India's growth over the coming years will be challenged by lacklustre global demand, high corporate leverage and impaired credit supply, Moody's Investors Service said on Tuesday.
The passage of land acquisition and Goods and Services Tax (GST) Bill has stalled, which illustrates that "political friction will keep the reform process uneven and slow-moving," it said.
"Domestic political developments amid an uncertain global environment in 2016 are likely to keep the market sentiment volatile," Moody's said in 'Inside India' report.
It however expects India's medium-term potential to be supported by the gradual implementation of further targeted policy reforms, improving the business environment, state of infrastructure and productivity growth.
Moody's said passage of bankruptcy law and NPA recognition in banks would be credit positive, if it leads to improved bank capitalisation levels, renewed loan growth and robust risk processes.
"Growth will be adversely affected by high leverage of some large corporates that will also weigh on credit demand, while impaired assets in the banking system will negatively affect credit supply," Moody's Senior VP and Manager Marie Diron said.
Moody's said lower nominal growth affects government revenues, suggesting that the government will have to rein in spending to meet its deficit target.
"This will leave little room for fiscal measures to support investment or offset potential negative external or domestic shocks, which continue to pose downside risks to our forecast of around 7.5 per cent real GDP growth in the next two years," it added.
It said Britain's exit from the European Union would have only "limited impact" on India's financial markets as exports to the UK and the rest of the European Union account for 0.4 per cent and 1.7 per cent of the GDP respectively.
"India is not significantly exposed to a potential sharp fall in capital flows to emerging markets," it said, adding only a very large and prolonged slump in imports from these regions would markedly dent India's exports.
Moody's expects macroeconomic policies to contribute to sustained robust growth, and thereby allow for gradual fiscal consolidation.
The US-based agency has a 'Baa3' rating on India with a positive outlook.
Moody's said the positive outlook on the sovereign credit rating incorporates the implementation of policies, as well as measures to improve fiscal, inflation and external metrics.
The move towards inflation targeting and improved monetary policy credibility contributes to maintaining inflation at moderate levels.
"We assume that the impact on inflation of the significant increases in public sector wages and pensions as most of the Pay Commission's recommendations are implemented, will be limited in size and short-lived. Meanwhile, ongoing fiscal consolidation contributes to more moderate inflation, which will help contain risk premia and thereby financing costs," Moody's said.
It said India's low income levels and potential to improve productivity offer opportunities to 'catch-up' GDP growth at levels higher than similarly rated peers over the longer term.
It said continued high corporate leverage, low nominal domestic growth and lack of corporate pricing power, will hold back investment activity for at least several quarters.
"Despite an accommodative monetary policy stance, we expect growth in domestic fixed asset investment to remain lacklustre," it said.
Outlining India's growth challenges, it said lacklustre global demand constrains exports, which account for around 20 per cent of GDP. Also two years of drought have dampened consumption, with weak rural incomes and higher food inflation lowering purchasing power.
Lastly, it said, high leverage for some large corporates weighs on credit demand while impaired assets in the banking system negatively affect credit supply.
Moody's said corporate deleveraging is likely to take time as cash flows are impacted by weak global demand, and, for the commodity producing and processing sectors, low prices weigh on revenues and profits.
Government's policy response will likely have mixed results. Imposition of minimum import prices for steel, for example, will be mildly positive for the sector.
By contrast, expensive telecom auctions in 2016 will contribute to a further increase in leverage in the telecom sector, which is yet to digest last year's auction outcome, Moody's said.