NEW DELHI: India's economic star is fading fast as a spluttering economy and reform paralysis put the country's prized investment-grade rating at risk and spook foreign investors.
The latest bad news came Wednesday when Standard & Poor's cut India's credit outlook to negative, saying the nation's investment grade rating faced a one-in-three chance of being downgraded to junk.
It isolated “political gridlock” as a key factor behind the warning.
But with Premier Manmohan Singh's unruly coalition hobbled by graft scandals and infighting, analysts are deeply sceptical the Congress-led government can set the economy to rights.
Nobody should “hold their breath for a born-again government,” said Rajeev Malik, economist at CLSA Asia-Pacific Markets.
“Coming from the most conservative of the rating agencies, it's a wake-up call for the government to do something meaningful soon,” he said of the S&P announcement.
But given government “policy paralysis”, the situation “is unlikely to change substantially”, he added.
In 2007 S&P raised India's credit rating to BBB-, the lowest investment grade, a landmark that allowed the country to tap new sources of capital by clearing the way for global funds to invest in New Delhi's debt.
But now “there's at least a one-in-three chance we may move the rating down in the next 24 months” if “growth prospects diminish” or reforms remain stalled, said S&P credit analyst Takahira Ogawa.
Growth in Asian rival China is also slowing but ratings agencies have kept their outlook on Beijing's A ratings positive thanks to its strong fiscal position.
Investors have been waiting for India to reduce the role of the state, ease red tape on business and open its doors wider to foreign investment.
But elections are due within two years and Kotak Mahindra Bank economist Indranil Pan said that “given the political scenario, any big-ticket reforms will be difficult”.
Stubborn inflation is also likely to keep interest rates high, weighing on growth.
A sovereign credit downgrade to junk status – which means a higher default risk – would force India to pay higher interest rates on international borrowings and discourage foreign investment urgently needed to upgrade its shabby roads, ports and other infrastructure.
Until recently, the country of 1.2 billion people was a must-have in foreign investor portfolios. But interest has waned with investors jittery about graft and policy U-turns, as well as infrastructure bottlenecks and slowing growth.
The economy grew by 6.9 per cent in the last fiscal year, the second slowest pace in a decade, while the fiscal deficit was a record 5.9 per cent of gross domestic product and the trade deficit was up by 57 per cent.
New plans to impose capital gains tax liabilities for foreign firms have also disheartened investors.
The new US ambassador to India, Nancy Powell, told a business audience in New Delhi on Friday curbs on foreign investment and other policies had caused “significant concern and dampen sentiment about India's investment climate”.
Ratings agency Moody's has kept its outlook stable for India.
But Moody's Analytics economist Glenn Levine said the government does not have the “leaders to push through tough-minded reforms needed to drive the next wave of growth”.
Even before the S&P warning, foreign portfolio investment was showing a net outflow. Direct investment is also sluggish while traders expect the rupee to hit new lifetime lows against the dollar in coming months.
Some see a return to junk status as inevitable.
“India has no light on the horizon,” Cyrus Daruwala, managing director at IDC Financial Insights, told CNBC.
Finance Minister Pranab Mukherjee says the government is “confident of overcoming difficulties” and “there is no need for panic”.
At the same time, he has repeatedly said he should not be blamed if he is unable to boost the economy, citing “the political situation on the ground”.