Why did Moody's upgrade us when we are going downhill?

Why did Moody’s upgrade the Indian government’s rupee-denominated debt ratings from junk to investment grade? Especially when the economy is going steadily downhill?

Consider, all that’s going wrong.

The fiscal deficit is slipping - badly. The target of 4.6 percent of GDP is likely to be overshot by at least 1 percent, and even the final figure may be a fudge, with oil subsides being underprovided for.

With industrial growth falling 5 percent in October, with second quarter GDP growth slipping below 7 percent, and gross tax revenues slipping well below budget estimates, the Indian economy is slipping badly.

[caption id=“attachment_163211” align=“alignleft” width=“380” caption=“Next year, the government is going to borrow even more.Reuters”]  [/caption]

The rupee has never been weaker - and could fall all the way to Rs 60 ( says CLSA ). The currency has dipped more than 20 percent from earlier this year.

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Food inflation is slowing due to seasonal factors , but manufacturing inflation ( core inflation ) is yet to be tamed. Energy prices inflation has been artificially suppressed.

Next year, the government is going to borrow even more if the Food Security Bill and other expenditure programmes take wing.

We can go on and on, but we need to return to the basic question: what did Moody’s see that we did not, that it should be upgrading short-term and long-term government rupee debt ratings from Ba1 (speculative) to Baa3 (investment-grade) just before a huge budget slippage?

Explaining its actions, Moody’s points to its Rating Implementation Guidance, which says that “Moody’s will maintain a gap between a government’s domestic and foreign currency debt ratings infrequently and only in compelling cases. The guidance was based on an analysis of the last two decades of sovereign defaults, which does not offer empirical justification for a rating bias in favour of either local currency or foreign currency government debt.”

While finance ministry bureaucrats are patting themselves in the back for getting Moody’s to sign on to the improved ratings, the real reasons for the upgrade are apparent in Moody’s policy corrections - not any improvement in India’s economic performance.

One, when India’s foreign currency-denominated debt is rated investment grade (Baa3), it makes no sense to keep the rupee-debt rating lower. Normally, rupee ratings for the Indian government should have been higher than its foreign currency ratings since, technically, no government can default in local currency. It can always print more notes to pay back lenders. Moody’s is essentially correcting its own anomaly.

Two, with the external environment deteriorating and the rupee crashing to Rs 52-53 to the dollar, the government has been opening the sluice gates for external borrowing . In November it raised foreign investment limits for investment in government and corporate bonds to $15 billion and $20 billion, while the limit is $25 billion for investment in infrastructure bonds and $30 billion for external commercial borrowings. That’s $90 billion in various kinds of foreign and rupee debt that will ultimately have to be repatriated in dollars or foreign currency.

Put another way, there is now little difference between a country’s ability to service its local currency and foreign currency debt. When you invite a foreign investor to buy government bonds denominated in rupees, you still have to return dollars to him when he sells it.

This is what Moody’s has to say. “Financial liberalisation - and especially currency convertibility - has opened the possibility that domestically generated confidence crises spill over to foreign currency debt through capital outflows and exchange rate crises. This powerful factor pleads for aligning the foreign currency and the local currency ratings in financially open countries with similar levels of local currency and foreign currency debts.”

Though this statement is generic and not said about India in particular, this is what it means for us: the domestic crisis of economic confidence has spilled over to external confidence (which is why capital is fleeing the markets), and hence the realignment of ratings for domestic and foreign currency government debt is not rally cause for celebration.

In short, the Moody’s upgrade in not a vote of confidence in the Indian economy, but a signal that domestic worries and external worries cannot be hermetically sealed from each other.

A deterioration in either external flows or the domestic economic situation could lead Indian government bonds back to junk.

Given our deteriorating external situation, with exports tapering off and the rupee falling, it would have been more logical for Moody’s to put the external situation on a rating watch instead of upgrading the local currency rating. As HDFC Bank chief economist Abheek Barua told Business Standard: “Looking at the fiscal situation of the country, India does not deserve to be in the ‘investment bracket’ at this point of time.”

But the situation in the eurozone probably saved us. Given the serious threats to the sovereign ratings in Europe, India is obviously in a far better situation.

Hence Moody’s chose to raise domestic ratings instead of lowering the foreign currency rating for now.

In the future, though, all bets are off.