Why S&P's and Moody's don't agree on Indian economy

The rationale offered by two rival rating agencies - Standard & Poor's and Moody's - for their vastly different outlook on the Indian economy on Tuesday gives cause for wonder about whether they are looking at the same economy at all.

S&P's, for instance said that India faces a 33 percent chance of a rating downgrade in the next two years if the government failed to press ahead with reforms as a result of the political gridlock, and the prospect that the 2014 election may also not throw up a decisive verdict for one party or the other.

Moody's, on the other hand, reasoned that the Indian economy's growth prospects in 2013 were better than earlier, particularly because the withdrawal of support by Mamata Banerjee to the UPA government had removed a stubborn impediment for policy action.

Strikingly, the rating agencies differed even on some aspects of the macroeconomic numbers. S&P's, for instance, warned that soaring fiscal deficit and high inflation would compound India's economic problems - and determine its ratings action going forward. But Moody's saw a more sanguine outlook, particularly on India's external trade front.

S&P's is making a rather more pronounced judgement call on India's politics as much on its economics, and that gives the agency reason to be downbeat about the immediate future.

Why are the outlooks of the two rating agencies so vastly different? Why isn't a reading of the Indian economy more even-keeled than this divergence seems to suggest.

The answer may lie in the weightage that each of the agency accords to various parameters. For instance, S&P's is known to look at "subjective" considerations in respect of a country's political system rather more scrupulously than, for instance, Moody's does - and assigns these political factors about as much importance as it does to raw economic data.

As psephologist Nate Silver noted last year (here), in the context of S&P's downgrade of the US from the gold-banner AAA status (which decision proved controversial, not least for the fact that S&P's acknowledged that it had made a $2 trillion error because of a flawed understanding of how the Congressional Budget Office data works), S&P's ratings have a very strong correlation with one measure of political risk: the Corruption Perceptions Index, published annually by Transparency International.

In fact, Silver claimed, S&P's ratings are far closer correlated to this subjective Corruption Perceptions Index than it is to a country's hardcore economic fundamentals - such as its GDP, long-term debt trajectory, recent deficits and its inflation rate.

The trouble with the Corruption Perceptions Index is that its legitimacy has been contested: it is seen as overly subjective, since they draw on the opinions of "experts" at international organisations - who may have spent only a little time in most of these countries and whose judgements aren't immune to the influence of cultural stereotyping.

In that sense, S&P's is making a rather more pronounced judgement call on India's politics as much on its economics, and that gives the agency reason to be downbeat about the immediate future.

But then, in the case of most countries, and most certainly in India, it is bad politics that drives bad economics. And even if the perception of the extent of the influence of bad politics is somewhat subjective, the need for looking at a country's political environment critically while determining a downgrade of its sovereign rating is compelling.

It's worth recalling that even earlier this year, when S&P's first warned of a sovereign rating downgrade of India to 'junk' status, it focussed just as much on the schizoid political arrangement between Prime Minister Manmohan Singh and Congress president Sonia Gandhi as the reason for the drag-down effect on the economy (more details here).

"The crux of the current political problem," S&P's report at that time had said, is the "nature of the leadership within the central government." Paramount political power, it added, rested with Sonia Gandhi - who held no Cabinet position - while the government was led by an "unelected prime minister", who lacked a political base of his own.

This "division of roles", the report added, had weakened the framework for making economic policy. Indicatively, it noted, the Cabinet was appointed largely by Sonia Gandhi and leaders of the allied parties, who chose their own candidates for the Cabinet posts allocated to them within the coalition. "The prime minister often appears to have limited ability to influence his cabinet colleagues and proceed with the liberalisation policies he favours (and constantly advocates in his public speeches)," that report noted.

In fact, the different philosophies behind the S&P's and Moody's approach to sovereign rating became manifest at the time of the August 2011 downgrade by S&P's of the US from its AAA rating.

Right after S&P's action at that time, David Levey, former managing director of sovereign ratings at Mody's, went public with his disagreement with the downgrade. Levey noted at that time that the S&P's downgrade of the credit rating of US Treasury bonds was "unwarranted", and went on to cite several reasons (details here).

As Reuters' finance blogger Felix Salmon noted at that time, the reason why it was S&P's and not Moody's the downgraded the US at that time was that the two agencies don't measure the same thing with their credit ratings.

An S&P's ratings, he wrote, "seeks to measure only the probability of default. Nothing else matters - not the time that the issuer is likely to remain in default, not the expected way in which the default will be resolved. Most importantly, S&P simply doesn't care what the recovery value is - the amount of money that investors end up with after the issuer has defaulted."

Moody's, by contrast, "is interested not in default probability per se, but rather expected losses. Default probability is part of the total expected loss - but then you have to also take into account what's likely to happen if and when a default occurs."

In that sense, S&P's rating action call on Tuesday is premised rather more on India's political outlook. But the sobering thought, which gives credence to S&P's call over Moody's, is that nobody ever lost money betting on the Indian political establishment's infinite ability to wreck the economy.