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Is India moving closer to a ratings downgrade?

Indranil Mukherjee | AFP | Getty Images

The plunging rupee has intensified concerns over India's dreary economy and raised the question whether Asia's third largest sovereign credit rating may be downgraded to "junk" status in the coming months.

Ratings agency Standard and Poor's (S&P), which cut its outlook on the country's BBB- rating to negative last year, told CNBC it continues to see a one-in-three chance of a downgrade in the next 1-2 years.

(Read more: Why this unloved market is due for a bounce)

However, if weak sentiment causes business financing conditions and investment growth to deteriorate further - putting the country's longer-term growth prospects at risk - the likelihood of a downgrade will increase, S&P said.

"India's long term growth prospects could weaken on a sustained basis, with negative implications for the sovereign credit fundamentals," Kim Eng Tan, senior director, Asia-Pacific Sovereign Ratings, S&P told CNBC this week.

A downgrade to junk status would result in higher overseas borrowing costs for Indian corporates and hurt the country's ability to attract foreign investment.

"It is, however, too early now to tell if this scenario will come to pass. This will be largely dependent on policymakers' reactions to these latest developments," Tan said.

(Read more: What's really holding back growth in India)

India's economy has experienced a deepening slowdown over the recent quarters, expanding just 4.8 percent in the January-March period. Growth is expected to remain under pressure in the coming months given tighter liquidity conditions and weakening capital investment and consumption.

On top of a deceleration in growth, the economy faces a rapidly decelerating currency, which hit a record low of 64.13 against the U.S. dollar on Tuesday. The falling rupee is negative for India's economy because it stokes inflation and raises the country's import bill, putting further pressure on the current account position deficit.

(Read more: Distant bright spot for India's battered rupee?)

So far, the government's response to bolster the weakening rupee through tightening liquidity and restricting capital outflows have failed to instill confidence in investors, who view the measures as a mere short-term fix.

"We view the capital outflows and depreciating rupee as an indication of weakening investor confidence in India. Measures introduced by the government to restrict capital outflows have also increased uncertainties among investors both foreign and domestic," said Tan.

By CNBC's Ansuya Harjani; Follow her on Twitter @Ansuya_H

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