If current lower growth and high inflation persist over the medium term, the domestic financial system's capacity to absorb government debt could fall quite considerably," Moody's said in a report.
This could change the structure of government debt, raise debt financing costs and weaken government debt ratios. Such a development is not Moody's base case forecast at this time, but a risk that the agency is monitoring, it said.
India's government debt has mitigated the credit challenges stemming from high fiscal deficits and large government debt burden during a period of slower growth, currency volatility, and rising interest rates, it said.
This is because the government debt is largely owed domestically, in rupees, at relatively low real interest rates and at long tenors. The report titled 'India's Government Debt Structure Mitigates Credit Impact of Macro-Economic Imbalances' said that the government's debt financing profile benefited from an increase in India's domestic savings during previous years of high GDP growth, as well as from capital controls.
Over the last decade, the domestic financial system absorbed longer term government debt at relatively low real interest rates, it said.
In the last three years, as interest rates have increased and growth has slowed, India's interest-growth differential has narrowed, yet it remains more favourable than in many similarly rated countries, and is a factor underpinning government debt sustainability, it added.
"As macro-economic imbalances have heightened in the last few years, the currency, maturity and interest rate structure of government debt has supported India's sovereign credit profile and Baa3 rating," it said.