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Friday, August 17, 2001



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Who is afraid of the rating agencies?

A. Seshan

STANDARD and Poor's (S&P) lowered its long-term local currency sovereign credit rating of India to triple B minus from triple B. At the same time, it affirmed its double B long-term and B short-term foreign currency and A-3 short-term local currency rati ngs. The long-term outlook was revised to `negative' (meaning it may be lowered) from `stable'. The local currency downgrade reflects, inter alia, the unchecked Budget deficits resulting in rising domestic indebtedness, and the lack of progress in econom ic reforms. It expects the Central and State Government Budget deficits to exceed 10 per cent of GDP this year.

The total debt of both the Central and State Governments could approach 70 per cent of GDP, or more than 400 per cent of revenues -- higher than in most similarly rated countries. Now India finds itself in the same position as in March 1991, in the midst of the Gulf War. It has come a full circle despite the decade of economic reforms.

In the agency's terminology, `BB+' or lower is in the ``speculative'' category, a euphemism for junk-bond status, denoting a high risk of default. India is on a par with Jordan and some Latin American countries in relation to one of the characteristics r ated. The S&P list is intriguing. How is it that Croatia is in a better category than India -- a BBB+ (local currency long-term) and BBB- (foreign currency long-term), A-2 (local currency short-term) and A-3 (foreign currency short-term) with a stable ou tlook?

Moody's Investors Service (Moody's) followed suit by revising the outlook on Ba2 foreign currency country ceiling to `stable', and Ba2 local currency rating to `negative' from `positive'. It has given more or less similar reasons to S&P's. It has acknowl edged that the availability of substantial foreign exchange reserves and low short-term government debt indicate a favourable liquidity position, but has alerted the country to a possible further rise in external debt liabilities.

The ratings of some public sector entities have also been lowered, which is understandable, because, no entity can have a higher rating than that of the sovereign. According to Sovereign Credit Ratings, a primer issued by S&P, the ratings are not country ratings -- an important distinction, the lack of understanding of which has led to much uninformed criticism. Basically, sovereign ratings address the credit risks of national governments in relation to their financial position. Thus, it is irrelevant t o talk about the relatively better performance of the country vis-a-vis other developing nations or the massive size of the forex reserves, built on borrowed money, or the highly diversified industrial base.

The fact that two-thirds of the gross and three-fourths of the Government's net budgeted borrowings for 2001-02 have been completed within four months of the year points to the tremendous pressures on the fisc.

No doubt, external resources have flowed in recently. Low ratings do not mean an end to inflow of funds. They will continue to be available, but at a higher cost. After all, even junk bonds have a market but with a high yield. There has even been a refer ence by some observers to the successful floatation of the India Millennium Bonds as proving that ratings do not matter in raising resources abroad. The conclusion should be to the contrary.

The interest rates paid on the bonds, whether denominated in sterling or dollar, were several basis points above the going international rates and the NRIs had never had it so good. Such high rates had to be paid because of the poor perception about the Government's finances. This is exactly what the ratings are expected to result in. One should also remember that the ratings apply to the bond market and not to the syndicated loan market.

Some organisations have criticised that the agencies' methodology is faulty. One does not know whether anyone in these organisations has really studied the issue. In assigning credit ratings by the S&P, each Government is ranked on a scale of one (repres enting the highest score) to six (the lowest) for each analytical category in relation to the universe of rated and unrated sovereigns. There is no exact formula to combine scores to determine the final outcome. The analytical variables are interrelated and the emphasis can change when, for instance, differentiating the degree of credit risk between a sovereign's local and foreign currency debt.

The weights given to various variables should be interesting, though the agency claims that there is no exact formula for arriving at the aggregate score. Does the real sector carry as much weight as the financial one? There was a feeling during the Gulf War that the junk-bond status given to the country's issues was a knee-jerk reaction to what was a problem of liquidity and not solvency. As the agencies themselves admit, there is a subjective element of judgment.

The downgrading by S&P and Moody's has had no significant impact on market, either internally or externally. The explanation given by Mervyn King, Deputy Governor of Bank of England, in an interview seems plausible: ``I think investors are also far more cautious about rating agencies than they were five years ago. And major financial institutions make their own judgment. More often than not, the rating agencies do not have access to any special information. Five years back, people would have commented a bout such rate cuts. They would have said the agencies must know something we do not. This does not happen any more. Since governments are more transparent these days, concerns about investors being unduly worried are not real any more.'' Most internatio nal lenders have their own database on India and make their own assessments. In fact, the export credit guarantee organisations of various countries have a global association where they exchange views and arrive at a consensus on country assessments. The problem with rating agencies is they are quicker in downgrading than in upgrading. Their poor record in anticipating the East Asian crisis has made them doubly cautious, unfortunately for India.

Regarding transparency of Governments, referred to by Mr King, till the beginning of the 1990s, the level of India's foreign exchange reserves was a closely-kept secret. This information was published only in the International Financial Statistics of the IMF once a month. Due to the time-lag in its publication and lack of publicity, or readership, it did not get any attention. During the Gulf War, the data became a matter of speculation. The RBI, however, continued to make the data available, because of necessity, to the IMF, the World Bank, and rating agencies.

The Department of Economic Analysis and Policy argued with the authorities that it was anomalous that the data was made available to organisations while the public was kept in the dark, leading to speculation. Thus, it suggested publishing the data in th e Weekly Statistical Supplement to the RBI Bulletin. The management agreed with the suggestion. Transparency in the publication of the data has taken much of the sting out of the ratings.

The absence of any impact on the local market is understandable. The stock market is still to recover from the after-effects of the recent events, including the abolition of badla. The volumes of transactions are reported to have come down significantly since the new settlement system came into effect. The debt market has been impervious to the developments because the nation is swimming in a sea of liquidity fed by fiscal deficits.

It is wrong to claim that there is no internal debt crisis emerging, as highlighted by S&P and Moody's. As early as 1987, an RBI study on `The Burden of Domestic Public Debt in India' pointed out that, ``if the existing trends in interest payments and ma rket borrowings continued, a point of no-return would be reached by 1992-93, when net market borrowings would not be sufficient to pay even interest on outstanding market borrowings.'' This is the `internal debt trap' about which there was a lively discu ssion in the press and in Parliament, thanks to the attention it received from the legal luminary and public finance expert, N. A. Palkhivala, who endorsed the conclusions of the study in his speeches on the 1988-89 Budget delivered all over the country. Unfortunately, the prediction came true. In 1991-92, the net interest payments at Rs 7,355 crore more or less equalled the net market borrowings at Rs 7,510 crore, marking the transition to the internal debt trap. In 1992-93, at Rs 8,147 crore, they exc eeded market borrowings of Rs 3,676 crore. As a result in the next year, net market borrowings shot up to Rs 28,928 crore. Due to the further deterioration in government finances in recent years, market borrowings have been growing so that there is some money left after making interest payments.

According to the latest Budget, interest payments on all liabilities taken together, account for nearly a half of revenue receipts. Caught in the quicksand of internal debt, the more the Government tries to pull itself up, the more it sinks. The central bank is saddled with the largest amount of non-performing assets in the financial system -- Rs 1.5 trillion of Government securities in its investment portfolio.

As Moody's has rightly cautioned, the low ratio of current account deficit to GDP provides no guarantee that external finances are healthy. Its decision to remove the `positive' outlook on the foreign currency country ceiling (assigned in October 1999) r eflects that current and capital account inflows on the balance of payments will be insufficient to prevent a further rise in the external debt liabilities. Commentators have missed the warning that, inter alia, lapses in contract enforcement allowed by bureaucratic discretion -- as illustrated by the Dabhol imbroglio -- have dampened domestic and foreign investor confidence.

It is true that the country is inherently strong because of its agricultural and industrial base, technically-qualified manpower and progress in new technologies. But what is required is a sound policy framework to mobilise the resources and remove such weaknesses as the excessive debt burden caused by heavy fiscal deficits. This should be the message the nation should read in the assessments of the rating agencies.

Pic.: The ratings by S&P's and Moody's underline the need for a zero fiscal deficit policy. Is Mr Yashwant Sinha making note?

(The author is a former Officer-in-Charge of the Department of Economic Analysis and Policy, the RBI.)

Related links:
S&P downgrades India rating -- Cites unchecked Budget deficits, rising indebtedness
Deserved downgrade
Moody's lowers India's rating

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