S&P downgrade and India's return to Slumdog status

Standard and Poor's (S&P) has warned that India could lose its investment grade credit rating. In a report titledWill India Be the First BRIC Fallen Angel? the agency said: "Slowing GDP growth and political roadblocks to economic policymaking could put India at risk of losing its investment-grade rating."

The agency revised its outlook on India's BBB-long-term sovereign credit rating to negative from stable.What this means is that India runs the risk of losing its investment grade credit rating and being rated as speculative or junk. Let us try and understand what this really means for India.

What is investment grade?

In 1970, the Penn Railroad, the largest railroad in the United States, went bankrupt. This was something that the rating agencies did not foresee. One of the repercussions of this bankruptcy was that the Securities and Exchange Commission (SEC, the American equivalent of the Indian Sebi) decided to penalise brokers who held bonds of companies that were less than investment grade. But who would decide what was investment grade?

 S&P downgrade and Indias return to Slumdog status

Reuters

As Roger Lowenstein writes in an article titledTriple-A Failure, "This prompted a question: investment grade, according to whom? The SEC opted to create a new category of officially designated rating agencies, and grandfathered the big three - S&P,Moody's and Fitch. Bank regulators issued similar rules for banks. Pension funds, mutual funds, insurance regulators followed...Many classes of investors were now forbidden to buy non-investment-grade bonds at all".

Every rating agency follows different rating techniques. The rating agency Moody's has 21 different types of ratings of which the top 10 are deemed to be investment grade. The remaining 11 are deemed to be speculative by the rating agency and "junk" by the market.

S&P has 12 different levels of ratings of which the top five are deemed to be investment grade.India's rating is BBB-, which is the last rating in the ratings which are deemed to be investment grade. If India's rating is downgraded, then the next rating is BB+.S&P defines it as a rating which is "considered highest speculative grade by market participants". Hence BB+ is the first rating at the junk level. The ratings are essentially meant to be an estimate of probabilities. Hence, the bonds of a country which has a BB+ rating are expected to default more than the bonds of a country which has a BBB-rating, thus making them more risky.

What will be the impact if India gets downgraded?

One clear impact will be foreign investors who are not allowed to invest in non-investment grade securities will stay away from India. This would mean that pension funds and other long-termfunds will stay away from India.It could also mean that if foreign investors with positions in India start exiting, the stock market might go down in the days to come. This comes after the brief rally we have seen recently in expectation of an interest rate cut by the Reserve Bank of India.

The way foreign investors think about India is very important in deciding how well the Indian stock market performs. Since the beginning of the year foreign institutional investors have been net buyers (the difference between what they have bought and what they have sold) of stocks to the extent of Rs34,551.33 crore. During the same period, domestic institutional investors have been net sellers of stocks to the extent of Rs 18,666.06 crore.

This buying by the foreign investors is the major reason behind the BSE Sensex, India's premier stock market index, giving a return of 7.85 percent since the beginning of the year. The threat of downgrade to junk status obviously does not put India in a good light in the eyes of foreign investors. Given this, the stock market is likely to go down, and bring down the overall economic confidence in the country as well.It would also mean that Indian corporates looking to raise money from abroad would have to pay a higher rate of interest.

The bond market in India will largely remain unaffected because it doesn't have much foreign presence.

The Azhar Syndrome

But the threat of a downgrade by S&P is a smaller worry than the Azhar syndrome. So what is the Azhar syndrome? The term was first used in a report of the name brought out byFirst Globalmore than three years back in March 2009. As the report pointed out: "The Azhar Syndrome is all about Azhar... the kid from the slums in Slumdog Millionaire. He flew to LA for the Oscars, slept on clean sheets in an air-conditioned hotel room, for the first time (and possibly the last time)...came to his Bombay slum home...and moaned to the press "It is so hot here, and the mosquitoes...I can't sleep". He is finished. A few nights in a clean hotel room, and the guy can't adjust back to the reality of his slum existence."

Like Azhar assumed that the "five-day" party that he had in Los Angeles would continue forever, so has the Congress Party-led United Progressive Alliance (UPA assumed that all is well and the economic growth that India saw for the last few years will continue forever on its own. India enjoyed a GDP growth averaging 8.7 percent during 2004-2008 and 7.8 percent during 2009-2011.

The solutions to the economic problems currently facing India are simple and largely agreed upon by everyone who has an informed opinion on the issue. Reuters

Pranab Mukherjee, the finance minister, rejected the threat of the S&P downgrade. In a press release, he said that the government is fully seized of the current situation and is confident that there will be a turnaround in our growth prospects in the coming months. Mukherjee expects the Indian economy to grow by 7 percent in this financial year. "A reversal of the interest rate cycle, weak crude prices and a normal monsoon were likely to improve the economic conditions and the slowdown would not be as sharp as widely feared, and that the economy would grow closer to 7 percent this fiscal," Mukherjee told a conference of the chief commissioners and directors general of income tax on 11 June 2012.

The things that Mukjerhee expects will help India grow at 7 percent are things he has no control over.This is the Azhar syndrome, which has plagued the UPA for a while now at work. Mukherjee and the UPA seem to be big believers in what Paulo Coelho wrote in his bestsellingThe Alchemist- A Fable About Following Your Dream: "Here is one great truth on this planet: whoever you are, or whatever it is that you do, when you really want something, it's because that desire originated in the soul of the universe. It's your mission on earth... And, when you want something, all the universe conspires in helping you to achieve it."

The world might conspire to give India its economic growth. Interest rates might fall. Oil prices might fall. And the country might have a normal monsoon. But this is no way to run a country.

The assumption that economic growth will happen because Mukherjee and his ilk say that it will happen is clearly worrying.As Ruchir Sharma writes in his recent bookBreakout Nations - In Pursuit of the Next Economic Miracles:"India is already showing some of the warning signs of failed growth stories, including early-onset of confidence."

To conclude

Hardly any constructive steps have been taken to revive economic growth which is falling. Just talking about growth does not create economic growth. The solutions to the economic problems currently facing India are simple and largely agreed upon by everyone who has an informed opinion on the issue.

As TheEconomistput it in a recent article titledFarewell to Incredible India: "The remedies, agreed on not just by foreign investors and liberal newspapers but also by Manmohan Singh's government, are blindingly obvious. A combined budget deficit of nearly a tenth of GDP must be tamed, particularly by cutting wasteful fuel subsidies. India must reform tax and foreign-investment rules. It must speed up big industrial and infrastructure projects. It must confront corruption. None of these tasks is insurmountable. Most are supposedly government policy."

But there isn't much hope going around. As the S&P report explains: "The crux of the current political problem for economic liberalisation is, in our view, the nature of leadership within the central government, not obstreperous allies or an unhelpful opposition. The Congress party is divided on economic policies. There is substantial opposition within the party to any serious liberalisation of the economy. Moreover, paramount political power rests with the leader of the Congress party, Sonia Gandhi, who holds no Cabinet position, while the government is led by an unelected prime minister, Manmohan Singh, who lacks a political base of his own."

Vivek Kaul is a writer and can be reached atvivek.kaul@gmail.com

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Updated Date: Dec 20, 2014 10:42:33 IST