How important are sovereign ratings?

In a surprise move, Moody’s Investors Service upgraded India’s sovereign bond rating by one notch from Baa3 to Baa2 ten days ago. The unexpected rating upgrade fuelled a fresh air of bullishness in the equity, currency and debt markets for a short while. The international rating agency has also changed its rating outlook on India to stable from positive. Before this upgrade, the first since 2004, India’s rating was just above the speculative grade. For the last couple of years, the government has been negotiating hard with rating agencies to take note of the reforms it has undertaken for a possible rating upgrade. Moody’s has finally obliged on two crucial components of credit rating: the actual rating and the outlook. It’s not surprising that Prime Minister Modi and Finance Minister Arun Jaitley quickly reached out to their Twitter accounts to acknowledge the rating upgrade.

However, on Friday last week, Standard and Poor’s (S&P) signalled caution: it kept the sovereign rating and outlook for India unchanged: BBB, a notch above investment grade, and stable outlook. S&P’s reasoned that its stable outlook reflects strong growth and fiscal deficit will remain in line with its forecast. But it ruled out rating upgrade in view of India’s low GDP per capita which, the agency estimates at close to $2,000 in 2017, “the lowest of all investment-grade sovereigns that we estimate”. Fitch, the third international rating agency, has not changed its stance on India’s rating yet. Fitch has kept India at the lowest investment grade, just above the junk status, for over a decade.

It is the first time that India has got Baa2 rating. Broadly, it reflects India’s reforms, development and economic advancement of past 25 years, and not just policy initiatives of last three years, though the upgrade captures reforms initiated by the current government as well. Since 1991, Moody’s has upgraded India’s rating thrice – Baa3 in 1994, Ba1 in 2003 and Baa3 in 2004 – and downgraded as many times: Baa3 1991, Ba2 also in 1991 and Ba2 in 1998. The latest upgrade is the highest rating India has got from Moody’s since 1991. Coming at a time when the economy is struggling, partly because of demonetisation and chaotic roll-out of GST that has pulled down growth to levels last seen in 2014, the unexpected surprise from Moody’s is a saving grace for the government which has faced a barrage of criticism for the downturn in growth over the last five quarters. The government’s elation over ‘belated’ recognition from an international rating agency is justified. But dismissing all criticism of its performance on economic front in recent times as unfounded is also unjustified.

Whether it is the government or opposition, taking a jibe at critics is nothing new in Indian politics. If the government used Moody’s rating upgrade to run down critics of its policy initiatives, urging those who had doubts to seriously introspect their own positions, the opposition did not miss the opportunity to mock at the government’s elation. It reminded the government that only a few months ago it had flayed the rating agency’s methodology. Moody’s India rating upgrade has come about on the back of three important policy initiatives: GST, bank recapitalisation and fiscal prudence. Other initiatives that influenced revision by a notch include measure to address bank NPAs, insolvency and bankruptcy code, inflation targeting and Aadhar-linked Direct Benefit Transfer (DBT).

Of these, the much-delayed and still-flawed GST is the most crucial policy step that will help formalisation of economy at a faster pace and add value to GDP. The outcome of all these reforms in terms of higher growth, widening of tax base and enhanced competitiveness will become clearer in coming years. But the point is: it is not only the current government but all government since 1991 have pushed the structural reform agenda forward. The current government is in a better position to push for reforms at faster pace as it has the advantage of a majority of its own, while the previous governments since 1991 were constrained by coalition politics.

India’s principal weakness is its high level of public debt at 68 per cent, which is higher than the Baa median of 44 per cent. This a key concern for S&P and also one of the main reasons for maintaining a status quo on sovereign rating. But Moody’s has expressed confidence in India’s longterm economic prospects that will stabilise debt as a proportion of GDP over the next few years. However, despite Moody’s rating upgrade there is little room for complacency for the government as challenges still abound for the economy. While bank credit growth is still at 60-year low, the risk of fiscal slippage also persists and current account deficit is no longer in comfortable zone. Similarly, industrial growth is still not encouraging, exports are far below expectations and the risk of inflation picking up is also a concern as oil prices have gone up sharply in the last six months.

Rating upgrade does not mean Indian economy is out of the wood. To maintain the tag of a fast growing major economy, despite recent slowdown, the reform agenda will have to be pursued with renewed drive. India badly needs reforms in labour laws, agricultural marketing, higher investment in rural and urban infrastructure and transformational changes in educational standards and healthcare for the country to grow at eight per cent, the rate the government also says it wants India to move. An upgrade is essentially a confidence booster for economy. It is also an indication of the overall health of economy in terms of the country’s financial and fiscal health to businesses and investors, both foreign and domestic. Getting a rating upgrade is significant. However, it does not change anything dramatically for the government because most of the positives have already been discounted.

Foreign fund flows are not determined by ratings alone but also by other factors like global liquidity and performance of companies. The upgrade will bring down borrowing costs for businesses but will not make much difference to the government which doesn’t borrow much in the overseas market. About a decade ago, the credibility of rating agencies had come under scanner when they failed to anticipate the financial crisis of 2008. They were also accused of colluding with investment banks for not junking potentially junk securities. But lately, they have reestablished their credibility, though some critics still slam their rating process. However, evaluation by independent agencies is considered important for allocation of capital globally. For governments, sovereign ratings are a matter of prestige.