New Delhi: Moody's Investors Service on Tuesday cautioned that a prolonged worsening in asset quality at PSU banks is the main threat to India's sovereign credit profile and made a case for the government bearing some of the cost of cleaning up bank balancesheets.


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"The main threat to the sovereign credit profile would be via a significant and prolonged worsening in asset quality at state-owned banks, beyond the recognition of bad loans currently under way, that causes contingent liabilities to crystallise on the government's balancesheet," it said.


High corporate leverage poses systemic risks if adverse growth and financial conditions pressure borrowers' repayment capacity, Moody's said, adding that the capital infusion by the government in PSU banks is likely to be larger than budgeted.


"When the borrowing is largely from the domestic banking system, governments could bear some of the costs of cleaning up bank balancesheets," it suggested.


As for the elevated level of government debt, Moody's in its report on Asia-Pacific sovereigns said it acts as a sovereign credit constraint for India and added that India has little fiscal space to stimulate economy if the growth momentum slows.


The rating agency is of the view that it will take a strong economic growth for the overall debt burden to fall. Actions by policymakers are likely to enhance India's medium-term economic strength and, in turn, the sovereign's financial strength in coming years.


"On the flip side, India's government has little fiscal space to stimulate the economy if momentum were to slow. In the absence of robust growth, India's debt could start to climb, and ultimately put pressure on the government's ability to fund itself," it said.


In India, it said, although the level of and growth in debt are modest, non-performing corporate assets put pressure on state-owned bank balance sheets.


It forecast India's debt to GDP ratio to fall to 65.7 per cent in 2016, from 67.5 per cent in 2015, but is still well above the median for Baa-rated sovereigns. This reflects the government's narrow revenue base.


Moody's said annual gross financing requirements are in line with Baa-peers: robust private savings, capital controls and bank liquidity requirements enable the government to issue debt with relatively long average maturity and moderate interest rates.


"This set of conditions allows India to sustain a debt burden that is significantly higher than its rating peers," it noted, adding that India's budget gap is expected to remain sizable -- at around 6 per cent of GDP in 2016, including state deficits.