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India's second COVID wave may derail a strong recovery in the economy and credit conditions. The country's rate of daily new infections keeps spiraling upward, accounting for almost half of the world's cases, overwhelming the Indian health system. S&P Global Ratings believes the possibility the government will impose more local lockdowns may thwart what was looking like a robust rebound in corporate profits, liquidity, funding access, government revenues, and banking system profitability.

The situation is fast-moving. The Indian recovery had been so vigorous across many measures, particularly in the last quarter of fiscal 2021 (year ending March 31, 2021), and yet the latest outbreak has escalated rapidly. Despite being the largest vaccine manufacturer in the world, India's vaccination rollout to the country's very large and largely rural population has proven challenging. The combination of a more infectious COVID variant and limited vaccination coverage will mean potentially higher infection cases.

The central government has avoided rolling out another nationwide lockdown, given this would be unpopular and economically costly. However, authorities have already imposed local lockdowns that cover much of the country, including Mumbai, New Delhi, and Bangalore.

The scope of lockdowns affects mobility, and is indicative of the strength of India's recovery. Much more extensive restrictions would prolong the pain of badly hit sectors, such as retail and tourism. Halts to domestic air traffic and subdued international travel may dismantle a fragile recovery underway for airports.

We look at two scenarios at how this might play out across sectors. Our severe scenario holds that new infections peak in late June 2021. Our second, moderate scenario posits that infections peak in May.

A drawn-out COVID wave would hit small and midsize enterprises particularly hard, and delay recovery in banks' asset quality. This would unfold in a context of still elevated credit risks especially from the tourism and recreation related sectors, commercial real estate, and unsecured retail loans.

A prolonged health crisis would hurt banks' asset quality more adversely. Banks have created some buffers through COVID-related provisions and additional capital raisings since the onset of pandemic.

In view of the current health situation, the availability of labor and supply chain bottlenecks may further crimp the cash flows of companies.

Macroeconomic Outlook

The Second Wave May Knock GDP Growth Below 10% In Fiscal 2022

India's second wave has prompted us to reconsider our forecast of 11% GDP growth this fiscal year. The timing of the peak in cases, and subsequent rate of decline, drive our considerations. Much will depend on social distancing, whether enforced or voluntary, the pace of vaccinations, and the degree to which previous infections provide immunity.

Mobility is key to economic activity even as the effect of reduced mobility on GDP evolves, as firms and households find ways to adapt.

We consider two downside scenarios, one which could well be our new baseline in the months ahead and one that implies a much more severe hit. The first, moderate scenario assumes that the seven-day average of reported cases peaks at around late-May, and then declines at a rate of 2% per day. The rate of decline in late 2020 was 1.7% per day. This means that new cases fall to half of peak levels in about one month.

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The severe scenario assumes a later peak and a slower decline. Specifically, that the seven-day average of cases peaks in late-June and then declines at 1% per day. This means that new cases fall to half of peak levels in just over two months. Our assumptions are based mainly on plausible paths for cases given past experiences in India and other countries. They are not forecasts of the pandemic's trajectory.

We map these assumptions into shocks to domestic demand via population mobility, which provides some empirical foundation to assess how the pandemic affects GDP. In our moderate scenario, retail and recreational mobility should remain stuck at about 70% of normal levels until May 2021, before gradually normalizing by September. In our severe scenario, mobility is 50%-60% of normal levels in May, recovers thereafter, but only normalizes by December. This means people are staying home more and spending less.

Our scenario projections below are the result of initial shocks to private consumption and investment that filter through the rest of the economy. For example, lower consumption will mean less hiring, lower wages, and a second hit to consumption. Both scenarios assume that the central bank eases monetary policy by cutting its short-term policy rate, in line with past behavior. Fiscal policy is assumed to be little changed, as the government waits before adding large-scale support.

Our moderate scenario suggests a hit to GDP of about 1.2 percentage points. This means full-year growth of 9.8% for fiscal 2022 (the year ending March 31, 2022). This compares with our baseline forecast of 11.0% growth for the period, set in March 2021. This would see a recovery taking hold again later in the year.

In the severe scenario, the hit is 2.8 percentage points, with growth of 8.2%.

We are careful about considering only growth rates given the low base. Even if real GDP does not rise from our estimates for the end of fiscal 2020, levels for all this year would still be above 9%. This still seems high but it is not a good outcome. It would leave the economy well below its pre-pandemic trend.

Will this latest wave exact even larger permanent costs? Before this latest wave, our models projected permanent damage to the level of potential GDP of above 10%. For now, we do not add to this estimate, in part because households and firms may have learned to better adapt to these shocks. However, the longer the pandemic remains intense, the greater the probability of permanent costs increases. A prolonged second wave would result in job losses and business closures, which could impair physical and human capital.

Sovereign

Severe COVID Scenario Could Defer Fiscal Stabilization

The depth of the Indian economy's deceleration will determine the impact on its sovereign credit profile. The Indian government's fiscal position is already stretched. We estimate the general government's fiscal deficit to have been about 14% of GDP in fiscal 2021, driving its net debt stock to just over 90% of GDP.

In both the moderate and severe downside scenarios for the Indian economy, there is a risk that the fiscal deficit would be higher than our forecast 11.4% of GDP this year, which could push the debt stock slightly higher still.

India's nascent economic recovery through March solidified government revenue. But the rapidly developing health crisis could derail this progress. Record case numbers, limited capacity in the healthcare system, and localized lockdowns aimed at curtailing the spread of the virus will likely take a toll on household consumption, and retail activity.

Should the outbreak worsen over the coming months, or if case numbers plateau at a very high level, this would elevate risks to India's economic and fiscal recovery. This assumes that the health system faces prolonged capacity constraints.

The second wave should not hit the economy as hard as the first wave did in the first quarter of fiscal 2021 (year ending March 31, 2021). Senior government officials including the prime minister and minister of finance have indicated that another national lockdown is not in the offing, despite the severity of the second wave. Should this remain the case, the hit on the economy will be limited compared with the effects of lockdowns one year ago.

Likewise, the Indian economy should resume its recovery once the second wave recedes, and to continue to grow at a faster pace than its peers at a similar level of per capita income around the world.

However, it is notable that the pandemic is more than a year old and is only getting stronger. The severity of the crisis is challenging the country's fiscal settings, which were already weak before COVID struck.

Our downside scenarios suggest a less robust recovery in government revenues, and the severe downside scenario may entail additional fiscal spending. Amid the second wave, officials have shown a preference for support measures from the central bank rather than additional fiscal interventions.

Over the next two to three years, fast nominal GDP growth will be critical in arresting the rise of the government debt to GDP ratio. This ratio may only stabilize the following fiscal year in the severe downside scenario.

Corporates

Potential Slowdown May Dent Credit Standing

Rated Indian companies are going into this second COVID wave with much improved operating and liquidity conditions than they did going into the first wave, last year (see chart 3).

The credit profile of these Indian corporate entities will likely be resilient to India's second COVID wave. The second wave has not materially affected the operations of most companies so far, with a few exceptions such as the automobile sector. So far, companies do not foresee supply chain disruptions or labor shortages. These were key factors in the operational disruptions experienced during the first wave.

Chart 3

Sectors such as commodities and automobiles, which were among the more severely affected by that initial stream of infections and associated lockdown measures, recovered strongly in the second half of fiscal 2021. Commodity prices are now much higher than in April 2020. The recovery in the global economy makes it unlikely that the sharp price declines of last year will be repeated.

The automobile sector should see lower demand over the next two to three months amid the continued restrictions on travel. However, pent-up demand will likely drive a strong recovery when such curbs are relaxed, as was seen during the second half of last year.

Consumer retail, another key laggard of fiscal 2021, will likely continue to underperform. Sectors such as telecoms, pharmaceuticals, and information technology, which were unaffected or even continued to grow in fiscal 2021, should remain resilient.

EBITDA for rated Indian corporates in the fourth quarter of fiscal 2021 in aggregate will likely be about 35% higher than the third quarter of fiscal 2020, the last normal quarter before COVID struck. The commodities and automobile sectors are mainly driving this rebound. Companies have also used stronger cash flows to cut debt. Leverage for most corporates should be meaningfully lower, which is particularly positive for speculative-grade companies (see chart 4).

Chart 4

Another key difference is that funding conditions are much better now than during the first COVID wave, when global capital markets had a big sell-off. Onshore bond markets temporarily froze during the first wave, amid liquidity issues among some domestic bond funds. This raised refinancing risk for several lower rated corporates.

By contrast, most rated Indian corporates today generally have much improved liquidity and much better access to funding. Many firms have used this access to refinance the bulk of their bonds maturing in 2021.

Out of about US$1.9 billion of bonds maturing in 2021 from speculative-grade companies, about US$1.6 billion was repaid by the end of 2020. The balance was prepaid or funded in the first quarter of 2021. Speculative-grade companies have a manageable US$1.5 billion of bonds maturing in 2022 (see charts 5a and 5b).

Chart 5a

Chart 5b

Infrastructure

Increasing Restrictions Imperil A Strong Recovery

The second wave may challenge an otherwise strong recovery for Indian infrastructure. A rebound in cash flows has supported credit metrics with rating upgrades and downgrades evenly positioned. Our severe scenario, with hits to economic growth and infrastructure sector cash flows, presents more downside risks. Leverage remains high, with a debt-to-EBITDA ratio above 6x.

Utilities will likely maintain earnings resilience due to regulated returns, fixed tariffs, and a quick recovery in demand. Counterparty credit risks and receivables delays pose the biggest risk for utilities, in our view. This includes renewables.

Airports are most at risk with international traffic recovery likely delayed by another year. If governments increase the severity and scope of restrictions on mobility, including curfews, this may set back what has been a strong domestic recovery.

Power:  The Indian power sector will generate revenue growth in the high single-digit to low teen, in our opinion. This would track the recovery in GDP. Even in the severe scenario, regulated returns and fixed tariffs would protect the earnings of power sector utilities.

Worsening receivables collection due to payment delays from weak distribution utilities remains the key risk, but the government's liquidity relief plan has stabilized overdue receivables.

GDP growth of 8.2% in fiscal 2022, as forecast under the severe scenario, could weaken the credit profile and liquidity position of distribution utilities. This might result in a higher working capital drag.

Chart 6

Chart 7

Airports:  The second wave is threatening India's air traffic recovery, with implications for airports. In the moderate scenario, domestic passenger traffic would hit about 75% of pre-COVID levels for fiscal 2022. In the severe scenario with extended lockdowns, the traffic recovery could be 10% lower than our current estimates. Weaker domestic traffic would hit the cash flows of airports. In either scenario, international traffic will likely be flat in fiscal 2022 compared with 2021.

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Roads:  In both the moderate and severe scenarios, we expect a sharp recovery in road traffic after a short disruption. Commercial vehicle traffic will show greater resilience as it supports logistics and essential services. Passenger vehicle traffic should also bounce back, with people more likely to shun public transit. Such assumptions are extrapolated from trends seen last year, when road traffic jumped to mid-teens growth above pre-COVID levels after sinking 60%-70% during the nationwide lockdown.

Ports:  A modest recovery for port volumes is likely in both our moderate and severe scenarios. Fertilizer and container traffic will show greater resilience than the crude and coal segments.

In the severe scenario, extended lockdowns that restrict labor mobility may hurt investment growth. Operating cash flows will largely recover for most infrastructure and utilities segments. Working capital drag and capital expenditure will be the key drivers for leverage. Budget announcements supporting power distribution utilities still lack details.

Financial Institutions

Systemic Risks Remain High Amid COVID Resurgence

India's domestic banks continue to face high levels of systemic risk. In the moderate downside scenario, the Indian banking system's weak loans should remain elevated at 11%-12% of gross loans. Credit losses will remain high in fiscal 2022 at 2.2% of total loans, before recovering to 1.8% in fiscal 2023.

Localized lockdowns will hit small and midsize enterprise (SME) borrowers and low-income households the most. Most borrowers have some cushion due to additional credit available under emergency credit guarantee plans and restructuring options.

Banks have already created COVID-related provisions in the range of 0.5%-1.5% of loans, which will provide some buffer. Additionally, the central bank has allowed banks to use all other floating and countercyclical provisions for the purpose of creating specific provisions against NPLs. The banking system's performance so far has been better than we previously expected, and this also adds some headroom to our estimates.

India's strong economic recovery right up till last month, and steps by the central bank and the government to ameliorate the effects of the economic crisis, have limited the stress on banks. Additionally, banks have raised capital to strengthen the balance sheet. This should help smooth the hit from additional COVID-related losses.

Not all sectors are affected equally by COVID.  The latest downcycle differs from the stresses faced by firms over the past five years, which typically weighed most heavily on large Indian companies. By contrast, COVID has disproportionately hit SMEs. Such entities will likely to be largest contributor to incremental nonperforming loans (NPLs) for Indian banks this year or next.

Service sectors such as airlines, hotels, malls, multiplexes, restaurants, airports, and retail trade have lost significant revenue and profit due to COVID containment measures. High risk segments such as commercial real estate loans also remain vulnerable.

Retail loans, especially unsecured personal loans and credit card debt (which together contribute about 10% of loans in the banking system), could also contribute to higher NPLs. Risks may also rise for commercial vehicle lending and micro finance lending (MFI), where borrowers have less financial buffer. Job losses in the informal sector may increase amid local lockdowns, hitting MFI.

The government's emergency credit guarantee plan for new loans to SMEs has supported liquidity for these cash-strapped entities. However, this is unlikely to completely restore the solvency of SMEs. In March 2021, the government extended to June 2021 the period for participating in the credit guarantee plan, and widened its scope.

On May 5, 2021, the central bank announced a second restructuring scheme. The new rules allow banks to restructure the debt of stressed individual and micro, small and medium enterprise (MSME) borrowers. This was meant as an easing to address difficulties caused by the second COVID wave. Conditions apply. The loans must meet the following criteria:

• They are capped at Indian rupee (INR) 250 million;
• They are only available to loans that have not entered restructuring so far;
• And only to loans that were classified as standard as of March 31, 2021.

In the same announcement, the central bank allowed banks to extend repayment moratoriums to up to a total of two years for those retail and MSME borrowers that have already placed some of their debt in restructuring. This will reduce stress on banks' balance sheets. We expect the volume of restructured loans to increase somewhat.

In the severe scenario, the Indian banking system's weak loans should rise to about 12% of gross loans. In which case, credit losses would likely rise to up to 2.4% of total loans in fiscal 2022, compared with our base case of 2.2%.

If the second wave in India continues to end-June 2021, the ensuing slowdown in economic activity would hit banks' asset quality. In this scenario, the solvency of some companies, especially in already stressed sectors listed above, would be highly strained. This could lead to higher new NPL formation in these sectors.

Defaults by large corporate and infrastructure companies will likely be limited, even in the severe scenario. If weak consumption is accompanied by large-scale job losses and salary cuts in the formal sector, this may hit the banking sector's unsecured personal loans and credit card loans. This accompanied with lower recovery rates from the large stock of bank NPLs, could lead to a rise in weaker loans.

In the severe downside scenario, the government and the central bank will likely extend support to borrowers, albeit with much reduced fiscal capacity than during wave one.

Any extension of government support mechanisms including forbearance on NPL recognition, extensions on existing guarantees or to provision of liquidity support, would support the borrowers facing temporary pain. However, if lending from nonviable borrowers is not recognized as NPLs, it will only delay the day that the banking system has to reckon with the effects.

Related Research

Economics 

• Economic Outlook Asia-Pacific Q2 2021: Three-Speed Recovery Will Benefit From Faster Global Growth, March 25, 2021
• Emerging Asia's Recovery Can Withstand A Reflation Trade, March 17, 2021

Corporates 

• Corporate Credit Recovery In Southeast Asia Lacks One Key Ingredient: Liquidity, April 13, 2021
• COVID-19 Heat Map: Some Bright Spots In Recovery Amid Signs Of Stability, Feb. 18, 2021

Cross-Sector 

• India's Second COVID Wave Heightens Downside Risks To GDP And Credit, April 28, 2021
• Cross-Sector Outlook: India's Escape From COVID, Feb. 16, 2021

Financial Institutions 

• The Future Of Banking: The Incumbents Strike Back, March 16, 2021
• Banking Industry Country Risk Assessment: India, Feb. 24, 2021
• Good Earning Capacity Gives Rated Banks In Emerging Markets A Buffer From COVID-19's Effects, Feb. 22, 2021

Infrastructure 

• Energy Transition In Asia-Pacific: A Marathon, Not a Sprint, April 19, 2021

Sovereign 

• Sovereign Debt 2021: Asia-Pacific Central Governments To Borrow US$4.1 Trillion, March 2, 2021

Editing: Jasper Moiseiwitsch

Digital Design: Evy Cheung