Fitch Affirms Rural Electrification Corp at BBB; Outlook Stable

Fitch Ratings-Hong Kong : Fitch Ratings has affirmed Rural Electrification Corporation Limited's (REC) Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) at 'BBB-'. The Outlook is Stable. A full list of rating actions is at the end of this commentary.

KEY RATING DRIVERS

REC's ratings are equalised with those of the Indian sovereign (BBB-/Stable). This reflects its public-sector status, ownership by the government of India, and strong strategic ties with the government, which result in a strong likelihood of extraordinary government support being provided if needed. REC is therefore classified as a credit-linked public-sector entity under Fitch's criteria.

REC is one of two public financial institutions that provide funds exclusively to the Indian power sector and the second-largest lender to the sector. The government has appointed REC as the sole central agency to implement two nationwide power reform projects aimed at increasing electricity coverage in rural areas and subsidising electricity distribution projects.

The Indian government owns 60.64% of REC and has provided support by allowing REC to issue tax-free bonds and 54EC Capital Gains Tax Exemption Bonds, and raise foreign commercial borrowing of up to 75% of its net worth without prior government approval. Fitch expects REC to continue to receive government support.

The government controls REC through its board, and the Ministry of Power signs yearly memorandums of understanding with REC to set annual operational and financial performance targets, which it reviews on a quarterly basis. The Comptroller and Auditor General of India appoints auditors for REC on an annual basis.

REC's capital adequacy ratio was 20.38% at the end of the financial year to March 2016 (FYE16), higher than the regulatory requirement of 15%. REC's healthy profitability is underpinned by its comfortable interest spread and lean operating cost structure. Fitch expects REC's net profit to increase by 15%-20% a year during FY17-FY19, driven by our forecast of 10%-15% annual growth in outstanding loans and the company's ability to maintain its interest spread at the current level.

At FYE16, 82% of REC's outstanding loan portfolio was extended to state power utilities, which have weak credit profiles. Nevertheless, the financial performances of state power utilities have improved in the past two years because the government has raised electricity tariffs and launched a financial restructuring package for them.

Concentration risk arises from REC's exposure to the power sector. However, this risk is mitigated by the guarantees from state governments for part of the loans extended to state utilities, the use of escrow accounts and the critical role that REC plays in providing infrastructure financing to its borrowers.

RATING SENSITIVITIES

Positive rating action would stem from a similar change in the ratings of the sovereign in conjunction with continued strong linkage with the state.

Significant changes to REC's legal status that would lead to a dilution of control by the government or deterioration in the likelihood or timeliness of support by the sovereign may result in the ratings being notched down from the sovereign's ratings. Further dilution in the state's shareholding to less than 51% would lead Fitch to rate the company on a standalone basis (from the top down), which may result in a downgrade.

The full list of rating actions follows:

IRFC

Long-Term Foreign-Currency IDR affirmed at 'BBB-'; Outlook Stable
Long-Term Local-Currency IDR affirmed at 'BBB-'; Outlook Stable
CHF200m 3.5% senior unsecured notes due 2017 affirmed at 'BBB-'