Global rating agencies may ‘junk’ India

Downgrade will up borrowing costs abroad, deter investors

MUMBAI: An avalanche of bad economic news, compounded by gross macroeconomic mismanagement, threatens to reduce India’s status as a respectable investment destination for global funds, earned barely 18 months ago, to junk status.

Rating agency Standard & Poor’s on Friday flagged India’s worsening inflation scenario and credit profile, characterised by rising fiscal deficits (the gap between government spending and its total expenditure, which has to be bridged by borrowings), raising the prospect of a downgrade of India’s sovereign rating from ‘investment’ to ‘speculative’ grade (i.e. junk).

S&P had rated Indian local debt at investment grade, or BBB-, for the first time on January 30, 2007, up from BB+. If the rating falls again to BB+, the world’s big pension funds and risk-averse investors will start giving India a miss. A downgrade would also means companies and banks here will have to pay higher interest rates on their overseas loans. Rates on loans are pegged to country ratings.

This and other bad news —including faltering industrial production, a rise in inflation and crude oil prices — plunged the BSE Sensex by 456 points.

India’s industrial output growth fell sharply to a six-year low of 3.8% in May from 6.2% in April. “The data suggests that the trade-off between rising inflation and falling growth is worsening,” notes Lehman Brothers’ economist Sonal Varma. “Between the hard choice of rising inflation and slowing growth, we expect the Reserve Bank of India to choose (tackle) inflation.” This means still higher domestic interest rates.

“The combination of industrial production numbers and the news of a further move-up in wholesale price inflation to 11.9%... emphasises the policy dilemma facing the RBI,” says HSBC’s India economist Robert Prior-Wandesforde. “Overall, the RBI is likely to retain a tightening bias.”

Summing up the grim mood, Barclays Capital regional economist Sailesh Jha said: “Recent developments in India lead us to a more bearish assessment of the macroeconomic outlook. Inflation will continue to accelerate, fiscal risks are picking up and financial asset prices are headed south.”

“Failure to respond adequately to negative developments as they arise… could point to a sustained deterioration in macroeconomic stability and… increase the probability that the ratings could be lowered,” S&P’s analyst Takahira Ogawa noted in a report.

The other global rating agency, Moody’s, currently maintains a stable rating on India’s foreign exchange exposure and on domestic debt. The agency’s India representative Chetan Modi said he would not comment on revisions - or even the possibility of one.

A sovereign downgrade reflects a thumbs-down for the management of India’s political economy. HDFC Bank treasurer Sudhir Joshi notes that although a downgrade is not imminent, it would have negative consequences.

“Two things will happen in the event of a downgrade,” says Prakash Subramanian, managing director and regional head, capital market, South Asia, Standard Chartered Bank. “Appetite for Indian paper globally will go down. Credit spreads will widen further, and domestic liquidity will suffer, forcing the government to revisit the ceiling on external commercial borrowings. Indian companies’ cost of borrowing will go up by 100 basis points or more (100 basis points equal 1%).”

S&P’s had raised India’s sovereign rating to ‘investment’ grade in January, 2007, citing strong GDP growth, gradual reforms and “consistent monetary and fiscal policy stances”, which had “sustained macroeconomic stability”.

What has changed since then? For one, global oil and food prices have soared, and with it the burden of subsidies borne by the central government, which has played havoc with the fiscal deficit. Add to that the impact of additional - some would say ‘profligate’ - expenditure measures such as a Rs 60,000 crore farmers’ debt waiver programme announced in Budget 2008, and the provisions of the Sixth Pay Commission for government employees, and the fiscal deficit “could exceed 9% of GDP” in 2008-09, notes Ogawa.

On Friday, global crude oil prices edged close to $147 on sustained geopolitical tension centred on Iran’s recent missile tests. The longer oil prices stay at those high levels, the more serious the implications for India’s fiscal deficit, particularly since a government in election mode may not be overly concerned about fiscal or monetary slippages. “The government is walking a tightrope because it cannot hike oil prices, and a duty cut will mean revenues will have to be sacrificed,” notes Subramanian. “It will have to absorb the burden in some way.”

Dhiraj Sachdev, head, PMS, HSBC Asset Management said the market had been spooked by the “I-4” factor - “IIP numbers, inflation, Infosys results and Iran tension” - but lower-than-expected industrial production data had probably done the most damage. “Also the fact that Infosys did not revise its dollar guidance impacted the market.”

Amitabh Chakraborty, president-equities, Religare Securities, too, said the IIP numbers did the damage. Other analysts see crude oil prices as the “mother of all problems”.