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Home >Opinion >Views >What we must focus on for India to get a sovereign rating upgrade

India’s handling of its sovereign-rating issues over the past two decades may be described as reactive and restrictive. Much commentary by stakeholders tends to appear around events that entail a perceived threat of a downgrade or a moonshot at an upgrade. The debate so far has largely been focused on a narrow set of rating drivers, such as India’s low external debt, high growth rate, fiscal deficit and some irrelevant factors like the size of India’s economy. The cohesive government effort that saw India improve its rank on Ease of Doing Business (EODB) charts is missing when it comes to its sovereign rating. The starting point for that should be a more nuanced understanding, by all stakeholders, of the what and hows of the global sovereign-rating process. This will help in formulating a pragmatic plan for sustaining and hopefully improving India’s rating.

Downgrade fears are overdone: In the recent budget, the Centre’s fiscal strings have been appropriately loosened to support economic growth. Despite misgivings in certain quarters, the chances of a downgrade of India’s ratings from low investment grade (IG) to junk over next 12 months is negligible. The reason for this conjecture is as follows:

a) The current rating of all rating agencies has already taken into account weak growth and a widened fiscal deficit. The global Big 3 of ratings are anticipating a recovery in 2021-22. S&P (BBB-) and Moody’s (Baa-) both have a stable outlook. A sudden downgrade without an outlook change is rare. Fitch has a negative outlook, but it typically takes a year or two to resolve its outlook;

b) Sovereign ratings are a rank-ordering of the relative risks of nations not repaying their financial creditors. The International Monetary Fund’s Fiscal Monitor Update of January 2021 states that the fiscal deficit for emerging economies is projected at 10.3% (2020). India’s budgeted fiscal deficit of 9.5% (2020-21) and 6.8% (2021-22) does not stand out as a negative outlier;

c) Rating agencies take a 2-3 year view and usually do not take knee-jerk action.

If India’s expected economic recovery in 2021-22 fructifies, the chances of a downgrade in next 24 months is minimal.

Ratings are imperfect but informative: The analytical efficacy and predictive value of various ratings vary. Corporate ratings tend to have the most predictive value. On the other hand, sovereign ratings remain the weakest analytically.

In the sovereign rating process, heuristics and qualitative factors play a much larger role than, say, in ratings of companies or banks. Which is not to say that it lacks rigour, detail-orientation and understanding. Economic metrics such as gross domestic product (GDP) growth, inflation, foreign exchange volatility, sovereign debt and asset levels are benchmarked for inter-country comparison. However, purely qualitative factors, such as World Bank Governance Indices, are also given high importance. This is similar to corporate credit ratings, where in addition to financial ratios, agencies also consider the quality of management.

While a sovereign rating has limitations, it is informative for investors in the country. Markets are also influenced by ratings to an extent. A study suggests that when an IG sovereign gets downgraded to junk, the yields of its foreign currency treasury bills tend to rise significantly. The study estimates a 138 basis points spike. ( See ‘The Ghost of Rating Downgrade: What Happens to Borrowing Cost when a Government Loses its Investment Grade Rating’, June 2016, Hanusch et al).

However, rating agencies may need to reflect on the relevance of historical benchmarks for sovereign debt and fiscal ratios. In the foreseeable future, no brake is expected on competitive quantitative easing by advanced economies. Given the globally burgeoning debt levels and redrawn fiscal boundaries, should debt ratio benchmarks not be re-adjusted? Should they not focus on more pertinent ratios, given the current reality?

Here, India’s latest Economic Survey makes a pertinent point by focusing on the specific measure of Interest Rate Growth Differential (IRGD). The survey reasonably argues that as long as the rate of nominal GDP growth exceeds that of interest paid by the government, a country’s debt level is not a problem, prima facie. Now, IRGD may be more applicable to global reserve currency issuers. However, it may be argued that the IRGD point is also valid for India, most of whose debt is in local currency, albeit with some limits.

Broaden the focus: Given today’s global economic volatility, a sovereign will have less control than pre-2008 on quantitative factors like GDP, inflation and foreign exchange volatility. However, qualitative factors, which are equally important for ratings, may be more amenable to government action. The median score of World Bank Governance indicators for BBB and BB rated sovereigns are 55 and 45. India is at 48. Looking at individual components, India compares well with its BBB peers in governance effectiveness, rule of law, and control of corruption. But on parameters like the Human Development Index (HDI), political stability and regulatory quality, India’s scores are lower than BB median values. The public discourse on ratings, unfortunately, often overlooks these factors, which have been embarrassingly low for decades. However, our EODB improvement has shown that focussed efforts yield results. Can we focus on improving our HDI and other factors as keenly as we focus on GDP and EODB, and thus make a stronger case for a rating upgrade?

Deep Mukherjee is a quantitative risk management professional and visiting faculty at Indian Institute of Management Calcutta

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