Reform measures undertaken by India will broaden its tax base and help the government cut down on debt, but high stressed assets in the banking sector pose contingent liability risks, Moody's said on Thursday.
It said effective implementation of key fiscal and banking sector reforms will address India's core credit challenges, and even though goods and services tax (GST) will have a muted short-term impact, but its benefits will accrue over the medium term.
"India is implementing a number of wide-ranging reforms and measures that, if effective, will broaden the tax base and anchor fiscal consolidation. Under such outcomes, the government's debt burden, a key constraint on India's credit profile, would ease gradually," the US-based rating agency said.
Moody's has a 'Baa3' rating on India with a positive outlook. Baa3 rating implies lowest investment grade — just a notch above 'junk' status.
It, however, cautioned that high non-performing assets (NPAs) pose contingent liability risks, limit private investment recovery.
Recent government measures to address NPAs and the promulgation of the Insolvency and Bankruptcy Code 2016 are "credit positive" for the sovereign, as they provide a clearer framework for NPA resolution, it added.
"However, outstanding structural issues remain within public sector undertakings (PSUs). Until NPAs are resolved, banks' ability to finance potential investment will be constrained," Moody's said.
Indian banks are saddled with NPA of over Rs 8 lakh crore.
Several structural impediments to NPA resolution remain, including the operating environment in key stressed sectors, challenging, particularly in the power, steel and construction sectors, Moody's said.
"Weak performance and profitability continue to weigh on companies' ability to service loans and deleverage balance sheets. Second, the market value of stressed assets is much lower than currently reflected on banks' balance sheets," it said.
The successful resolution, either through debt relief or asset sale, will require banks to take a significant loss after writing down the value of these assets to market value and PSU banks' weak capital levels limit their ability to take such write-downs.
"To do so, would require simultaneous capital injections from the government, which the government has indicated it is not prepared to do at this stage," Moody's said.
With regard to GST, Moody's said its long-term benefits will include higher productivity growth due to efficiency gains in business operations, greater investment as inter-state tax barriers are reduced, enhanced tax compliance and an expanded revenue base.
It said over the medium term, the GST will contribute to productivity gains and higher GDP growth by improving the ease of doing business, and enhance India's attractiveness as a foreign investment destination.
"It will also support higher government revenue generation through improved tax compliance and administration. Both will be positive for India's credit profile, which is constrained by a relatively low revenue base," it said.
At 21.9 per cent of GDP in 2016, the government revenues were lower than the 26.1 per cent median for Moody's 'Baa'- rated sovereigns.
Further, demonetisation, financial inclusion efforts will help broaden the tax base, while expenditure reforms enhance spending efficiency.
As of May 2017, the stock of currency in public circulation had recovered to about Rs 14 lakh crore from a low of Rs 7.8 lakh crore in December 2016 immediately following demonetisation. Remonetisation has improved liquidity conditions and helped stabilise the economy.
"Over time, demonetisation will help strengthen India's institutional and fiscal framework, by helping to reduce tax avoidance and corruption," Moody's said.
It further said expenditure reforms will increase efficiency and fiscal flexibility by reducing leakage.
One of India's key credit constraints is its very high debt burden relative to its sovereign rating peer group.
"Although the level of general government debt declined to 67.5 per cent of GDP in 2016 from 84.7 per cent in 2003, it remains significantly higher, both as a percentage of GDP and annual revenues, than for most similarly rated sovereigns," Moody's said.