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The New Government's Reform Policies Will Be Critical To The Credit Profile Of Indian Corporates And Banks
Primary Credit Analysts: Abhishek Dangra, FRM, Singapore +65-6216-1121; abhishek.dangra@standardandpoors.com Takahira Ogawa, Singapore (65) 6239-6342; takahira.ogawa@standardandpoors.com Amit Pandey, Singapore (65) 6239 6344; amit.pandey@standardandpoors.com Secondary Contacts: Mehul P Sukkawala, CFA, Singapore (65) 6239-6337; mehul.sukkawala@standardandpoors.com Rajiv Vishwanathan, CFA, Singapore (65) 6239-6302; rajiv.vishwanathan@standardandpoors.com Vishal Kulkarni, CFA, Mumbai (91) 22-3342-4021; vishal.kulkarni@standardandpoors.com Contributor: Dharmakirti Joshi, Mumbai (91) 22-3342-8043; dharmakirti.joshi@crisil.com
Table Of Contents
A Pivotal Election For India's Sovereign Creditworthiness Addressing Key Issues Through Policy Can Yield Greater Gains Over The Medium Term Corporates: Policy Inaction Could Add To Stress Policy Measures Can Affect Banks' Asset Quality And Capitalization Related Criteria And Research
WWW.STANDARDANDPOORS.COM/RATINGSDIRECT
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Election outcomes generally don't affect the economy beyond improving sentiment. However, we believe the outcome of India's general election can provide an insight into the political stability, ability, and willingness of the new government to implement much-needed reforms to restore higher economic growth. Standard & Poor's Ratings Services believes the direction and pace of policy reforms, more than which political party takes control, can affect the ratings on the sovereign as well as corporate entities and banks. In our view, a decisive mandate can create an enabling environment for speedy resolution of policy bottlenecks and reforms, and improve private sector investments. This can lay the foundation for India's return to a stronger and healthier phase of growth in the medium term. Conversely, a fragile government could further delay critical reforms as decision-making gets hampered, curbing revival in the investment cycle and derailing growth. India's 16th general elections--the world's largest democratic exercise, where more than 800 million people are eligible to vote--are underway. To claim the right to form a new government, a single political party or a coalition of political parties needs to win 272 out of 543 seats. Overview The effectiveness of the next government will depend on its mandate--strong (one large dominant party) or weak (fractured mandate). We believe post-election economic prospects and reforms could have a bearing on the investment-grade rating on India and the ratings on corporate entities, banks, and financial institutions. A weak government could limit reforms, resulting in sub-par 5% GDP growth in the medium term, while a strong government can restore business confidence and improve the investment climate to boost economic growth to above 6%. The infrastructure, power, metals and mining, and petroleum sectors are more exposed to risks from development in government policies affecting corporate performance and banks' asset quality and capitalization needs.
Tackling lower economic growth, high inflation, and large fiscal deficits are some of the key challenges for the next government. After two years of sub-5% growth, slow policy implementation, and ambiguity in policy direction, corporate performances have weakened. Infrastructure, power, and metals and mining companies were more affected. Their bank loans also grew sharply in the past five years, accounting for a significant proportion of industrial bank loans. In turn, rising levels of stressed assets in the banking system is affecting the asset quality and capital needs for banks. The new government's policy directions will set the medium-term growth expectations and long-term structural factors for the economy. In our opinion, structural reforms are essential for India to return to healthier economic
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growth of above 6% on a sustainable basis and stimulate investments. The current Indian parliamentary elections and subsequent policy actions could decide if the sovereign rating on India (unsolicited ratings: BBB-/Negative/A-3) remains investment grade. If we revise our sovereign outlook to stable, those negative outlooks on banks and corporate entities which reflect only the sovereign outlook could also be revised to stable. However, ratings on government-related entities, companies rated above the sovereign, and banks that are capped at the sovereign rating level or benefit from uplift due to government support will likely be downgraded, if we lower the sovereign rating (see table 1).
Table 1
Ratings/Outlooks That Could Be Directly Affected By A Sovereign Rating Action

Sector Sovereign Corporates--Government-related entities Corporates--Ratings above the sovereign or ratings above the transfer and convertibility assessment Banks Ratings that could be affected India NTPC Ltd., NHPC Ltd., Power Grid Corp. of India Ltd., Oil and Natural Gas Corp. Ltd. Tata Consultancy Services Ltd.*, Reliance Industries Ltd. Axis Bank Ltd., Bank of India, HDFC Bank Ltd., ICICI Bank Ltd., IDBI Bank Ltd., Indian Bank, Indian Overseas Bank, Kotak Mahindra Bank, State Bank of India, Syndicate Bank, Union Bank of India Indian Railway Finance Corp., IDFC Limited., Power Finance Corp. Ltd., Indian Infrastructure Finance Co. Ltd., Export-Import Bank of India
Financial institutions
*Only the foreign currency rating on Tata Consultancy Services Ltd. would be affected. The rating and outlook on Infosys Ltd. and Wipro Ltd. are not likely to be affected by sovereign action as these ratings and outlooks are not constrained by those on the sovereign.
India's economic growth prospects and policy environment have a bearing on our ratings on Indian corporate entities and banks. Our ratings already incorporate a gradual improvement in economic growth and the policy environment. In the medium term, any material changes in growth prospects and high-impact policy decisions could further affect the ratings on corporate entities and banks.
A Pivotal Election For India's Sovereign Creditworthiness

We believe that the outcome of the current elections could impact the sovereign rating on India. The new government's policy decisions and their impact on economic growth prospects and fiscal health will have a significant bearing on the government's credit profile. We believe the success of the next government in accomplishing three key points will be important to support its creditworthiness: Improving the policy environment to restore investor confidence and lower funding costs to promote investment. Reducing the vulnerability of government finances to shocks such as commodity price increases. Returning the economy to stronger real GDP growth than that in the past two years. On the other hand, a combination of slower growth and an increasing subsidy burden could undermine sovereign rating support further. Slower economic growth can decelerate government revenue growth increasing fiscal challenges. And as developed economies' growth regains traction, interest rates and commodity prices are likely to
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rebound. India's growth prospects could weaken further if the government reacts by cutting down capital expenditure. This spending is already at relatively modest levels for a fast-growing low-income economy. With India's infrastructure still a significant bottleneck, such an outcome could mean even slower economic growth going forward. Policy drift and uncertainty contributed to slipping economic growth, lower investments, and the continued vulnerability of public finances to commodity price increases in the past few years. The winners of the election and the composition of the next national government remain unclear. There is still little visibility if the next government will enact policies that could reverse the deterioration in credit metrics. The policy orientation is likely to be determined by not just the winning party, but also the shape of the next ruling coalition government. (See "India's Election Is Pivotal For Its Sovereign Creditworthiness," published April 15, 2014, on RatingsDirect on the Global Credit Portal.)
Addressing Key Issues Through Policy Can Yield Greater Gains Over The Medium Term
Strong government measures to address key economic issues will likely have a far greater impact on India's growth trajectory over the next five yearsrather than immediately, in our opinion. Such action could boost India's annual GDP growth by 100 basis points in the medium term, in our view. We believe economic growth will vary based on the political mandate and government's actions to execute reforms. In our base case, we expect GDP growth to touch 6% in 2014-2015. We foresee two growth scenarios, based on broad macroeconomic estimates for India in the medium term.
Scenario 1: GDP growth above 6%

A decisive mandate with a clear lead for one party and its allies, followed by rapid execution of pro-reform policies, should be extremely beneficial for India's economy in the medium term, in our view. In this scenario, our best case, the probability of reforms materializing will increase with the stability of the government, and growth could touch 6.2% in 2014-2015, based on the following assumptions: Normal monsoons support agricultural growth. The global economy recovers as anticipated, with the U.S. growing at 2.8%, large countries in the eurozone pulling themselves out of a two-year recession, and China growing at a slower but still strong rate of more than 7%. Positive impact of debottlenecking/project clearances under way since 2013. We believe that despite a strong mandate at the elections, the upside to growth in 2014-2015 is limited as it takes time to revive the economy. Annual GDP growth could average 6.5%-7% from now until 2018-2019 if India gets a stable government and reforms gain momentum.
Scenario 2: GDP growth below 5%

Conversely, a fractured mandate, with a struggle for leadership, will make it difficult to execute reforms, in our opinion. A fragile political outcome will further delay long-pending and critical reforms as decision-making gets hampered, curbing revival in the investment cycle and derailing growth. We believe that the impact of a weaker government will be less in 2014-2015, but can result in a lower GDP growth of 5.5%. This will still be an improvement over the less
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than 5% growth expected in the current fiscal 2014 (year ended March 31, 2014) as some positive effects of debottlenecking projects that are underway kick in and higher global growth lifts exports. India will revert to less than 5% growth in 2014-2015 if rainfall is less than normal or global recovery falters. We believe the cost of a fragile mandate will be high over the medium term because India may not be able to revert to a higher growth trajectory. The resulting slow policy action and uncertainty can then trap the country in the 5% GDP growth rut.
Certain Key Factors Can Impact Growth

The key issues to growth that need to be addressed are: investment revival; inflation; financial system strength; and the goods and services tax. Restoring business confidence to revive investment will be vital for growth. Greater clarity on land acquisition guidelines (prices and timelines), environmental approvals, and fast-track project clearances will be critical to improve the business climate, build a healthy project pipeline, and boost manufacturing activity. Capital investments and industrial activity have significantly slowed down over the past four to five years (see chart 1). The government started to address some of these constraints in the second half of 2013. It set up a Cabinet Committee for Investment (CCI) to accelerate the decision-making process on major investment projects, many of which had been pending for a long time. However, setting up the CCI was an administrative action; the benefits will only come from effective execution and implementation of the process, which is yet to be fully seen.
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Chart 1
Controlling inflation is important to realize economic gains. Steps to ensure low food inflation and commitment to fiscal restraint will be critical to manage inflation expectations. Better coordination between the government and the Reserve Bank of India can ensure smooth transition to a period of low inflation. In our view, India requires reforms to boost agricultural productivity, increase efficiency of the food supply chain, and rationalize increases in minimum support prices and rural wages. High inflation in the past few years has affected growth. Food prices contribute about half the headline consumer price inflation, making structural agriculture sector reforms a key tool to control inflation. Also, the new government will need to decide if it wants to ratify the recommendations of the Urijit Patel committee, which recommended flexible inflation targeting. Supporting the strength of India's financial system is key too. We estimate that the ratio of stressed assets (gross nonperforming loans plus standard restructured advances) to total loans of Indian banks could increase to about 12% by the end of fiscal 2015 from 10.2% at the end of September 2013. Increasing number of restructured accounts and rising nonperforming loans can affect banks' capitalization and make the financial system weaker. The government will need to capitalize some public sector banks, which account for majority of the bank credit in India to maintain the health of banks and financial institutions and provide them enough capital buffer to support growth and meet regulatory requirements.
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Implementing the Goods and Services Tax is the biggest reform needed in indirect taxation in India. The tax can improve economic efficiencies and, according to the National Council of Applied Economic Research, provide gains to India's GDP of 0.9%-1.7%. The political mix at the center and the states could affect the possibility of this long-pending reform being finally implemented.
Corporates: Policy Inaction Could Add To Stress

We believe government actions supporting higher economic growth, reforms in key sectors, and lower leverage are crucial to improve the credit profiles of Indian corporates. The investment climate for corporates can improve only with greater policy clarity and better overall growth prospects. Improving the framework for land acquisition, environmental clearances, and the tariff-setting mechanism can help corporates and the economy in general. At the same time, more specific and directed policy actions in key sectors like infrastructure, power, metals and mining, and petroleum (oil and gas) can have a high impact on companies in these industries. In our view, the cost of inaction could be significant as some companies in these sectors are already facing stress because of a deteriorating economic and policy environment over the past few years. These sectors together account for over 50% of outstanding gross bank loans to industries. Uncertain policies and regulation, debt-funded expansion, and slower economic growth hit financial performances of Indian companies in the past few years. Government policies and court rulings added to operating uncertainties in some sectors. Sectors such as infrastructure were hit by delays in approvals (for land acquisition, environment clearances, tariff review). Court rulings staying or reversing government actions on allegations of impropriety/ irregularities in the telecom and mining sectors added to uncertainty for companies in these sectors, in our view. In contrast, policies for the telecommunication sector announced earlier this year have reduced some regulatory uncertainty, although implementation will be the key. (See Moderating Regulatory And Competitive Risks Are Positive For India's Top Telecoms, published March 20, 2014). However, similar policy urgency is required for a revival in other sectors, in our view. We look at the likely impact of the new government on few of the key sectors.
Table 2
Key Issues For Indian Corporates In Sectors With High Policy Impact
Policy impact Very high Very high Bank loans as of February 2014 (bil. INR) 4,847 4,047 Bank loans as of February 2009 (bil. INR) 1,193 1,739 Five-year CAGR (%) 32 18
Sector Power Infrastructure
Key Policy Developments to Watch Measures to improve fuel linkages; new tariff mechanism; and reforms of state electricity boards. Government spending; processes to speed up environmental clearances and land acquisition; and tariff review mechanism for public private partnerships. Lifting of mining bans; environmental issues; transparent auction mechanism for natural resources; improving efficiency of Coal India; and procedures for land acquisition. Pace of aligning fuel prices to market rates; gas price revision; and subsidy mechanism.
Metals and mining
High
3,889
1,479
21
Petroleum (oil and gas)
Very high
571
727
(5)
INR--Indian rupee. CAGR--Compounded annual growth rate. Source: Reserve Bank of India and Standard & Poor's.
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Power
Addressing fuel shortages, timely tariff revisions, and improving the credit quality of state electricity boards (which carry out most of intra-state power distribution in the country) are crucial issues for the new government. We note the government has taken some measures to address these issues over the past two to four years, but we expect the majority of the policy impact to be seen in the coming years. We believe improving efficiency at Coal India and implementing a mechanism to pass on higher input costs to customers could improve the profitability of coal-based power producers. The government's proposed hike in gas prices will push up costs for gas-based power companies, although the availability of gas should improve. Continued fuel-supply shortfalls over the past three-to-five years have forced power companies to rely more on fuel imports, pushing their generation costs. Some power projects are therefore either not operational despite being ready, operating at sub-optimal levels, or have been put on hold. Earlier this year, India's central power sector regulator revised tariff-setting norms for 2014-2019 for projects it regulates, which are linked to stricter operational parameters. Change in tariff calculation is likely to lower NTPC's EBITDA by 10%-12%. Similarly, the EBITDA for Power Grid and NHPC could decline by less than 5%. We do not expect these changes to have any rating impact. Moreover, power companies have challenged the regulator's orders in court. In our opinion, deregulation of power tariffs is crucial for improving the credit profiles of power companies in India. The populist measures of governments have led to power tariffs not being raised, forcing power distribution companies to bear the financial burden of providing cheap power. We believe reforms to ensure full recovery of cost and timely subsidy reimbursement by the state government are crucial to improve the financial health of state electricity boards. So far the government has been only offering support packages to these boards when they face high financial stress, without structural reforms to prevent recurrence of such stress.
Infrastructure
We believe problems relating to land acquisitions and environmental clearances for infrastructure projects are the most critical areas that the new government could address. A stronger infrastructure sector could also boost efficiency in the economy. Setting up of independent regulators and having a transparent mechanism for setting tariffs for projects could ease some of the burden for infrastructure companies, in our opinion. On the other hand, delays in resolution of these issues would add to uncertainty in the operating performance of infrastructure companies and hinder further investments, which an "infrastructure deficit" country like India can ill-afford. The absence of an independent regulator and the lack of appropriate policies to encourage private sector participation have negatively affected the sector. Aggressive bidding for projects based on unrealistic forecasts have also resulted in losses for infrastructure companies. These factors have resulted in projects facing difficulties in servicing debt, and have made lenders cautious in lending to new projects. The government passed a land acquisition bill in August 2013, which promises to give "fair" compensation (set at 2x market price for urban land and 4x market price for rural land) for acquired land. However, efficacy of the bill and its
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impact on industries is not certain yet. This is because: (1) the cost of land acquisition may increase manifold from the current rates for acquisition; (2) uncertainty about acquisition prices may remain because of complexities in arriving at the market price; and (3) the timeline for final clearance and "right of way" to complete the projects is still uncertain.
Metals and mining

We believe transparency in policies for environment clearances and land acquisition is critical for large investments required in the metals and mining sector. In our view, implementing a transparent auction process will go a long way in ensuring efficient allocation of natural resources. It will reduce the country's dependence on dominant miners such as Coal India, the country's largest coal producer, and avoid allegations such as of irregular allocation of coal blocks. Improving efficiency at Coal India could also increase coal supply, and reduce production costs for other industries. Delays in land acquisition and environmental clearances led to the cancellation/scaling down of multi-billion-dollar investments plans of ArcelorMittal and Korean steel company POSCO in Odisha. Delays in land acquisition have also slowed down Indian steelmaker Tata Steel Ltd.'s green-field capacity expansion plans. Mining bans by courts and delays in environmental clearances in key states have significantly reduced India's iron ore, coal, and bauxite output, hurting miners. In turn, the ban lowered availability of raw materials for the steel, power, and aluminum industry. Vedanta Resources PLC's EBITDA from non-oil segments fell 25% in the fiscal year ended March 2013, compared with a year earlier, largely due to the ban on iron ore mining. These factors are reflected in our negative outlook on Vedanta. The cancellation of some coal blocks that had been allocated in the past has also limited availability of coal and increased production costs for industries.
Petroleum (Oil & Gas)

The oil and gas sector has a lot to look forward to from the new government. The pace of aligning fuel prices closer to market prices and reducing subsidies is critical for the sector. We believe formalizing the subsidy sharing and payment mechanism, and gradually phasing out subsidies for fuel will lead to more stability in cash flows for companies in this sector. These policy actions can significantly impact the cash flows for oil market companies (OMCs) such as Indian Oil Corp. and the profitability for government-owned upstream companies such as Oil and Natural Gas Corp. Ltd. (ONGC). The policies will also influence investments by private producers such as Reliance Industries Ltd. The government still partly controls prices of most fuels (diesel, kerosene, and liquefied petroleum gas) in the country, even though petroleum prices were deregulated in 2010. OMCs continue to sell fuel at controlled prices (lower than market price). Our rating on government-owned upstream company ONGC factors the negative impact of the company bearing about 40% of the subsidy burden. The existing subsidy sharing mechanism is ad-hoc, without a formal regulatory, contractual, or legislative mechanism. Another crucial decision is regarding the pricing for domestically produced gas. An increase in gas prices is likely to attract more investments into the sector. We estimate that higher gas prices can improve ONGC's EBITDA by about 20% and Reliance Industries Ltd.'s by 5%-7%. Gas prices are currently capped well below import-parity prices. This has discouraged investments in gas exploration and production, even when power plants and other industries are facing a shortage of gas. The government had proposed raising the price to $8.4 per million Btu. from $4.2, effective April 1, 2014. However, the decision has now been kept in abeyance by India's Election Commission following a directive by the Supreme Court.
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Policy Measures Can Affect Banks' Asset Quality And Capitalization

Indian banks face three key challenges as the country heads into elections: (1) asset quality problems; (2) sizable capital needs, especially for public sector banks; and (3) the system's high financing costs. We believe the new government and its policy choices can play a crucial role in directly addressing these issues. We believe policy reforms in key corporate sectors could affect the banking sector's asset quality, given that loans to the corporate account for a large part of gross bank credit (industry 45% and services 23%). In addition, policy actions could have a greater impact on some sectors that have a higher degree of corporate debt restructuring, and loans to many of these sectors have grown rapidly in the past five years. However, in the next 12 months, we expect the asset quality of Indian banks to remain weak, because it will take some time for policy measures to bring about an improvement in stressed loans. In our view, banks' asset quality has weakened because of slow economic growth, elevated interest rates, and high leverage of companies in distressed sectors. Corporate performance can directly impact the asset quality of banks, which have played a major role in funding projects that require heavy capital expenditure in the power, other infrastructure (telecom, road, and ports), metals and mining, construction, and cement segments (see chart 2). Asset quality is under the most strain in the infrastructure (about one-third of stressed cases), metals and mining, and textile sectors, which together contribute over 65% of the debt under restructuring (see chart 3). The other sectors under stress are chemicals, construction, and ship-building. Among the other industries, it is typically the small and midsize companies that made aggressive debt-funded capital expenditure or acquisitions in 2005-2008 that are under stress. These sectors might require strategic measures at the level of the individual company, and further capital investments, which are more likely in a growing economy with improved business climate.
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Chart 2
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Chart 3
Indian public sector banks need sizable capital to support growth and meet Basel III requirements, which are effective from April 1, 2013, and will gradually increase till 2019. Public sector banks' reliance on capital infusion from the government is likely to remain very high. The new government will have to increase the allocation for capital infusions to enable banks to maintain healthy balance sheets, given deteriorating asset quality, and also to support growth. However, it will be essential for the new government to balance this with medium-term fiscal consolidation, given India's sizable fiscal deficit.
Table 3
Bank Credit Growth And Policy Impact On Sectors That Are Relatively Less Affected By Policy Actions
Policy impact Medium Medium Low Key policy developments to watch Import Duty changes on gold; and export requirements. Fuel pricing policy; and excise duty levels. Infrastructure growth depends primarily on government spending and PPP projects. Bank loans as of February 2014 (bil. INR) 697 673 529 Bank loans as of February 2009 (bil. INR) 276 352 198 Five-year CAGR (%) 20 14 22
Sector Gems and jewelry Auto, auto parts, and transport equipment Cement and cement products
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Table 3
Bank Credit Growth And Policy Impact On Sectors That Are Relatively Less Affected By Policy Actions (cont.)
Drugs and pharmaceuticals Sugar Low Medium Drug price control. Minimum Support price; revenue sharing; and cane area reservation. Paper and pulp import duties and wood prices. 491 337 329 291 176 166 11 14 15
Paper and paper products Low
INR--Indian rupee. CAGR--Compounded annual growth rate. Source: Standard & Poor's and Reserve Bank of India.
Related Criteria And Research

Related Research
India Banking Outlook 2014: Little Respite In Sight, Feb. 10, 2014 India's Structural Issues Limit Growth And Effectiveness Of Fiscal Consolidation, Dec. 24, 2013 Sector Review: Asia-Pacific Credit Trends 2014: The Pace Of India's Corporate Recovery Hinges On The Government's Reforms Post Elections, Dec. 10, 2013 Research Update: Rating On India Affirmed At 'BBB-/A-3'; Outlook Remains Negative, Nov. 7, 2013 Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.
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The New Government's Reform Policies Will Be Critical To The Credit Profile Of Indian Corporates And Banks

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Ratings/Outlooks That Could Be Directly Affected By A Sovereign Rating Action

A Pivotal Election For India's Sovereign Creditworthiness

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Scenario 1: GDP growth above 6%

Scenario 2: GDP growth below 5%

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Certain Key Factors Can Impact Growth

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Corporates: Policy Inaction Could Add To Stress

Sector Power Infrastructure

Metals and mining

Petroleum (oil and gas)

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Metals and mining

Petroleum (Oil & Gas)

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Policy Measures Can Affect Banks' Asset Quality And Capitalization

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Paper and paper products Low

Related Criteria And Research

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