The Indian economy is on track to recover in fiscal 2022. Consistently good agriculture performance, a flattening of the COVID-19 infection curve, and a pickup in government spending are all supporting the economy. S&P Global Ratings believes strengthening macroeconomic conditions should limit the downside credit risks of key sectors.

India needs many things to be right for its recovery to continue. Most significantly, the country needs to quickly and thoroughly vaccinate most of its 1.4 billion people. The emergence of yet more contagious COVID-19 variants with the potential to evade vaccine-derived immunity present a major risk to this recovery. As does the possibility of early withdrawal of global fiscal stimulus.

Near-term prospects are positive. With a sustained decline in national confirmed COVID-19 cases allowing for a gradual relaxation of formerly stringent epidemic control measures, high frequency economic indicators continue to show improvement. IHS Markit Purchasing Managers' Indices for India's manufacturing industries rose to 57.7 in January 2020. The same index for services rose to 52.8. An index above 50 reflects expansion. This signals a recovery is unfolding in the economy's secondary and tertiary sectors.

Goods and services tax (GST) revenues are showing year-on-year growth in recent months (see chart 1), durable goods demand appears healthy, and mobility trends continue to normalize. Though the Reserve Bank of India's (RBI) latest consumer confidence survey shows depressed sentiment, expectations are improving for households and businesses.

Chart 1

Apple Mobility Index shows that driving in India has surpassed pre-COVID levels and is stronger than many other large countries (see chart 2). The index tracks requests for directions by people using Apple devices, and is therefore a proxy for mobility. The data suggests lockdown fatigue, and a greater willingness to leave home given the lack of a second COVID outbreak wave, and low COVID-19 mortality rates.

Chart 2

Sovereign Ratings Hinge On Post-Crisis Recovery

Our sovereign credit ratings on India balance the economy's above-average trend rate of growth, sound external settings, and well-established institutions against very weak fiscal and debt metrics. We expect the speed of India's post-crisis recovery to have important implications for the sovereign credit rating. This includes the sustainability of the government's strained fiscal position.

Bigger Budget To Shore Up Nascent Economic Rebound

The Indian government's recently released budget will also support the recovery, with higher than expected expenditures programmed for fiscals 2021 and 2022 (see "India's Bigger Budget Is A Shot In The Arm For The Economy," published Feb. 2, 2021). India's improving growth prospects are critical to its ability to sustain the higher deficits associated with its more aggressive fiscal stance. The country is also maintaining a large net debt stock that we estimate to be around 92% of GDP at the general government level.

Nevertheless, India's economy still faces important risks as it transitions from stabilization to recovery. We estimate that India faces a permanent loss of output versus its pre-pandemic path, suggesting a long-term production deficit equivalent to about 10% of GDP.

Put another way, nominal GDP will only return to its fiscal 2020 full-year output in fiscal 2022, even in the event that real GDP growth meets or modestly surpasses our 10% growth expectation (see chart 3 and "Rising Demand, Falling Infections Temper India's COVID Hit," published Dec. 15, 2020). This means that fiscal 2022's high real GDP growth forecast is largely a function of various economic activities coming back online.

Chart 3

Chart 4

India Infrastructure: Recovery Gains Momentum

Localized containment measures are replacing nationwide lockdowns. This has rejuvenated demand and removed supply bottlenecks and labor shortages, supporting a sharp recovery in infrastructure use.

The pace of recovery varies widely. Airports are still struggling with most flights grounded. Utilities are faring better, bolstered by regulated, contracted or availability-based returns that protect their operating cash flows despite an earlier fall in unit demand.

Table 1

Industrial Infrastructure More Resilient Than Consumer Infrastructure

Power:   We expect high single-digit to low teens growth for the Indian power sector, in line with the recovery in GDP growth. The increase in average daily demand every month since September 2020 suggests utilities' operating earnings will remain resilient (see charts 5 and 6).

Chart 5

Chart 6

Airports:   We assume domestic passenger traffic will climb back to three-quarters of their pre-COVID levels in 2022. This suggests downside risks for consumer air travel, assuming restrictions continue on some routes and fares.

Passenger traffic (domestic and international) may only fully recover by fiscal 2024 (see chart 7). We expect cargo revenues to grow and that this will provide some stability to the sector. Cargo volumes have been more resilient, dropping only 36% in calendar 2020, compared with 2019.

Chart 7

Roads:  A strong recovery in road traffic masks differences among segments. Heavy commercial vehicles supporting logistics and essential services have been the fastest to recover. Passenger vehicle traffic and airport feeder roads are recovering more gradually as travel restrictions are lifted.

Ports:  A growth in volume should largely track India's economic rebound. Fertilizers and container traffic are expected to come back faster than crude and coal segments (see chart 8).

Chart 8

Recent budget allocations will increase infrastructure spending by one-third to US$77 billion in fiscal 2022. Plans for supporting distribution companies, disbursements from specialized developmental lending agencies, and measures to strengthen the banking system should also bolster the infrastructure sector. The effect of these moves won't be evident in the next one to two years.

Operating Cash Flows, Working Capital, And Capex Drive Leverage

Operating cash flows will largely recover in line with the sector. Delays in receivables collection may result in working capital shortfalls for utilities. This may present the biggest risk to the entities' otherwise stable cash flows.

A recovery in demand may prompt some players to restore some of their shelved capital expenditure plans. In view of lower borrowing costs and abundant liquidity it's likely that surplus cash will be invested back into business rather than for deleveraging. Most rated infrastructure companies will likely maintain aggressive to high leverage. This will likely limit ratings upside.

Strong Earnings Stabilize Credit Profiles Of Corporate India

Earnings recovery post COVID-19 related disruptions has been stronger than expected.   Earnings of most rated entities across sectors have bounced back ( see chart 9). An increase in commodity prices and a revival of domestic demand after lockdowns were eased have driven upside earnings surprises. Changes in consumer choices, for example a preference for personal transport for health-safety reasons, have helped sectors such as automobiles.

Fiscal 2021 earnings should be stronger than fiscal 2020. The biggest swing in earnings estimates are from commodity related entities (steel, metals, oil & gas). The auto sector has also surprised to the upside. The recovery has been slightly delayed compared with commodities. The auto recovery started in the third quarter of fiscal 2021. The commodities recovery started in the second quarter of fiscal 2021.

Sectors that we expected to remain resilient such as telecoms, pharmaceuticals, and IT services have performed as expected. Concerns that the telecom sector's earnings could be affected by lower average revenue per user (ARPU), given the increase in unemployment and a largely prepaid market, did not materialize.

Among rated companies, we only see one sector operating well below fiscal 2020 levels in fiscal 2022--consumer retail--given the sector's high sensitivity to mobility. The lockdowns severally affected the retail sector, especially companies without a meaningful online presence. Retail sales are about 60%-70% of pre-COVID levels. This is a significant improvement from the lockdown era, when sales were about one-third the pre-pandemic level.

Chart 9

Credit metrics improve in line with earnings, but remain below pre-COVID expectations.   The earnings recovery means that credit metrics in fiscal 2021 will improve from fiscal 2020 levels. We previously expected a more gradual improvement (see chart 10).

Chart 10

However, the expected credit metrics are still weaker than we expected in 2019 for the same set of companies, prior to the pandemic, largely due to earnings weakening. A slowing economy, and some-related COVID hits in the fourth quarter of fiscal 2020, largely explains that drop.

Capital expenditure and dividend plans are below targets set in 2019. These are insufficient to offset lower earnings. Debt levels have not significantly declined from, say fiscal 2019 or 2020 levels, which has made corporate credit metrics more dependent on earnings. We would need to see a strengthening in credit profiles before we reveres the downgrades that we implemented in the first half of 2020.

One in four ratings still on negative outlook imply downside risk.   About one-quarter of outlooks on ratings of Indian corporates are negative. Though down from a peak of about 37% during mid-2020, this implied that sustained earnings recovery will be important for ratings to stabilize. A resumption in capital expenditure is also worth watching, especially if earnings remain strong. However, we see capex as less of a risk to ratings than a reversal in earnings.

Refinancing risks remain low for 2021 at least. Taking advantage of the benign funding markets in 2020, sub-investment grade rated corporates proactively refinanced and redeemed about 80% of their US$1.9 billion bonds due in 2021 (see charts 11, 12a and 12b).

Chart 11

The recovery of rated companies has been faster than the average recovery seen in corporate India. Most companies we rate are in sectors that are largely insulated from COVID-19 related disruptions, rather than sectors that are more exposed, such as property, entertainment companies, etc. Further, our rated pool tends to be the larger companies that generally withstand shocks better.

Chart 12a

Chart 12b

Indian Banks: Pain Subsiding

India has worked hard to shield its banks from the effects of COVID-19. Some hit to the banking industry was still inevitable. S&P Global Ratings expects Indian banks' asset quality to remain strained and profitability to be low in the fiscal year ending March 2022. While the Indian economy is on a mend, the pandemic has delivered a huge permanent GDP loss of about 10%.

In our view, India's banking system's performance is likely to start improving materially in fiscal 2023, trailing an economic recovery of 10% in fiscal 2022. The economic growth prospects over the next three years remain strong.

The sharp economic contraction in the current fiscal year will translate into higher nonperforming loans (NPLs). We estimate the banking system's weak loans at 12% of gross loans. Credit cost should remain elevated at 2.2%-2.7% (see chart 13).

Chart 13

Our estimate of the weak loans ratio includes one-time restructuring, which we now expect to be at 3%, closer to the lower end of our previous forecast, given India's economic recovery is stronger than earlier anticipated (see "Rising Demand, Falling Infections Temper India's COVID Hit," Dec. 15, 2020).

Indian financial institutions' reported NPLs in the current fiscal year improved to 7.5% in September 2020 from 8.2% in March 2020. This could be attributed in part to the six-month loan moratorium and a Supreme Court ruling barring banks from classifying any loans as nonperforming assets (NPA). The gap between the economic reality and reported numbers has widened in December 2020. Banks' pro forma NPLs, in the absence of the court ruling, would have been about 60-170 basis points above their reported numbers.

This pandemic-induced downcycle is somewhat different from the last five years, when large Indian companies were stressed. Corporate earnings have strongly recovered after the COVID shock, and we expect it to recover by the second half of 2021.

Sectors, such as construction, real estate development, airlines, tourism, restaurants, recreation, and hotels, continue to struggle with suboptimal activity levels, and could be a source of stress to banks. Small and midsize enterprises (SME) have been hit hardest this time.

The government's emergency credit guarantee scheme for new loans to SME (up to 20% of their outstanding loans) has helped liquidity for cash-strapped SMEs, although their solvency will likely not be entirely restored.

Retail loans are likewise pressured. Unsecured personal loans and credit card loans remain vulnerable to any widespread job losses, which may strain borrowers' cash flows. Early signs of stress are already visible. Loans that are more than 30 days past due (a leading indicator of stress) have jumped in the banks' credit card portfolio as a percentage of outstanding loans, rising sharply to 7.6% as of Aug. 31, 2020, from 4.9% the year before.

In our view, steps taken by the Reserve Bank of India and the Indian government to cushion the effect of the economic crisis have helped ease the stress on bank balance sheets. Government initiatives, including the emergency credit guarantee scheme for SMEs and the partial guarantee scheme for nonbank financial companies, have alleviated system stress.

The recent budget announcement, including plans to establish a "bad bank" and strengthening of the National Company Law Tribunal framework, could also in principle benefit banks by ensuring that management resources are not spent on recoveries from weak credits. But India's challenge has always been on execution. Meanwhile, we expect NPL recoveries under the Insolvency and Bankruptcy Code to regain momentum in fiscal 2022, once new cases can resume under the code and the economy rebounds.

On a positive note, India's banks are building capital buffers to deal with the COVID crunch. Both private- and public-sector banks have been raising capital (including hybrid capital) from the market to strengthen their balance sheets. This is over and above the government's announcement of a cumulative Indian rupees (INR) 400 billion capital infusion into public sector banks this year and next.

Banks have also been building reserves and making additional provisions, which in our view should help cushion the hit from COVID-related losses. The system's NPL coverage ratio stood at a 25-year high of 72.4% as of September 2020 (see chart 14).

Chart 14

Bank profitability should also help bolster capital. The industry's profitability has shown signs of improvement, recording a positive return on average assets (ROAA) of 0.7% in the six months ended September 2020, helped by stable margins, sharp cost controls, and lower credit cost.

While credit cost should be elevated in the current year and next, our projected profitability of the banking system at 0.7% in fiscal 2022 is better than that pre-COVID as banks earnings were weak prior to the onset of COVID-19 (see chart 15). All this should help better prepare banks to face the current downcycle and pave the path to recovery.

Chart 15

Finance Companies: A Glimmer of Hope

Indian finance companies' collections are showing sustained improvement in the past six months. Some companies have raised equity, and government schemes have ensured reasonable liquidity for the sector. As a result, financing costs have fallen sharply for some. However, risk premiums for weaker finance companies (or those with perceived governance issues) have been rising. We expect such polarization to persist in 2021.

Stronger finance companies are likely to gain market share and to continue to benefit from differentiated funding access. In our view, the companies will find their differentiated business niches with the weaker companies resorting to originate-and-distribute business models.

On the asset quality front, the performance of finance companies has been a mixed bag. The companies dealing in housing finance and gold loans are expected to be less affected compared with the ones in financing for micro enterprises or commercial vehicles.

Generally, asset quality in finance companies is weaker than that in major private sector banks, and the stress higher. For those finance companies we rate in India, our fiscal 2022 projected credit growth is 14%, credit cost 1.4%, and return on average assets 2.8%, an improvement from 10%, 2.4%, and 1.9%, respectively, estimated for fiscal 2021.

S&P Global Ratings believes there remains high, albeit moderating, uncertainty about the evolution of the coronavirus pandemic and its economic effects. Vaccine production is ramping up and rollouts are gathering pace around the world. Widespread immunization, which will help pave the way for a return to more normal levels of social and economic activity, looks to be achievable by most developed economies by the end of the third quarter. However, some emerging markets may only be able to achieve widespread immunization by year-end or later. We use these assumptions about vaccine timing in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Related Research

S&P Global Ratings research

• India's Bigger Budget Is A Shot In The Arm For The Economy, Feb. 2, 2021
• India-ASEAN Infrastructure: Sovereign Strains Add To Lockdown Pain, April 27, 2020
• Tech Disruption In Retail Banking: Top-Tier India Banks Lead The Change, Jan. 18, 2021
• Rising Demand, Falling Infections Temper India's COVID Hit, Dec. 15, 2020
• The Stress Fractures In Indian Financial Institutions, Nov. 24, 2020
• India Infrastructure: Recovery Won’t Be Quick, Nov. 23, 2020
• RBI's Proposed Corporate Ownership Of Indian Banks Poses High Risks, Nov. 23, 2020
• India's Proposed Resolution Of Lakshmi Vilas Bank Shows A Shift In Stance, Nov. 19, 2020
• Global Banks Country-By-Country 2021 Outlook: Toughest Test For Banks Since 2009, Nov. 17, 2020

Other research

• A global survey of potential acceptance of a COVID-19 vaccine, Nature Medicine
• Smallpox And Its Eradication, World Health Organization, 1988
• Polio-Free Countries, Polio Eradication Initiative