Credit Rating : A new hurdle for the Indian economy?

Indian economy which is still struggling through a bumpy phase seems to have another hurdle on its path. Moody’s, one of the top credit rating agencies has lowered India’s rating outlook to ‘negative’ from ‘stable’, citing increasing risks in the country’s economic growth as the reasons for the same.

    
            

BY HARDIK GOEL | 6 min read

On 8^th November 2019, global ratings agency Moody’s cut its outlook for India’s credit ratings to “negative” from “stable”, citing the ongoing economic slowdown, financial stress among rural households, weak job creation, and the liquidity crunch in non-banking financial companies as reasons for the same. Moody’s has affirmed India’s Baa2 long-term sovereign rating, the second-lowest investment grade score, but said the negative outlook indicated that an upgrade was unlikely in the near term.

In order to understand this concept in depth, there is a requirement to have clarity on certain aspects.

What is Credit Rating?

In simple terms, credit rating is a measure of how well an entity whether that’s a country, company or individual, can pay back the money it has borrowed. In other words, it refers to credit-worthiness. It indicates the  financial risk associated with entities such as governments, non-profit organisations, and countries, among others. The rating is given to entities by the credit rating agencies after analysing their business and finance risk. Some renowned credit rating agencies are Moody’s, Standard and Poor’s (S&P) and Fitch.

How are they calculated?

Each rating agency has a different method to calculate credit ratings. Agencies rate entities, that includes companies, state governments, non-profit organisations, countries, securities, special purpose entities, and local governmental bodies. At the time of calculating the rating, credit rating agencies consider several factors like the financial statements, level and type of debt, lending and borrowing history, ability to repay the debt, and past debts of the entity before rating them. Once a credit rating agency rates the entities, it provides additional inputs to the investor following which the investor analyses and takes a sound investment decision.

Significance of different ratings

Triple-A is the highest rating that can be given, and triple-D is the lowest. Anything below a B, however, is viewed as pretty risky. The ratings are broadly divided between "investment grade" and “junk”. The lower the rating, the greater the risk that the borrower will not be able to pay back the money.

How a downgrade in ratings affects a country?

When a government seeks to borrow money, it’s rating reflects its ability to pay back the amount. The higher the rating, the cheaper the borrowing cost. However when ratings of a federal government are downgraded, it has wide ranging negative impacts and hence, difficulty in getting loans.

●       The immediate impact of a credit rating downgrade is that the interest rates paid by the federal government will go up.

●       The credit ratings of both banks and many corporations are tied to the federal government’s. This means a federal government downgrade will have an impact on many companies, investors and individual borrowers.

●       Share markets would be affected, but so would other borrowers, including foreign governments.

●       Further, the credit assessments of governments and banks are often intertwined, especially in times of financial crisis.

●       A downgrade for either banks or governments increases bank borrowing costs. This makes it more likely that banks will need to be bailed out by the government in the near future. This puts more pressure on the government’s finances, which could lead to another government credit rating downgrade, and therefore creates a vicious cycle.

●       A rating’s downgrade not only affects banks. Recent research shows that when a government’s credit rating is downgraded, companies with similar credit ratings also see a ratings change, even if there is no fundamental change in their own creditworthiness.

●       And on top of all that, when banks face higher borrowing costs, they either pass this on to households and  investors in the form of higher lending rates and/or cut back on their lending.

Will India go through the same phase?

This depends on how and from where the government borrows. Many countries tap the global debt or credit markets to raise money. However, India has been an outlier on this count. It has not issued a bond or raised money directly in the international market so far, which means that to a good extent, a downgrade has limited impact. Rather, the impact is felt almost fully by private firms or state-owned companies which raise foreign currency funds.

In this year’s Budget, the government announced its intention to go in for a sovereign bond, but hasn’t moved on it yet in the backdrop of criticism and caution by the RBI. In the past, Indian policymakers with long memories had stymied attempts to issue a sovereign bond or borrow from the international market directly. One of the reasons for that has been what they perceive as the alleged bias of credit ratings agencies.

How the government reacted to the news?

The negative rating seems to be an additional burden on Finance Minister Nirmala Sitharaman, who is proactively taking steps to reverse India's economic fortune.

However despite this, the ministry strongly reacted to the development.

A statement issued by India's finance ministry, said, "India's relative standing remains unaffected."

The government explained that the fundamentals of India's economy remain "quite robust" and the recent series of reforms would stimulate investments and strengthen the economy.

"Government of India has also proactively taken policy decisions in response to the global slowdown. These measures would lead to a positive outlook on India and would attract capital flows and stimulate investments," it said.

"The fundamentals of the economy remain quite robust with inflation under check and bond yields low. India continues to offer strong prospects of growth in the near and medium-term," the finance ministry statement added.

The Bottom Line

While government measures to support the economy should help to reduce the depth and duration of India's growth slowdown, prolonged financial stress among rural households, weak job creation, and, more recently, a credit crunch among NBFIs, have increased the probability of a more entrenched slowdown. It seems that because of these issues Moody’s took the step to downgrade India’s credit rating. However, India might soon recover through this phase and emerge as a healthy economy. Also, Fitch Ratings and S&P Global Ratings, the other two international rating agencies still hold India's outlook as stable.