Standard & Poor's cut India's credit rating outlook on Wednesday to negative from stable, reflecting the toll that hefty fiscal and current account deficits and political paralysis are exacting on Asia's third-largest economy.
The negative outlook jeopardises India's long-term rating of BBB-, the lowest investment grade rating, and sent Indian bonds, stocks and the rupee lower.
India has no sovereign global bond issues, but a downgrade would increase borrowing costs for local companies and make it harder to refinance debt, and may have a further chilling effect on foreign investor confidence in the country in general.
"The outlook revision reflects our view of at least a one-in-three likelihood of a downgrade if the external position continues to deteriorate, growth prospects diminish, or progress on fiscal reforms remains slow in a weakened political setting," S&P credit analyst Takahira Ogawa said in a note.
The high cost of oil along with soaring gold imports drove India's current account deficit to its widest in eight years in the 2011/12 fiscal year which ended in March, according to government forecasts, or 4 percent of gross domestic product (GDP), up from 2.6 percent in the previous fiscal year.
Meanwhile, India's fiscal deficit swelled to about 5.9 percent of GDP in the fiscal year that ended in March, far above the government's 4.6 percent target.
Many economists believe New Delhi will have a tough time hitting its target of cutting the deficit this fiscal year to 5.1 percent of GDP, given a hefty subsidy burden and a weakened government that has failed to push through significant reforms.
The deficit burden is exacerbated by a sharp slowdown in growth, with the Indian economy expanding at just 6.1 percent in the December quarter, the weakest in nearly three years.
S&P reaffirmed its BBB- long term rating on India. Moody's rating agency has a Baa3 rating on the country, while Fitch is at BBB-. All are just one notch above non-investment grade or "junk" status. Moody's in December issued a stable outlook for India.
"The writing was on the wall given the country's weakening debt profile and sluggish investment climate," said Radhika Rao, an economist at Forecast Pte in Singapore.
"With the coveted investment grade now at risk, one can only hope this acts as a wake-up call for the government," Rao said.
Foreign investors have become net sellers in Indian debt and equity markets this month, although for the year-to-date inflows remain positive.
General elections looming in 2014 are expected to limit the prospects for significant reforms that would improve the investment climate and India's fiscal position.
(For a graphic on India's budget, click link.reuters.com/cyt96s)
(For a graphic on balance of payment, current account, click: link.reuters.com/jyj47s)
"There is no need for panic," Finance Minister Pranab Mukherjee told reporters after S&P's announcement. "The situation may be difficult, but we will be surely able to overcome (it)."
Mukherjee has vowed to raise diesel prices "soon" but resistance from populist parties in the coalition government means a decision has long been put off.
He said on Wednesday that India was likely to pass some financial reforms in the current session of parliament, which started on Monday.
But with the next few weeks of debate likely to be dominated by the finance bill, reforms are expected to be limited in the near-term.
An executive decision to raise the ownership limit for foreign airlines to 49 percent in domestic carriers is expected in May, although it has been delayed several times. The opposition has opposed a bill to allow more foreign investment in the insurance industry but Mukherjee says it will be passed by the summer.
(Also read: Experts react to rating agency's move to cut India outlook, click here)
BIG SUBSIDY BILL
India imports most of its oil and then subsidises fuel to consumers, a double exposure to global energy prices that led to a balance of payments crisis in 1991.
Meanwhile, a series of policy moves, including one that would retroactively tax indirect investments and another that targets tax havens used by foreign portfolio investors, has further soured already-weak investor sentiment.
India's 10-year bond yield rose 4 basis points to 8.63 percent soon after the S&P move, while the ailing rupee weakened and stocks fell, although markets recovered some of their losses.
Spreads on Indian bank bonds widened by 5-10 basis points after the outlook revision, with ICICI Bank's 2020 issue trading at 400 bps above U.S. Treasuries.
"This action should at least now push the government into action by announcing new reforms or look to implement the already announced ones. Until then, we will see markets, including the currency, remaining under pressure," said Arun Singh, senior economist at Dun & Bradstreet in Mumbai.