This is part 12 of a series of articles on the impact of COVID-19 in the banking and insurance sector with inputs from leading BFSI experts of the Manipal Global Academy of BFSI. Read part 1, part 2, part 3, part 4, part 5, part 6, part 7, part 8, part 9, part 10 and part 11 here. This article was written by Rajan Sundaram, a faculty member at Manipal Global Academy of BFSI.
On April 29, 2020, the Japanese security firm Nomura said India’s sovereign rating is vulnerable to a downgrade. Nomura’s views follow rating agency Fitch’s warning that India’s deterioration in fiscal outlook may put pressure on the sovereign rating. India’s sovereign rating has largely remained stable over the last several years, with changes limited to outlook.
Even at the peak of the global financial crisis, it was only the global rating agency Standard & Poor (S&P) that changed the country’s outlook from stable to negative, only to restore the outlook to stable within a year, despite elevated fiscal risks (read higher debt to GDP ratio), as it expected India’s growth prospects to improve.
Moody’s surprised the markets by upgrading India’s rating in November, 2017, but then Moody’s has always been an outlier. However, even Moody’s had changed India’s outlook to ‘negative’ in November 2019.
How do credit rating agencies assign ratings and why is it important for a country to have a high sovereign rating?
Assigning credit rating to a country may be compared to the due diligence done by banks on borrowers to find out whether they have the ability and willingness to repay. Credit ratings express a credit rating agency’s opinion about the ability and willingness of any issuer – governments, financial institutions, corporations, insurance companies and structured finance – to meet its financial obligations in full and on time. While there are more than 70 agencies around the world, the Big Three — Standard & Poor’s, Fitch and Moody’s — dominate, controlling 91% of the global market.
Though there are slight differences in the rating scales that the big agencies use, all fall into two broad categories. These are an investment and speculative grades. The investment grades range from AAA, very high credit quality, to BBB-, moderate credit risk. There are eight other notches between AAA and BBB-.
When a country wants to raise money through foreign investments, Credit Rating agencies conduct an independent assessment of the country’s economic and political scenario and arrive at a sovereign rating. India’s current BBB- status is just one step away from junk and assures foreign investors that they can feel safe about investing in Indian bonds or businesses. Any downgrade is hence likely to upset the apple cart and hence to be avoided at any cost.
Why talk about downgrade now?
Nomura blamed the Indian government’s deteriorating debt dynamics and a poor fiscal track record coupled with businesses and the broader economy ravaged by the nationwide lockdown, now in its fifth week, for its warning. The views follow Fitch Ratings’ warning on April 28th where it said that deterioration in India’s fiscal outlook as a result of lower growth could put pressure on its sovereign rating. Last week, Fitch had revised lower its forecast for India’s FY21 growth to 0.8%.
With the economies of most of the countries being ravaged by COVID-19, many countries including the USA have unravelled plans to expand their fiscal space to help the individuals and businesses (particularly small ones) battered by the virus. In India too, we hear differing views from economists. While most of them feel that this is not the time for countries to bother about fiscal deficits, there have also been contrarian views suggesting that India should stick to its fiscal deficit target.
Even before COVID-19 struck, India’s fiscal affairs have not been rosy. The current government had been often accused of moving its expenses to the next fiscal, thus playing with its fiscal deficit numbers. Earlier this week, Fitch Ratings had cautioned that India’s sovereign rating could come under pressure if there is further deterioration in fiscal outlook as a result of lower growth or fiscal easing. The statement came amid reports of further fiscal easing to support growth over the extended coronavirus lockdown.
Given the sudden shock to the economy in the backdrop of the pandemic, the government may temporarily suspend the Fiscal Responsibility and Budget Management legislation (FRBM) and will push the fiscal deficit beyond the 0.5 per cent of GDP that the current fiscal rules allow. This was what might have prompted the rating agencies to talk about downgrading India’s sovereign rating.
What may be the impact of a rating downgrade?
In the investment market, expectations drive prices. Thus, even a mere suggestion that the rating agencies might lower India’s sovereign rating would be sufficient to drive down bond prices. That was what precisely happened when the yields on the sovereign bonds spiked up. Ratings downgrade to the sub-investment grade could dent prospects not only for India’s bond inflows but also FDI into the country in the medium term.
The Nomura report also suggests that the other two rating agencies might also consider rating downgrade, which could dent prospects for the opening up of India’s bond markets.
Does India need to care?
When yields on a sovereign bond go up, it implies that investors would demand a higher rate of interest when investing in these bonds. Also, increasingly it would become difficult for the country to find lenders, as beyond a point investors would not be willing to take more risk.
Here are some more reasons to show why India SHOULD care:
- Rating agencies compel developing countries to pursue more prudent and sensible monetary and fiscal policies.
- Second, a favourable rating enables governments to raise capital in the international financial market.
- Third, Institutional investors in both the developed and developing world rely heavily on rating agencies in making investment decisions.
- The economic cost of credit rating could be gauged from the fact that countries with a low rating such as Greek and Brazil had to pay nearly 6 to 7 per cent more to borrow and this could wreak havoc on the already struggling economies of these countries.
Developing countries are aware of the price they have to pay in case of lowering of ratings by rating agencies, and while they talk outwardly as if they don’t care, they do all they can to ensure better ratings.
Having said that, are the ratings “gospels” and don’t rating agencies err in their judgements knowingly or unknowingly? A review by International Monetary Fund suggested that since 1975 all the sovereigns that have defaulted were rated as a non-investment grade at least one year before they defaulted. Also, between 1983 and 2009 no country with investment grade rating defaulted.
The credibility of the credit rating agencies took a beating during the 2008-09 financial crisis when junk bonds were rated AAA by them and sold to millions of investors worldwide. In India too, banks were in for a rude shock when the top-rated corporate-like IL&FS suddenly failed and plunged the Indian banking sector into crisis.
However, it is “business as usual” for the rating firms. Sovereigns may love them, or hate them, but they can ill afford to ignore them.
About the Author
Rajan Sundaram is a banker with more than 3 decades of experience with Canara Bank. Earlier, he was a faculty with Canara Bank, specializing in the area of Credit, Risk Management and Legal & Recovery. He has also been AVP (Credit Analyst) with Wells Fargo.
A holder of MBA (Finance) and PG Diploma in Human Resources Management from IGNOU, Rajan Sundaram has been Academic counsellor for the MBA Program at IGNOU and guided students for their MBA projects. He has taught papers on Statistics for Management and HR for IGNOU. Sundaram has also taught papers on Trade Finance and Quality Management at B Schools. Apart from academic teachings, he is a freelance trainer on credit and soft skills programs.
Furthermore, he contributed articles to Canara Bank House Magazine and Vinimaya a publication from NIBM Pune. He has presented research papers at Management Development Institute (MDI), Gurgaon and other colleges. Currently, he is serving as a faculty of Banking in Manipal Global Academy of BFSI.