India is facing a mixture of factors that may shake its sovereign credit metrics. Amid external turbulence, its foreign exchange reserves are falling, and its current account deficit is rising. Meanwhile, the economy is battling faster inflation and tightening financial conditions both at home and globally.

India's strong economic growth rate has long been an important counterbalance to its high fiscal deficits and debt burdens, and its sound external balance sheet helps to buffer against global market turbulence. We expect these strengths to help neutralize the risks inherent in the treacherous global environment.

Under more severe conditions though, a few factors could have the potential to apply downward pressure on our sovereign credit ratings on India (BBB-/Stable/A-3). In this article, S&P Global Ratings discusses those factors and their likely credit impact.

Frequently Asked Questions

What risks do falling foreign exchange reserves and rising current account deficit pose to the sovereign credit ratings on India?

Despite India's strong external balance sheet, it has not been able to escape the difficult landscape the rest of its emerging market peers have faced over the course of 2022. The fall in its foreign exchange reserves to around US$533 billion currently, from a peak of about US$634 billion in 2021, is driven in part by India's growing current account deficit, which we forecast will jump to 3% of GDP in the current fiscal year, versus just 1.6% of GDP in fiscal year ended March 2022, as the country's import bill surges.

We expect commodity prices, particularly for energy, to stabilize around current levels through 2023, after which they may decline more meaningfully. This would alleviate the pressure on India's current account, and is a key assumption supporting our expectations for the deficit to decline gradually through fiscal 2026. Nevertheless, if its current account deficit remains higher for longer, compared with our current base case forecasts, that would impinge on India's external balance sheet. Although India is a modest net external creditor currently, it may return to a small net external debt position. However, this contingency alone is unlikely to add material downside pressure to our sovereign ratings on India. India is also likely to continue benefitting from the active use of its currency in international transactions and the government's ability to fund itself via deep local currency debt market.

How are higher inflation and tighter monetary conditions affecting India?

The external trends mentioned above are fueling higher consumer price inflation and interest rates in India, and we see this trend lasting at least through the remainder of fiscal 2023. The Reserve Bank of India (RBI) started a rate hike cycle in May 2022 after inflation breached the upper bound of its 2%-6% target range. We expect the RBI's policy rate to end fiscal 2023 at 5.9% versus 4.0% prior to the commencement of the tightening cycle. Higher rates and faster price increases will somewhat suppress consumer behavior, and this could soften near-term growth momentum.

At the same time, the rise in rates is pushing up the cost of government funding. So far this year, the yield on the Indian government's two-year bonds has risen by about 230 basis points (bps) in the secondary market, to around 7.3%.

Like we said previously (see "Inflation and Rate Hits Won't Knock Out India Inc.," published on RatingsDirect on Aug. 23, 2022), a stress scenario assuming consumer price inflation and benchmark interest rates surpassing our current forecasts by 300 bps and 250 bps, respectively, for an extended period of time, could put more pressure on the sovereign ratings. This is because such a development could entail significantly slower economic growth, higher net general government fiscal deficits and net indebtedness, and a weakening of India's institutional capacity to maintain sustainable public finances. Under this scenario, the government's already elevated interest burden could rise even further.

Nevertheless, the fiscal and growth-related strains that we forecast as a base case are less likely to have a material impact on sovereign credit metrics. That's because our current forecasts entail relatively fast real and nominal GDP growth. Additionally, although capital costs more now than during the era of record-low rates, a more worrying increase in its interest rate burden remains improbable without a much higher, and stickier, consumer price inflation trend. However, we retain our forecast for inflation to average 6.8% in fiscal 2023, before falling to 5.0% in fiscal 2024 and 4.5% per year beyond that.

After an 8.7% expansion in fiscal 2022, India's economy looks set to slow. How is the economy likely to perform in the event of a deeper global economic slowdown, and what will this mean for the sovereign ratings?

We forecast India's real GDP growth at 7.3% in fiscal 2023. Although this marks a slowdown following an usually strong rebound in fiscal 2022, it nevertheless represents sturdy growth supported by solid underlying momentum, particularly in the domestic economy. India's banking sector has shown solid recovery prospects since the nadir of the pandemic-led economic contraction in fiscal 2021, and both private consumption and investment trends remain favorable. High frequency indicators, including purchasing manager's indices in services and manufacturing, automobile sales, and labor market surveys, suggest that India has so far maintained its momentum against the advent of external difficulties.

Consistently strong economic growth remains a core pillar of support for the sovereign ratings on India. This is true partly because fast economic growth helps to sustain the Indian government's large fiscal deficits and elevated stock of debt.

We believe a deeper global economic slowdown than we currently anticipate could have an adverse impact on India's economic performance in fiscals 2023 and 2024. Potential channels of risk for India include tighter global monetary conditions, prolonged high inflation, and poor investment or consumer sentiment both at home and abroad. In our view, India's economy is unlikely to downshift for an extended time on this basis alone, especially given its predominantly domestic orientation. Still, in the event of a prolonged downturn in real and nominal GDP growth, material downward pressure on the sovereign ratings could emerge, especially if large government deficits are left unchecked.

India continues to run high fiscal deficits, and maintains a sizable stock of debt relative to GDP. What are the risks associated with its weak fiscal settings?

A deep economic downturn would exacerbate the existing risks inherent to India's weak fiscal position.

India's general government deficits average well above 7% of GDP annually, and its debt stock stands at about 86% of GDP on a net basis. These metrics, along with its high interest burden, contribute to our very weak assessments of India's fiscal health. Consistently rapid economic growth, which supports revenue generation and helps the government finance its large annual shortfall, is critical to sustaining India's public finances over the medium term.

Our real GDP growth forecast of 6.5%-7.3% through fiscal 2026 is sufficient to meet this requirement. At the same time, the Indian government is experiencing sprightly revenue growth. One important contributor to this strong performance is the goods and services tax (GST), which helps to generate higher revenue during periods of faster inflation and solid consumption growth. GST revenue in August was 28% higher than the same period in 2021, and fiscal year-to-August (April-August) growth stood at 33%. In addition to the positive impact of improving consumer trends, we also believe revenues are benefiting from gradual improvements to the administration of the GST framework.

However, should economic growth falter for an extended period, the government's net indebtedness relative to GDP is likely to rise further. In that scenario, the resulting increase in its fiscal deficit could become more difficult to manage within the envelope of the government's annual revenue and financing capabilities.