversial demonetisation shock last November (see below). Against the odds, although poor people were much affected by it, most of them welcomed Modi’s plan to combat corruption and tax evasion. PM Modi is now confident of extending his 5-year mandate in the 2019 general elections. His re-election prospects are reinforced by a fragmented opposition and the historic Congress Party still being in limbo under the elitist and anything but charismatic leader Rahul Gandhi. Lastly, the BJP’s strength has been further highlighted by the election (by an electoral college) of BJP candidate and governor of Bihar Ram Nath Kovind as the new President of India.

The BJP’s high chances of obtaining a majority in the upper house, together with its current majority in the lower house, would greatly support Modi’s reform programme. It would pave the way for moving forward two major reforms blocked in Parliament: the labour market and land acquisitions. These both top Modi’s priority list because of the positive impact they could have on economic development. However, in order to maintain a positive political dynamic, they are more likely to be put on the government agenda after the 2019 elections. These are indeed very sensitive issues which have encountered strong regional resistance. Therefore, even with a Parliament majority, a breakthrough could be difficult for Modi. Meanwhile, in line with the past three years of rule, Modi’s reformist and business-friendly stance is likely to continue.

Hindu nationalism and Pakistan the dominant threats to stability

While political continuity is expected in the next few years, the biggest concern may come from an overly dominant BJP party allowing Mr Modi’s Hindu nationalist instinct to spread across his supporters and indirectly hinder his economic goals, as illustrated by his appointment of a Hindu extremist and anti-Muslim cleric as the new state leader of Uttar Pradesh, and by the controversial ban on selling cows for slaughter. There is a risk of further instability from rising religious tensions, especially between Hindus and Muslims, but also with other communities. During 2016, many public protests took place against intolerance and more may follow in the future in an ostensibly pro-Hindu climate. Another underlying risk is that Mr Modi could abuse his dominant political position, as his leadership style is more personalised and centralised than that of his predecessors. Meanwhile, India’s internal stability continues to suffer from (albeit decreased) terrorist attacks from Naxalite (Marxist) militant groups in several poor states, which are partly fuelled by a widening wealth gap, and from attacks related to Hindu-Muslim tensions.

The IS threat in India has so far been contained but it could be exacerbated among local Muslims by the resumed conflict at the Kashmir border. Historic hostilities with Pakistan have indeed been revived since 2016 and will require much attention in the future as both countries continue to build up their military capacities and the China-Pakistan Economic Corridor (unwelcomed by New Delhi) moves forward. Thus India’s relations with China will oscillate between pragmatism – while competing for influence in the Indian Ocean and South Asia – and sporadic tensions as shown recently with the armed standoff over the Bhutan border dispute. Also, with Pakistan building closer links to China, India is expected to continue deepening its ties with the USA.

Growth slowed down by domestic shocks and corporate debt 

The strong momentum enjoyed since Modi came to power has faltered. Growth in economic activity decreased in the 2016/17 fiscal year (ended in March 2017) and could decline further slightly in this current 2017/18 fiscal year. The drop has largely resulted from the cash crunch following the government’s sudden decision in November 2016 to withdraw the two largest bank notes (accounting for 86% of total money) from circulation and replace them with new ones. This ‘demonetisation plan’, aimed at combatting tax evasion and black money – a failed goal based on a recent report from the Reserve Bank of India – and developing digital payments, has been a monetary big bang affecting a still dominant informal and cash economy, from agriculture to industrial production and private consumption. Thus the GDP growth rate went down to a still robust 7.1% (against 8% in FY2015). Now, while the situation has largely returned to the pre-demonetisation level, a second domestic shock has been hitting the economy: goods and services tax (GST). Its accelerated introduction last July amid uncertainty about procedures and rates contributed to bringing GDP growth down to a three-year low in the first quarter of 5.7% (compared with the previous quarter). This is happening in a context of deleveraging from financially weak banks and indebted companies in major sectors, which could prevent growth from reaching 7% in FY2017. Growth could accelerate gradually and head towards 8% by 2021 as the impact of the two shocks mentioned above fades, but this won’t be before FY2018.

An overall upbeat MLT outlook strengthened by reforms

India’s upbeat MLT economic outlook is fuelled by favourable economic conditions such as low oil prices and inflation being at its lowest level for decades (under 4%) allowing cuts in interest rates. The balance of payments is strong with a more contained current account deficit thanks to cheaper oil imports – a boon for a large net oil importer – and stronger exports of services (particularly software), which have more than offset decreased workers’ remittances (India’s main source of income from exports) from the Gulf countries. The current account deficit is expected to rise to above 6% of current account receipts in the coming years but will remain financed by strong (and increasing) FDI. In addition to these positive developments, India’s large domestic market and strong consumer demand will act as a buffer to external shocks such as China’s weakened global demand and potential adverse US trade measures during Mr Trump’s mandate. A stricter immigration policy and more nationalist economic policy in the USA could harm India’s key sector, IT (i.e. its main source of income from exported services). This could affect outsourcing activity in India and Indians’ remittances from the USA, where the visa policy has become more restrictive as regards foreign high-skilled workers.

Another dimension that galvanises a dominantly buoyant mood in the MLT concerns Mr Modi’s reform drive. Investor confidence has increased since he came to power in 2014, which is highlighted by accelerated FDI and a stronger rupee – in contrast to the volatility of many currencies in other emerging countries – which has returned to its mid-2015 level. The government has indeed been working on improving the business environment, starting with reducing red tape, focusing on deregulation, digitalisation and liberalising many sectors by making them more open to FDI.

Besides the bold but chaotic ‘demonetisation plan’, Modi’s most significant achievement is GST. This was hurriedly brought into force last July with the aim of streamlining the complex tax system and replacing the numerous local and state taxes. Although many exemptions and rates will make it more complicated than initially expected, this remains the most important tax reform since independence.

On the negative side, so far there has been limited progress with the ‘Make in India’ plan, which aims to substantially develop manufacturing activity and, crucially, politically speaking, support job creation. All in all, apart from the tax reform, the pace of reforms so far is below expectations even though it undoubtedly fares well compared with Mr Modi’s predecessor. This could be explained by a resistance to change due to the weight of tradition, bureaucracy, the power of state governments and a still important and interfering role played by the State in the economy.

An unhealthy banking sector and weakening investments 

Against a generally positive macroeconomic picture, three downside risks can be distinguished. The biggest one is related to the heath of the banking sector, especially that of state-owned commercial banks (SOCBs, owning 70% of total bank assets), which are vulnerable to high and constantly rising stressed assets (from 10% to more than 12% of total loans between March 2015 and the end of 2016 for the whole sector)1 and are exposed to a heavily indebted corporate sector in steel, mining and infrastructure fuelled by ample investments several years ago. While private debt write-offs are not retained mostly for political reasons and setting up a bad bank is being considered, the ongoing recapitalisation of SOCBs – burdened with higher non-performing loans (NPLs) – is too slow and its magnitude (INR 700 bn for the 2016-2019 period, i.e. at best one fifth of the estimated required amount) far insufficient to ensure a clean-up of the sector.

The second downside risk results directly from the bad loan problem within state banks and from high corporate debt, notably in infrastructure. They both affect credit supply and demand. The demonetisation policy has exacerbated this situation through its detrimental impact on economic activity. Thus bank credit growth to the private sector fell to 5.1% last March, i.e. a 50-year low, and rose above 6% in the following months. There are two consequences. One is to further fuel the rise in NPLs. Another lies in the tendency to delay private and public investments, which is reflected by the decreasing domestic investment rate since 2012. This weighs on general economic activity and could eventually reduce India’s growth potential in spite of high savings and a favourable demographic profile.

1 Stressed assets include NPLs (up from 4.3% to 9.5% of total loans between March 2015 and the end of 2016) and restructured loans (around 3% of total loans at the end of 2016).

Stable but weak public finances

A third and longstanding risk comes from weak public finances characterised by a relatively low tax base and heavy interest payments on public debt (around 23% of revenues). Fiscal consolidation is underway and is likely to be supported by GST. But it is slow, with the general government budget deficit stubbornly expected to go above an already high 6% of GDP in the coming years. In fact, the budget trajectory may have to be revised upwards if the central government gives in to farmers’ protests and electoral promises by writing off their debts (estimated at 2% of GDP) by 2019. Public debt has remained close to a high 70% of GDP for many years and is forecast to decrease gradually towards 60% of GDP by FY2021 in an optimistic scenario. Despite the government’s limited fiscal space, Mr Modi’s strengthened political position should lead his government to increase public expenditure in infrastructure, particularly transport and power generation, i.e. two chronic hindrances to economic activity, and social spending benefiting the countryside with the 2019 elections in mind.

A positive external debt profile and robust liquidity position

India has a sustainable external debt. Its gross external debt ratios have stabilised at quite low levels in the past two years, particularly the ratio to GDP (close to 23%), whereas the ratio to exports has been fluctuating at around 97% after having reached 99% in FY2016, i.e. a 13-year high. In the medium to long term, those ratios are forecast to decrease slightly thanks to strong economic performances exceeding increasing external borrowing. The predominantly long-term maturities of external debt have kept the debt service under 10% of export receipts since FY2004. This ratio is expected to be around 8% in the coming years. The small share of USD-denominated debt in the domestic corporate sector (out of a total debt of 46.6% of GDP at the end of 2016) should allow it to cope with the US policy of interest rate hikes.

India’s external liquidity is strong. Thanks to a boost from rising FDI and exports having grown faster than imports, foreign exchange reserves have reached a historic high as they remain on a constant upward trend that began in 2013. Last June, their level allowed a comfortable cover of 7.2 months of imports (from 5.2 in 2012) and of more than 3.5 times the short-term debt.