ARC Ratings assigns India Sovereign Rating of BBB+, Outlook stable ISSUER RATINGS DATE Republic of India December 12, 2014 ISSUER RATINGS - FOREIGN CURRENCY ISSUER RATINGS - LOCAL CURRENCY BBB+ A-2 Medium and Long Term (BBB+, Stable) Short Term (A(A -2) COUNTRY CEILING - FOREIGN CURRENCY A- Foreign Currency (A(A-) A- A-2 Medium and Long Term (A(A -, Stable) Short Term (A(A -2) COUNTRY CEILING - LOCAL CURRENCY A Local Currency (A) FIRST TIME RATING ACTION London, December 12, 2014, ARC Ratings SA (ARC), a global rating agency, has assigned a long-term foreign currency issuer rating to the Republic of India (India) of BBB+. The agency also assigned a long-term local currency issuer rating of A- to India. The outlook on both ratings is stable. In addition, the agency assigned a foreign currency country ceiling of A- and a local currency country ceiling of A to the country. Short-term sovereign ratings of A-2 were assigned. All ratings assigned are unsolicited. SUMMARY OF KEY RATING CONSIDERATIONS (1) We expect India's growth to accelerate from an annual average of 4.8% in 2012-14 to 6.5% in 2015-17 (relative to an annual average of 8.5% in 2005-2010), driven by a recovery in corporate investment, robust domestic consumption and the new government’s aggressive growth-enhancing structural reform program. (2) Government debt exceeds 60% of GDP – high relative to BBB rated peers. However, the key debt ratios are on a downward trajectory and is supported by a favourable currency composition (94% local currency), maturity structure (average maturity over 9 years), and ownership base (limited foreign holdings of local currency debt) relative to BBB rated emerging market peers. Prospects for fiscal consolidation are limited, although we expect budget deficits to improve marginally to 6.5% of GDP in 2015-17, down from an average of 7.6% in 2010-14. (3) India’s current account deficit improved from 4.7% of GDP in 2012 to 2% in 2014, limiting the economy’s exposure to external financing conditions, and expected to continue to tighten in 2015/16, thanks, in part, to low oil prices. (4) The corporate sector has high external leverage and banks are encumbered by an overhang of bad assets which has ARC Ratings, S.A. 1/4 impaired credit growth. We expect domestic credit conditions to ease gradually in 2015/16 but to lag growth. RATING RATIONALE The agency explained that the key rating drivers supporting the BBB+ foreign currency rating are: (1) The country’s low external vulnerability, vulnerability characterized by low external debt ratios and moderate current account deficits. Foreign currency indebtedness of the government is very low, as are non-resident holdings of government securities. Reserves are more than adequate at USD 315 billion; (2) Growth dynamism. dynamism Notwithstanding the slowdown of recent years, India has enjoyed an annual growth rate of on average 6-7% over the past decade. Faster-paced growth is being fuelled by the pro-business policy reform agenda of the new government of Prime Minister Narendra Modi. One of the most important pillars of this initiative is the planned implementation of a Goods and Services Tax (GST) in early 2016. In addition, more investment spending by the government, albeit cautious of fiscal limits, is also a positive for the country. India’s key credit constraints are: (3) It’s large government debt and deficits. deficits Government debt stands at 66% of GDP, and fiscal deficits are persistently in the range of 6-7% of GDP. However, ARC expects the new fiscal conservation efforts will likely to lead in a gradual decline in these ratios, also underpinning the country’s credit ratings. The agency noted that India’s growth prospects are a key consideration for its sovereign ratings. India’s structural reform agenda targets a broad array of growth-enhancing areas in the energy sector, infrastructure, the labour market, as well as the fiscal accounts. Should these reforms be realized, India could reach a growth platform of 8-9%. In ARC’s opinion, execution of the GST is critical for putting India solidly on a higher growth platform. The GST would open up the domestic market to trade, dismantling barriers, thereby lowering the cost of doing business. It could in time also strengthen the government’s weak revenue base, a key credit weakness, with government revenues very modest compared to peer countries, at just 20% of GDP, insufficient considering spending demands. In the short-term, India’s economic recovery is assisted by falling energy prices, which improve the economy’s terms of trade. Low oil prices also help government finances, and have helped facilitate the reforms in government subsidies. The response of corporate investment remains central to this robust growth scenario; it has slowed markedly in recent years, causing non-performing and restructured loans in the banking system to climb to close to 8%, but the current macro conditions support improvement in this important credit variable going forward. Similarly, foreign direct investment (FDI) is low in India, just around 1% of GDP each year though the potential is high. ARC expects reforms to accelerate growth-enhancing FDI inflows, particularly into critical areas such as energy and transport infrastructure. To date most FDI has been in India’s growing services sector. India’s favourable demographic situation, a fast growing and increasingly urbanized population, is a driver of consumption-based growth, but also exerts considerable political and economic pressures on the country. ARC Ratings, S.A. 2/4 The combination of fiscal restraint and accelerated growth is expected to lead to a steady improvement of India’s key government debt and solvency metrics, which are high relative to many of its peers. Interest expense of over 20% of revenues cuts into vital government investment spending, to the detriment of economic growth and development. Reforms that are being undertaken in the fiscal sphere, which include the assignment of universal identification documents and expenditure rationalization, are critical for containing the size of the government deficit. The government targets a reduction of the central government deficit to 3% in FY 2016/17, implying a consolidated government deficit of 6% by that date. Further reductions in the size of the fiscal deficit appear challenging given the substantial development and infrastructure needs, although the quality of spending is expected to continue to improve. ARC expects the reform of subsidies, particularly fuel subsidies, to create further fiscal space for the government and allow for reallocation of expenditure towards investment; however we expect food and water subsidies to remain in place. Other supporting factors for India’s sovereign ratings include the economy’s increasing diversification and the strengthening performance of the export sector. In addition, responsible monetary policy supports price stability in India. The Reserve Bank of India’s (RBI) tight monetary policy and tailwinds from lower global commodity prices have brought down inflation from an annual average of 9.4% in 2010-13 to below 5% by the end of 2014. We expect anchored inflation expectations to allow the RBI to cut rates in 2015 without jeopardizing its medium-term annual inflation target of 6%. In turn, more accommodative monetary policy will stimulate credit growth and lower the government’s domestic borrowing costs. ARC’s A- local currency sovereign rating stance is aligned with our view that sovereigns have much greater flexibility in their national currencies, and also reflects the government’s ample access to credit in the local markets. About 95% of the government’s debt stock is rupee-denominated and almost all of it is held locally. ARC’s A- country ceiling for foreign currency transactions is based on our assessment of transfer and convertibility risk. The country ceiling for local currency transactions of A underlies the premise that a central government is the best credit in a country in local currency, although it gives a one notch uplift for an extraordinary issuer. ARC’s sovereign ratings of India are determined using a methodology and scorecard that looks at the entire economy’s balance sheet and liquidity profile, and also do not overemphasize GDP per capita, which in India’s case is very low at about USD 1,600. Per capita GDP is a useful proxy for assessing institutional development but often doesn’t reflect default risk. The agency notes that India’s weak institutional complexion will not impair it from growing at a fast annual rate approaching 8-9%, and it has never posed an acute problem for its debt repayments prospects. RATING OUTLOOK AND KEY TURNING POINTS India’s ratings carry stable outlooks, and take into consideration our expectations for the behaviour of policies that will unleash faster growth, a more investment-friendly business environment, and greater competitiveness, while also addressing fiscal shortcomings. ARC Ratings, S.A. 3/4 Triggers that could prompt a rating downgrade include underperformance on the policy front, and in turn weak growth, and deteriorating fiscal conditions. Other factor that could change India’s ratings downward would be if the faster growth momentum exerts pressure on the balance of payments and leads to a large-scale build-up in debt in the economy. India’s ratings could be upgraded in the event that private long-term investment - both domestic and foreign - picks up considerably, creating a new plateau for economic dynamism. Sharply improved revenue performance of the government would also be favourable to the rating dynamics. ABOUT ARC RATINGS ARC is a global ratings agency based in London and Lisbon that partnered with CARE Ratings in India. ARC has also established partnerships with rating agencies in Brazil (SR Ratings), Malaysia (MARC) and South Africa (GCR). ARC is focused on carving out a niche based on the local knowledge and expertise of its partners across the globe. ARC is registered with European Securities and Markets Authority (ESMA). Please visit www.arcratings.com for further details. THIS DISCLOSURE IS FOR INFORMATION PURPOSES ONLY AND DOES NOT DISPENSE THE READING OF THE RESPECTIVE RATING REPORT. ARC Ratings, S.A. 180 Piccadilly London W1J 9HF UNITED KINGDOM Phone: +44 (0) 203 282 7594 E -mail: [email protected] Site: www.arcratings.com Key Contacts: Alexandra Mousavizadeh Joan FeldbaumFeldbaum-Vidra Managing Director Head of Sovereigns +44 (0) 781 3977 670 +1 201 574574-5783 E-mail: [email protected] E-mail: [email protected] Registered as a Credit Rating Agency with the European Securities and Markets Authority (ESMA), within the scope of the REGULATION (EC) Nº 1060/2009 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL, of 16 September, and recognised as External Credit Assessment Institution (ECAI) for Corporates by the Bank of Portugal. Ratings do not constitute a recommendation to buy or sell, but only one of the factors to be weighted by investors. ARC’s ratings are assigned based on information collected from a wide group of sources. ARC Ratings uses and treats this information with due care and attention. Although all due care was taken in the collection, cross-checking and processing of the information for the purposes of the rating analysis, ARC Ratings cannot be held liable for its truthfulness. ARC Ratings must make sure that the information has a minimum level of quality prior to assigning a rating based on such information. ARC Ratings, S.A. 4/4