5 reasons why India can see a rating upgrade

With oil prices under check, at least for now, measures to stem rupee’s fall against the US dollar and curbing gold imports that contributed in containing the current account deficit (CAD) over the past few months, India seems to be in a sweet spot with economists expecting a outlook upgrade by credit rating agencies.

In his latest report titled ‘India Economic Watch’, Indranil Sen Gupta, India economist at Bank of America Merrill Lynch (BofA–ML) suggests that though the April 2012 outlook downgrade by Standard & Poors (S&P) was unwarranted, he now expects rating agencies to upgrade their outlook for India sooner rather than later.

Here are five reasons on why Bank of America–Merrill Lynch thinks a rating upgrade could be a possibility:

First, growth is bottoming out far higher than Brazil or Russia, allaying concerns about falling potential. By 2018, he believes that the growth should rebound to 7.5% especially if the Narendra Modi government steps up infrastructure investment.

“We grow more confident of our call that the slowdown in growth has been largely driven by the global downcycle rather than domestic structural issues. In fact, growth is bottoming out far higher than Brazil or Russia. This is why we always found concern that India would fall out of BRICs in 2012 to be baseless. In fact, we believe India should emerge as the second-largest EM after China by 2019,” the report says.

Second, the drivers of inflation are fading and with the rainfall deficit narrowing, a spike in inflation will be short lived.

“In any case, we think that inflation is peaking. Although we have higher–than–consensus inflation forecasts (8.5% in August, 7.8% consensus; 8% in July, 7.4% consensus, 8% actual), this is driven by a temporary spike in tomato prices on poor rains. This will reverse with the seasonal rainfall deficit down to 11% of normal. This leads us to expect the first rate cut by the Reserve Bank of India (RBI) in February,” the report suggests.

Third, risks from twin deficits have proven to be overdone, BofA-ML believes; and expects the CAD to compress to 1.7% of GDP in FY15 from 4.8% of GDP in FY13, partly on gold import curbs.

“While we expect the current account deficit to expand to 2.4% next year after the inevitable removal of gold import restrictions, this would be still in line with our optimal estimate of about 2.4%. This supports our view that the current account deficit was statistically overestimated in FY13,” Gupta says in the report.

Fourth, Governor Raghuram Rajan is recouping FX reserves, like Governors Jalan and Reddy, to stabilize Rs 58 – 62/USD. This reverses the policy mistake of unsustainable appreciation in 2H09-1H11 that ended in ~50% depreciation.

Finally, this should allow the RBI to cut rates from February onwards even if the US Federal Reserve hikes rates.

“We believe that the RBI can cut rates even if the Fed hikes from September 2015, with Governor Rajan recouping FX reserves. We see it cutting policy rates by 75 – 100 bps (basis points) starting in February, even if Fed Chair Janet Yellen hikes from September 2015, as our US economists expect. In our view, RBI and Fed monetary policy is no longer synchronous,” the report says.