Understanding what S&P's warning means for India

S&P has quite expectedly retained India’s credit rating at BBB (-) with the caveat that if the new government next year fails to perform and reverse the slowdown in the economy, there would be a downgrade. Added is the clause that if there are any moves made which disrupt the status quo downwards (due to the elections), the downgrade would be enforced. The government has said that we should not worry and that things are under control. What are we to make of this downgrade threat?

A country rating is important when the nation borrows from the international market. The euro based countries borrowed and hence their rating determined the interest rate that they had to pay to find investors. But, for India, debt of the government is essentially in domestic currency and hence the rating per se does not affect the ability to borrow. Hence, even though the main grievance of the rating agencies is that the fiscal numbers do not look all right and nothing much is being done to control subsidies in particular, none of this actually poses a threat to the outside world as things are being done in rupees. Therefore, the government really does not get affected.

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However, the rating comes in the way when Indian companies have to borrow from abroad because their rating is often linked to the sovereign. Normally the rating does not exceed the sovereign, except where there are dollar enhancements outside the country when the rating is notched up. But a low rating for the country sounds warning signal to the investor that the country is at risk. Now, given that the government and the RBI are doing their best to encourage borrowers to tap the euro markets for funds to shore up our forex reserves, a downgrade would men bad news for these companies as enhanced perceived risk will automatically push up the cost of borrowing. Also, when there was a currency crisis a couple of months back, the concept of a sovereign bond was also spoken of, in which case the rating would matter. As long as the audience was NRIs, it would still not matter, but if the idea is to attract foreign investors with higher rates, then the rating would come in the way. Therefore, while presently the government may not be affected by the rating, at the end of the day, the repercussions are felt which makes this opinion important.

Is S &P right in their judgment? Rating agencies have their own way of looking at economies and hence are entitled to their opinion. They do feel that the fiscal situation and the apparent lack of direction when it comes to subsidies or fuel pricing are major concerns. The counter view can be that if the FM gets in the number of 4.8 percent fiscal deficit ratio by the end of the day, then it should not matter how it is done. All countries subsidise food and fuel and the US crisis was all about health care which is a major expense for the government. Therefore, the view here could be that the same standard is not being applied uniformly.

S&P does point out that whatever fiscal discipline that has been achieved so far has been at the cost of cutting down on development project expenditure or selling state enterprises which is not the right way to balancing the budget. Quite clearly, there are no easy answers here, because a sovereign has a right to decide on the quality of its budget and would be justified in not letting an extraneous entity dictate the composition of its budget or policies on grounds of a rating. But then these are the rules of the game which are being played and countries have to comply with the same or risk the downgrade. Given that we are on the precipice of the investment grade category, any deviance would mean toppling into the sub-investment grade.

At a broader level, it has been noticed that in the aftermath of the sovereign debt crisis, the rating agencies have been more stringent when it comes to giving ratings and have been quick to pull the trigger on grounds of what could be a risk factor to the equilibrium. While a default is never on the cards for an economy like India where the fundamentals are strong, on a relative scale, we are not doing that badly when it comes to deficits or even growth for that matter. But, the concerns of the rating agencies are definitely valid, and something which there has been considerable debate internally. Issues like subsidies are a tough nut to crack for any government as they have social and political implications. While subsidies tend to leak quite badly, successive governments never try and plug them and increase the efficacy by merely raising these levels, hoping that a proportionate amount flows to the targeted beneficiaries.

So, how should we react to such opinions? They can definitely not be ignored because it does affect borrowers as well as the reputation of the country. The reason why we consider ourselves to be different from some of the slippery economies is based on these ratings, which like any opinion of say the World Bank on Doing business or UN on Human Development or Transparency International on corruption, become global benchmarks. Until a different acceptable method of rating is in place, these ratings will continue to dominate public opinion. The emerging markets are in the process of looking for alternative methodologies for rating, and given the ambivalence in the attitude towards the existing rating agencies after the dual crises, there could be viable competition in future. Efforts are already on to devise alternative models which use a varied scale and also look at the initial conditions and levels of development in countries when according a rating. This is based on the premise that when higher levels of poverty exist, using developed countries benchmarks may not be appropriate as government action has to be affirmative and cannot go by the book.

However, to the extent that the S&P view is important and relevant, and their concerns are valid, though not new, efforts should be put to better the fiscal quality of the economy, because any improvement will be better for the country - especially if subsidies are made effective within the existing perimeter. It only needs more character, which is not difficult provided there is the will to reform. The issue is, is it there?

The author is Chief Economist, CARE Ratings. Views are personal.