Moody’s Downgrade: A ‘Rating’ For Growth

India is 18-24 months away from being downgraded to ‘junk’. The global credit rating agencies consider a rating of BBB (minus) / Baa3 and above to be ‘investment grade’.

All ratings below that are termed as ‘speculative grade’, more commonly known in bond market parlance as ‘junk’ category.

The government and policymakers of an emerging market economy, thus, strive to be rated at least as an ‘investment grade’ destination.

This demarcation allows an emerging market to become more ‘investable’ in global investment portfolios. It thus drives in foreign inflows into India as well as allows the Indian government and companies to access the global markets in a greater manner.

In 2003, on the back of five years of substantial reforms by the NDA government, Moody’s became the first rating agency to upgrade India from junk to investment grade. S&P and Fitch, the other two global rating majors, were slow to react but on seeing the strong growth that followed, upgraded their ratings as well in 2007.

Moody’s decision to downgrade India back to Baa3 / BBB (minus) with a negative outlook brings India on the throes of being downgraded to below investment grade. S&P, which has a stable outlook, warned of a negative rating action as well.

Lest We Believe, This Is Not Due To Covid-19

The basis of caution of both of the agencies is growth. India will be downgraded to junk for a lack of growth.

Or growth, but which is well below potential.

Or growth, but well below the levels required to be able to justify an investment-grade rating.

If you would have told anyone in 2005 that India will be downgraded to junk for lack of growth, they would have laughed you away. India, was at that time, part of ‘BRIC’ – a great disservice, we believe to all these nations by Jim O’Neill of Goldman Sachs – the wonder economies.

Three years of 9 percent real gross domestic product growth made everyone extrapolate India to be a sustainable double-digit real GDP growth economy. Four forecasts as part of an International Monetary Fund review paper of 2007 for the long term potential India Real GDP growth had a minimum of 7.3% and a maximum of 9.8% as their range forecast.

This, by the way, includes the bewildering high growth prints of FY15-FY18. The 6.2% has yet been lower than Quantum’s own long-held (since 2007) long-term real GDP estimate of 6.5%. Many called us pessimists then. The same may now call us optimists.

Growth Is Key

Business models and investment decisions in India are based on nominal GDP growth of 10-14%. Rating agencies overlook the near 30 percentage point difference between India’s public debt to GDP and other emerging market peers with similar ratings, as they expect India’s high growth to solve the high debt issue over time.

We still do not see rating agencies downgrading India just because the general fiscal deficit to GDP will reach over 10% of GDP this year. The key rating sensitivity is whether India’s will reach its growth potential. The need for continued reforms in India to boost GDP growth is thus very high.

Moody’s upgraded India in 2017 on the back of the implementation of GST and IBC. However, this downgrade, just two years later stating ‘the countries policymaking institutions will be challenged in enacting and implementing policies…’, which can mitigate the risk of sustained low growth, deterioration in government fiscal position and stress in the financial sector.

The nominal GDP growth has been below 10% for the last two years and expected to be so for at least two more years. The banking and financial sector has been in a mess for many years now, Covid-19 was only the straw that broke the camel’s back. Factor reforms of land, labour, and capital remain unresolved. The political economy is not keeping pace with the change in times and, in fact, is making India’s institutions weaker. India’s job creation problem is soon turning the demographic dividend into a disaster.

These are indeed constraining growth. No one really talks about 8% real GDP growth anymore. Many will kindly accept 5-6%. This is indicative of the extent to which the expectations have been smothered.

6% – New Normal?

6% may still be good from a global growth perspective. But, is it good enough for India? Is it enough to lower our future debt burden? Is it enough to create the demand and hence the jobs that the 10 million Indian graduates will seek every year for the next 10 years? Is it enough to get 300 million Indians out of poverty?

India’s savings and investment rate are now below 30% of GDP. India needs continued foreign savings to increase the investment rate to boost GDP growth. Recent FDI flows have been steady, but portfolio flows both in equity and debt have stalled and/or reversed.

Monday’s rating downgrade was expected and may not have too much of a market impact.

Rating changes, as they say, are a lagging indicator. If the move to ‘junk’ has to happen, markets will price it ahead of the reality. The impact of it would be seen in the bond market inflows and in the pricing of Indian dollar corporate bonds. Not a good sign, when we are preparing to enter into global bond indices. The impact would also be seen in the Indian currency as the market prices in slower or lower inflows into Indian equities, bonds and other asset classes.

As it stands, the government’s economic and fiscal response to the wealth and income destruction due to the imposition of lockdown has been limited. At Quantum, we estimate an income, consumption, and investment shock of around 9% of GDP which is likely to derail two more years of economic activity.

At the start of this decade, India had the potential of becoming a ‘breakout’ nation. Alas, as the decade ends, India will be fighting to prevent a ‘breakdown’.

Arvind Chari is Head - Fixed Income & Alternatives at Quantum Advisors. Views expressed are personal. Disclaimer.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.