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New Delhi/Mumbai: India suffered an unexpected reverse after global credit rating agency Standard and Poor’s Ratings Services (S&P) on Friday warned there was a one-in-three chance of the country’s sovereign rating being downgraded to junk status in the next 12 months.

If indeed the rating agency does act on its grim warning, not only will it raise the overseas cost of borrowing for Indian companies, it will also adversely impact the country’s image as an attractive foreign investment destination.

While S&P acknowledged recent policy initiatives and fiscal consolidation measures undertaken by the government, the rating agency maintained that it may downgrade India if it perceived any reversal of the initiatives or worsening outlook on the external sector. “Such a conclusion could come from anaemic investment growth, reversals on diesel or other subsidy measures, or inability to increase electricity supply to meet increasing demand. Similarly, if India’s general government fiscal or current account deficits worsen contrary to our expectations, we may lower the ratings," it warned.

S&P, which cut India’s rating outlook to negative from stable in April last year, warned for the first time in October that the country has a one-in-three likelihood of a downgrade of its sovereign rating within the next 24 months.

However, for the time being, S&P reaffirmed its BBB- long-term sovereign rating, the lowest investment grade, adding that for a stable outlook, the Indian government has to carry through with its plans to unleash public and private investments such as by enacting the land acquisition Bill, implement the goods and services tax, and further trim fuel and fertilizer subsidies. “We believe these measures could restore India’s robust growth, and thereby ameliorate its public debt trajectory," it said.

S&P’s credit analyst Takahira Ogawa said there has been some easing of pressure towards the ratings downgrade compared with a year ago.

“But unless we see significant improvement in the reform drive, reversal of outlook to stable from negative is difficult," he said on a conference call.

Raghuram Rajan, chief economic adviser in the finance ministry, expressed his disappointment at the development.

“International institutional investors who have invested over $17 billion into India so far this year do seem to have a different view," he said in a release. “The government will continue to do what is necessary to keep India on a stable, sustainable, and strengthening growth path."

Current political uncertainty and an impending general election seem to have significantly impacted S&P’s call on India. Ogawa said that while it was difficult to say who would win the national election, the next government was likely to be headed by another coalition.

“Whether the next government has weak or strong fundamentals and will be able to push for structural reforms will be important to see," he added.

Ogawa said S&P does not expect any significant improvement in structural reforms that require legislative sanction.

“Given the political cycle—with the next elections to be held by May 2014—and the current political gridlock, we expect only modest progress in fiscal and public sector reforms. For example, reforms of fertilizer subsidies, introduction of a nationwide goods and services tax, easing of restrictions on foreign ownership in various sectors such as banking and insurance sectors, will take time, in our view," S&P said in the statement.

While the government has partially deregulated domestic diesel prices by allowing state-owned oil companies to increase prices by 0.50 per month, S&P said the signals on its subsidy policies are mixed, criticizing the proposed food security Bill, holding that it could double the size of the food subsidy bill to about 1.6% of gross domestic product (GDP).

The risks highlighted by the rating agency such as political uncertainty and the inability to draw big-ticket investments will be keenly watched by foreign investors, said Ananth Narayan, regional head of global markets and co-head of wholesale banking (South Asia) at Standard Chartered Bank.

S&P’s assessment of the current macroeconomic environment was realistic, said Diwakar Gupta, managing director and chief finance officer at State Bank of India.

“Any improvement in the situation depends on implementing good governance and removing impediments. The government has been taking steps to revive investments and bring in fiscal consolidation. We are hopeful that the move will sustain," he added.

The rating agency does not expect the Union government to meet its fiscal deficit target of 4.8% of GDP in the current fiscal year.

“It depends on global commodity prices and election-related spending, among other things," it said.

S&P expects the combined fiscal deficit of the Union and state governments to remain at about 7% of GDP in 2013-14 before starting a gradual decline in the medium term.

“If we were to add losses at state electricity boards, the figure would exceed 9% of GDP," it added.

Even though inflation had moderated, the threat of a fresh round of price increases persists.

“Notwithstanding recent policy rate cuts, we believe the Reserve Bank of India (the central bank) will keep CPI (Consumer Price Index) inflation in the single digits. Some of the recent price increases are supply side in nature and require fiscal measures," it added.

While April inflation based on the Wholesale Price Index decelerated to a three-and-a-half year low of 4.89% from 5.96% a month ago, retail inflation slowed to 9.39% from 10.39%.

S&P expects India’s economic growth to recover to 6% in 2013-14 from a decade’s low of 5% last year and the current account deficit to moderate, while staying above 4% during the year.

It also expects India’s real GDP per capita growth to rebound to 4.6% in the current fiscal year ending 31 March 2014, from 3.6% a year ago. “These are higher than those of most of its peers but substantially lower than about 6% on average over the five years up to the fiscal year ended March 2012," it said.

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