Sunday, September 30, 2012

Cliff effect of a possible downgrade of India's credit

In the month of June, 2012 global rating agency Standard and Poor's (S&P) threatened to downgrade India's sovereign credit rating to ‘speculative' from the lowest notch of ‘investment' grade. The report containing the threat was sensationally titled ‘Will India be the first BRIC fallen angel ?' Predictably, this warning was a red rag to bullish ministers in Indian government and they characterised the report as whimsical, tendentious and mischievous. It was argued that Indian economy was the second fastest growing among large countries (next only to China) and that India was capable of springing pleasant surprises.

Earlier in April, 2012, Standard & Poor's scaled down India's credit rating outlook from ‘stable' to ‘negative' with a warning of a downgrade if there is no improvement in the fiscal situation and political climate.

This chronology of events shows that deterioration in the state of Indian economy as reflected in economic data released during the April – June quarter was quite palpable. If India’s rating is downgraded (from the present BBB-) to BB+ or any rating below (also known as ‘junk’ rating), the economic consequences will be horrendous.

Many otherwise knowledgeable people criticize rating agencies for rating countries like Spain and Italy which are reeling under severe economic pain, higher than India. The reason for this apparent paradox is the disparity in their per-capita incomes. Whereas Spain and Italy have per-capita annual incomes of $ 31,550 and $ 31,090 respectively, India’s is only $ 3,560 according to World Bank’s assessment for the year 2010 under ‘Purchasing Power Parity’ principle. India is ranked 153 out of 215 nations. It is logical to assume that an economy with higher per-capita income can withstand economic shocks better. Spain is rated BBB+ and so is Italy.

If we look at the methodology adopted by S & P to award sovereign ratings, we will realize how shockingly imminent our downgrade is. S & P factors in political, economic, external, fiscal and monetary profiles of the country. Crucial determinants for political score are dynamics of policymaking and transparency of institutions. Who can deny that these are our Achilles’ heel now? It is interesting to note that when S & P downgraded USA from AAA to AA+ in August, 2011, it presented the following reason:

“the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.”

Economic score is determined, inter alia, by assessing income levels, growth prospects and volatility. India’s performance is poor on income levels; volatility is unfavourably high on account of continued dependence on monsoon and uncertain availability of infrastructural facilities like power.

Status of currency and external indebtedness are taken into consideration for external score whereas sustainability of fiscal deficit determines fiscal score. India’s fiscal position continues to deteriorate on account of government’s inability to optimize management of subsidies owing to political compulsions. Monetary score varies with credible monetary measures to tackle inflation. So whichever way you look, the chances for a downgrade in our rating are uncomfortably high.

Why Cliff Effect? : In economics, if the effect of an action is disproportionately high either positively or negatively, the effect is christened as “cliff effect”. If India is downgraded from BBB- to BB+, the consequential adverse impact will be immense. Though downgrade by a notch is normally not a significant development, fall from investment grade to speculative grade is considered as calamitously precipitous (and hence the cliff effect).

Many international investors detest funding speculative investments. Even those who are ready to lend will charge higher rates of interest. Generally, corporates will not get a better rating than the country’s sovereign rating. Therefore, even major Indian banks will face higher interest burden for funds sourced abroad. For instance, as on 31st March, 2012, SBI had deposits worth Rs.61,433 crore in its foreign branches and borrowings outside India equivalent to Rs.78,127 crore. SBI had also raised capital funds abroad in the form of innovative perpetual debt instruments equivalent to Rs.3,179 crore. Interest rates on these funds raised abroad will go up if India’s rating is junked. ICICI Bank’s deposits in foreign branches on 31st March, 2012 was equivalent to Rs.13,128 crore and borrowings outside India Rs.84,509 crore. Indian banks and other corporate will face two consequences: 1)Raising funds abroad will become more difficult and 2)whatever funds are available will attract higher interest costs.

Sharp differences in credit qualities of investment-grade and speculative-grade sovereigns are brought out by the following observation of S & P: “An average of 1% of investment-grade sovereigns have defaulted on their foreign-currency debt within 15 years, compared with 30% of those in the speculative-grade category. All sovereigns that have defaulted since 1975 had speculative-grade ratings at least one year before default.” These facts are chilling and one hopes that Government of India will do all it can to stave off a ratings downgrade instead of shooting the messenger (rating agency) when it is too late.

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