Downgrade. With Standard & Poor's threatening to place India among junk-status nations, the word has acquired an ominous dimension. Not without reason, for if and when India is downgraded, the consequences would be deplorable if not catastrophic. The cost of borrowing will increase both for the government and corporations. FIIs will be forced to exit; this would be calamitous for the Sensex. The rupee, already weakened, will suffer another downward slide. Investment will be hurt.
We face the risk of being the first BRICS nation to get the junk status—not a nice appellation for a country which aspires to become a global power. India can avoid the ignominy but for this the government has to take decisions which are fiscally prudent and economically sensible. It has to improve the investment climate; for this the anti-industry rules and regulations, framed under the influence of politically influential activists, have to be scrapped. It is no longer a choice between good economics and electorally sound politics; it's a Hobson's choice: we have to reform. The alternative is downgrade.
When any institution, whether the government or a private company, sells bonds, it means it is borrowing money from investors and, in turn, promises to pay you back the money when the bond matures, plus the interest accrued.
The big three rating agencies—Fitch, Moody's and Standard & Poor’s—specialize in evaluating credit risk and assess how likely a bond borrower is able to pay back its debt to lenders. This ability of the borrower to meet its obligation is expressed in the bond’s credit rating which is basically a forward-looking opinion about credit risk.
When a bond is given a high credit rating by rating agencies, it is known as an investment-grade bond, while the one that is likely to default is called non-investment grade bond, or simply a junk bond. The default risk is higher in junk bonds, meaning there are greater chances that a company or government is unlikely to pay its obligations when the bond matures. Another feature of junk grade bonds is that they offer a high-yield to investors than investment-grade bonds.
The credit rating system determines this default risk of a bond. Each rating agency applies its own methodology in measuring creditworthiness and uses a specific rating scale to publish its ratings opinions. Typically, credit rating is based on a grading system beginning with the top rating of ‘AAA’ (for bonds least likely to default) to ‘D’ for bonds that have defaulted. Investment grade bonds are those that are assigned high ratings namely, AAA, AA, A, BBB, by S&P's or Aaa, Aa, A, Baa by Moody's. Junk bonds have a rating of ‘BB/Ba’ or lower than that.
Impact of downgrade
The impacts of downgrading of sovereign credit by ratings agencies are diverse, affecting almost all sectors of economy directly or indirectly. One of the sectors severely impacted is banking. Because of the downgrading, banks find it more expensive to borrow fund that in turn increases their costs and thus puts margin under pressure. In the case of eurozone, global lenders are finding it a riskier proposition to lend to those banks having exposure to debt-ridden economies like Greece, Portugal and Ireland.
Greece: In recent years, a few countries’ credit rating was downgraded to junk status by rating agencies. The most important one was the downgrading of Greece by S&P’s. On April 27, 2010, S&P’s cut Greek long-term government bonds three notches to speculative or below investment-grade or junk status (from B to CCC). It also downgraded Portugal’s sovereign debt by two notches. S&P’s says it has growing concerns about the ability of the Greek and Portuguese governments to repay debts. It said the cash-strapped Greek government's policy options are narrowing because of weak economic growth prospects.
“The downgrade results from our updated assessment of the political, economic and budgetary conditions that the Greek government faces in its efforts to put the public debt burden onto a sustained downward trajectory,” said S&P’s credit analyst Marko Mrsnik.
The fallout of ‘junk’ rating of Greece was immense that was felt worldwide. Global stock markets nosedived when S&P's downgraded Greek bonds to junk status and downgraded Portugese bonds two notches. Major European stock indices dipped more than 2.5 per cent. The shockwaves were also felt across the Atlantic. On the Wall Street, the Dow Jones industrial average shed more than 200 points. The euro dipped more than 1 per cent against the dollar to nearly an eight-month low.
In India, too, the bellwether Sensex of the Bombay Stock Exchange lost 310 points on April 28, 2010, from its previous close of 17,690 on April 27 as investors became nervy.
For Greece, the downgrading made it clear that investors are less likely to provide loan to Greece, making it harder for the eurozone country to trim down its deficit via borrowing. In other words, the loss of Greek bonds’ investment-grade status means that it will have to pay higher interest rates on its bonds to attract investors if it wants to borrow money from bond market. Secondly, junk status also increases the possibility of restructuring of the existing debt.
On June 14, 2010, Greece received the second blow when Moody’s Investors Service downgraded Greece’s bond ratings to junk status because of concerns the country could fail to cut its deficit and pay down its debt.
Greece and the EU have collectively been engaged in taking various measures to regain investor confidence after the downgrading and rescue Greece from defaulting on its loans which would have disastrous consequences for the global financial system.
For instance, last year on June 29, the Greek Parliament approved a slew of austerity measures that included voting for $40 billion in tax hikes and spending cuts. The plan also called for the sale of state-owned assets. Further, on July 22 last year the EU and the IMF agreed to give Greece another bailout worth about $155 billion. Another notable step was taken on February 10 this year when Greece agreed to new austerity measures demanded by its international creditors.
Cyprus: Another country downgraded to junk status in recent times is Cyprus. In March this year, Moody's downgraded euro member Cyprus to Ba1 (junk status) and gave it a negative outlook on, what it believed, heightened concerns over the exposure of its large banking sector to Greece. Moody's was the second agency to downgrade Cyprus' credit rating to junk after S&P's in January.
“Overall, the fragile market confidence in Cyprus, which has already led to a loss of access to international debt markets, is likely to continue, with a high potential for further shocks to funding conditions for the sovereign and the domestic banks,” Moody’s said.
The downgrade came as a blow to island country as it was in need of $2.6 billion to help recapitalize the Cyprus Popular Bank, its second-largest bank that is heavily exposed to the Greek debt. Since the downgrading effectively cut off Cyprus from the global credit markets, it has turned to Russia for $3.3 billion low-interest loan to meet its financing needs for this year.
Cyprus also became the fifth eurozone nation to seek a bailout from the European Union and IMF. Cyprus was widely expected to seek a bailout by the EU and the IMF to prop up its banking sector, crippled by its heavy exposure to the Greek government debts and by the losses on loans given to Greek banks and businesses.
The final push for a bailout came from the three big rating agencies which downgraded Cyprus’ credit rating to junk status, making it more difficult for the country to raise funds from the capital markets.
The Cypriot government said in an official announcement in Nicosia that it made a formal request to its eurozone partners for financial assistance from the 17-nation group’s temporary bailout fund, the European Financial Stability Facility (EFSF).
“The purpose of the required assistance is to contain the risks to the Cypriot economy, notably those arising from the negative spill—over effects through its financial sector, due to its large exposure to the Greek economy,” it said in a statement.
Portugal: Another eurozone country to have been downgraded to junk status recently is Portugal. In February this year, Portugal’s sovereign credit rating was lowered to below investment-grade by S&P’s on Europe’s inability to resolve the region’s debt crisis. The rating was lowered two notches to BB with a negative outlook, indicating chance of further downgrade. S&P’s move followed Fitch Ratings and Moody’s in downgrading Portugal’s debt to junk.
The downgrade forced many funds to offload Portuguese bonds which were also removed from Citigroup’s European Bond Index. Portugal's 10-year bond prices plunged, sending yields surging more than 100 basis points to 13.85 per cent—the second highest level in the eurozone after Greece, according to Reuters data.
In short, junk status not only implies inability or difficulties in borrowing but also brings the threat of further sliding downwards.
One need not be an economist to know that we cannot afford any further slide downwards. Industrial production has come down dramatically, and there are no signs of revival. Agriculture, which supports the largest chunk of the population and which has been languishing for quite some time, faces another problem in the form of failing monsoon. Unsurprisingly, growth rate has been badly hit. Even worse is the government's proclivity to remain focused on the political rather than the economic.
Can India face it?
A number of red flags have been raised about the state of the Indian economy. On June 18, rating agency Fitch downwardly revised India’s credit outlook to negative while retaining India’s sovereign debt rating to BBB-just one notch above ‘junk.’ Two months earlier, Standard & Poor’s had also scaled down India’s rating outlook to BBB- and in June had said India could be the first Bric country to lose investment grade rating. Hence, internationally, India finds itself in the same category as Azerbaijan, Colombia and Iceland. Not only this, it is now in a lower category than Italy, Ireland and Spain, which are at the heart of the ongoing eurozone crisis. As two global credit rating agencies, Standard and Poor’s and Fitch, have scaled down their outlook for India citing a slowing economy, policy inaction, worsening fiscal and current account deficits, there is an ongoing debate on the consequences of their pronouncements. A downgrade can have, among other things, a bad impact on the exchange rate of the rupee. The slide of rupee would have a spiral effect on various sectors of the economy. It would also add to inflation. Apart from that, the ability of Indian banks and corporations to borrow overseas could be hit if the country's sovereign rating is downgraded. If India gets the junk status, a lot of foreign money would shy away from India. It would have a bad impact on stock markets as well. Collectively, all these could lead to contraction of India's economy.
Currency depreciation
The sliding rupee is the most potent symbol of an economy lurching into a deep crisis of low growth and high inflation, which is called stagflation. In the last days when Pranab Mukherjee was finance minister, a few reform measures were announced by RBI. The belief was that these token measures would be enough to shore up the rupee. The central bank ignored the reality that foreign investors were more concerned about the fiscal deficit, General Anti-Avoidance Rules (GAAR) and policy paralysis than a cap on investment in government bonds. If rating agencies downgrade India to junk status, it would have an immediate effect on the rupee which will touch new lows.
Under certain circumstances, currency depreciation may not be such a bad thing if it results in higher exports, thus bringing down the trade deficit (the difference between the value of exports and the value of imports) as well as the current account deficit (the gap between inflows and outflows of foreign currencies) and the capital account deficit (the difference between the inflows and outflows of capital, both in the form of portfolio investments in stock exchanges and foreign direct investments) in the balance of payments. But, at the current juncture, the fall in the value of the rupee portends ill for the Indian economy. Let’s see how.
Imports would cost more
The weakening of the rupee would be a matter of serious concern as it is having a telling effect on the already high imports bills. India currently imports 80 per cent of the country's total requirements of crude oil; oil accounts for around one-third of the country’s total annual imports. The next big item in the country's import basket is gold (which the government is trying to curb). India also imports roughly half of the edible oils it consumes. Our import bill is already very high and, due to rise in prices of petroleum globally, the petroleum bill has mounted to $154 billion. If rupee goes further down, the petroleum bill would increase substantially.
Even if the higher prices of imported crude do not immediately translate into higher prices of petrol, diesel and cooking gas, increase under recoveries being incurred by government-owned oil refining and marketing companies—Indian Oil Corporation, Hindustan Petroleum and Bharat Petroleum. Experts say that the rise in the import bill of crude oil in rupee terms represents a classic case of India “importing inflation.” Further, the burden of import of cooking oil, pulses and other commodities would add to the problem. India is importing 9 million tonnes of edible oil and up to 5 million tonne of pulses annually.
In the financial year ended on March 31, 2012, India’s trade deficit jumped by a phenomenal 56 per cent over the previous year to touch a level of $185 billion. In last two years, the value of imports rose by nearly one-third. If the trend continues, it would be really difficult in the foreseeable future.
Availability and cost of borrowing
The junk status would make overseas borrowings for both the government and corporations more expensive. They have to offer higher interest rates to compensate for the perceived higher risk. Corporations are already reeling from a high interest rate regime in India. Even prime borrowers, leading companies like those of the Tatas and Ambanis, have to pay an interest rate of around 14-15 per cent. “A change in India's current external rating could have ‘cliff effects’, impacting both the availability and the cost of foreign currency borrowing for Indian banks and firms,” the RBI said in a report on financial stability.
Investments would be affected
Foreign inflows into stock markets would be adversely affected. It is not only expected to have negative impact on stock markets but on investors as well. India could witness a flight of capital as foreign investors-who are barred from investing in a country with ‘junk’ status-would be compelled to pull their money out and look for other destinations. It is important to note that many investors have charters that prohibit investment in junk-rated countries.
As on July 13, 2012, the number of registered foreign institutional investors (FIIs) in the country stood at 1,754 and the total number of sub-accounts were 6,358 during the same period. The total investment so far in 2012 (till July 13) by FIIs in the Indian equity market is $9.82 billion (Rs 49,349 crore), according to data available with the Securities and Exchange Board of India (Sebi). Globally, there is a clear tendency among investors to shift towards risk-off trades, so even a small negative trigger, local or global, can reverse this trend, which would have huge effect on domestic stock markets.
FDI inflows in the country in 2011-12 were $36.50 billion. India allows FDI in most sectors through an automatic route, barring certain sensitive segments like telecom and defence for which clearance from the FIPB is required. A number of projects have been implemented in areas such as electricity generation, distribution and transmission, as well as the development of roads and highways, with opportunities for foreign investors. Such projects would be affected if foreign investors pull out their money.
As it is, foreign investment is slowing down. FDI in the first two months of the current fiscal fell to $3.2 billion from $5.15 billion a year in the same period. Foreign portfolio investors withdrew a net $1.4 billion, as compared with an inflow of $1.82 billion a year ago. Experts say that the government’s inability to push through vital changes—such as opening up insurance, multi-brand retail and pension—has badly hurt sentiments.
It is true that Swedish home products giant Ikea has announced the largest foreign investment in India’s retail sector, 1.5 billion euros (Rs 10,500 crore), in two phases. But things are not moving fast enough.
Contraction of economy
Downgrade to junk status would further add to inflation woes as higher prices of petroleum products would have a spiral effect. Further, the downgrade would have impact on consumer loan rates. Besides, it would erode business confidence.
What can be done
India has to take decisions which are fiscally and economically prudent. It has to substantially cut down the fiscal deficit. This can only be done by boldly slashing subsidies which are bleeding the exchequer. The government also has to scale down wasteful expenditure. Spending on populist schemes has to be checked. But then these would be political decisions, which would require political will.
Further, the investment climate has to be enhanced. During the United Progressive Alliance’s rule, anti-industry rules and regulations have been framed under the influence of politically influential activists. Unsurprisingly, doing business in India has become difficult, resulting in slump in business confidence. Let alone foreign investors, even Indian businessmen are looking overseas for their expansion plans. This has to change.
Apart from the adverse economic scenario globally, low business confidence has also resulted in decline in exports which has further pushed the rupee down. Efforts are needed to boost exports.
At the same time, the import bill, which has zoomed menacingly, has to be brought down. Since a major part of our imports is petroleum, the government has to start taking right away on short-, medium- and long-term measures to reduce our dependence on imported crude.
Policy paralysis has not made matters any better. Inter-ministerial wrangling, procrastination and red-tapism continue to mar government functioning. Prime Minister Manmohan Singh and UPA chairperson Sonia Gandhi ought to get rid of such inadequacies. Tax issues, particularly the one related to Vodafone, have played havoc with government-business relations and severely maligned India's image. Thankfully, the Prime Minister is seized of the matter and some good is likely to come out of his direct intervention. But it is an uphill task for him and his team when it comes to getting out of the shadow of downgrade. When Singh delivers the customary Independence Day speech from the ramparts of the Red Fort, downgrade would weigh heavily on his mind. The promises he would make about the economy this time would have to be backed with action.
