It is happening again. In 2012, we had Fitch downgrading its India’s rating outlook to Negative. In 2020, we now have Moody’s downgrading its rating from Baa2 to Baa3. What would would this mean? This post aims to demystify the importance and actions of Rating agencies. It will also try to reflect the consequences of a rating downgrades and upgrades on the direct financial well being of a country and its indirect impact on the residents. However, just an important point before we move ahead, Moody’s rating downgrade aligns its rating given to India with other reputed rating agency. India post this rating downgrade is at ‘Investment Grade’.
Challenges Imposed Under Covid
The scale of Global humanitarian, medical and financial tsunami brought in by COVID is unprecedented. The first priority of any Government has been to ensure the medical, followed by financial well being of its residents. The large scale lockdowns spanning over 2 months in India has hit both the business communities as well as the individuals on their financial budgets.
While COVID was on the doorsteps of India, the economic situation of the country was already reeling with a multi-year slow down triggered by extreme shocks in past couple of years from events such as Demonitisation, GST, massive Credit frauds caused by IL&FS, excessive defaults and NPAs for banking sector, not to mention collapse of Yes Bank and DHFL. A combined impact of all this was impacting the revenue source of the country via a weaker Tax revenue which does not give india much of a head room for finance dole outs like any other Country. The Finance ministry would have been in a Catch-22 situation. If they give a massive dole out, it would need to stretch beyond its purse risking its Credit Rating. If they don’t, the residents would be hit.
Credit Rating Agencies (CRA)
CRAs are corporate bodies who have over a period of time earned a reputation of being able to analyze the financial well being of Individuals, Corporate Bodies and Countries. Amongst the list of credible Global Credit Rating Agencies are S&P (Standard and Poors), Fitch Ratings, Moody’s Investor Services, etc. In India, CRISIL, CARE, India Ratings and ICRA are the reputable CRAs.
CRA review the financial position of entities to identify their credit worthiness and the ability of any entity to meet it’s credit obligations. How do they do that ? Simply putting how would you identify if a person is credible enough to repay his debts ? Analyze existing incomes, expenditures, available assets, liabilities and future earning potential of a person and you would get a good idea about the person’s credit worthiness. The same applies for a country. Does the country earn enough income via taxes so that it can meet its expenses such as subsidies, interest payments, infrastructure programmes, etc ? If its incomes are less than its expenses, it must be borrowing money to meet its requirement. Is the country borrowing more than more than its sustainable level ? If the country’s growth rate is fast enough, then it should be alright for it to borrow now as the same can be repaid in future by the growth it achieves. But what if the growth slows down and the Country continues to borrow ? This is where the CRAs may start becoming uncomfortable and would challenge the Country’s rating.
The end product of a CRA is reflected in the form of a Credit Rating. It is a rating scale which reflects the credit worthiness of the entity. Generally these scales are in the form of alphabets and numbers. Comparative ratings scales of the three major Rating agencies is below. The most broad categorisation is Investment Grade and Non Investment Grade. Further, the investment grade is broken down into granular ratings as detailed in the chart below
A bit in detail for Moody’s is below
So when a CRA says that they have downgraded an entity, it would mean shifting down lower in the table of their Ratings. In the example above, it would mean from BBB to BB or from AAA to A. It would entail that the respective entity’s financial health has deteriorated and the entity can no longer sustain the benchmarks of the respective credit grade.
Illustration of Country Credit Ratings
You may be wondering what’s India’s comparative ranking amongst other countries in the world when it comes to Investment based credit rating. The info graphics below showcase S&P ratings of all countries as of Mar 2019. AAA (Dark Green) is the highest rating, while CC/D is (Black) is the lowest. India is at BBB (Amber).
How are the Ratings Used in Practise ?
All the financial institutions in the world analyze the credit worthiness of the Countries in which they want to take investment exposure. For example, before taking a decision to invest in India, the respective investment bank would want to analyze India’s credit worthiness to conclude if it would be a good investment or business outcome. In order to perform the analysis, financial institutions build comprehensive credit analysis decision models in which one of the key input is also the rating issued by reputed CRA for the respective country.
Hence if a CRA downgrades a country’s credit rating, it would feed into the credit analysis models of all major financial institutions across the globe and the consequences can be any or all of the following :
- Expensive Credit – This is the first and the most obvious change which happens as a direct consequence of a downgrade. If a country’s credit rating is downgraded, it becomes more risky in comparison to the peers. The lenders would want to get more return for the increased risk they have to take to lend a downgraded country and the corporates residing in the country. In a worse case situation, the funding to a downgraded country may also get stopped as not all institutions intend to invest in countries which are below ‘Investment Grade’. A rating downgrade can also have a negative impact on the prevailing Government Bond yields (interest rate), increasing the borrowing cost by the Government. The government bonds are considered as the ‘risk free rate of return’ in a country and all other borrowings in the country get benchmarked against the risk free rate of return. An increase in the risk free rate of return will eventually drive up the rate of borrowing within an economy.
- Less allocation of investments and Capital – International investment banks & pension funds diversify their investment allocation across different countries to reduce the risk of excessive exposure to a single country on the overall portfolio. The credit rating of a country widely influences how much percentage of the funds would get allocated to a specific country. Generally, low risk countries enjoy higher allocation of investments compared to high risk countries. If a country gets downgraded, it would result in reshuffling of investments from the respective country in favour of other countries and hence preventing any further flows of capital into the downgraded country.
Flight of Capital Outside India – If a country gets downgraded, international institutions would revisit their investments in such country and it is likely that they may want to trim their holdings in the downgraded country and invest it in other countries. This would involve a flight of capital from the country, negatively impacting the Balance of Payments position of the country
Currency Depreciation – If country’s credit ratings downgrade has an immediate impact on the depreciation of its currency as a downgraded country would have find lesser demand for its currency. For more details on currency depreciation, please read Rupee Depreciation- – How Does it Affect YOU.
Rating Downgrade of the Corporates – Many financial institutions across the globe follow a principle – Credit Rating of a Corporate can not be greater than the Credit Rating of the respective country in which they reside. As a result, irrespective of the credit worthiness of the Company, they face the credit rating downgrade hammer. This reduces their ability to raise finances at a competitive rate from foreign sources at a cheaper rate and hence increasing their overall borrowing costs.
Downgrades are Not Permanent
Though it is vital to know the consequences of a credit downgrade on the country and the residents, but at the same time it is important to know that a downgrade is not permanent. It comes when the financial position of a country deteriorates. If the associated elements which have resulted in the deterioration of the financial position are rectified, the health will get restored – resulting in reinstating of the credit rating – or a Credit Rating Upgrade. For now, it is a wait and watch game to see how fast the economy comes back to its foot after the COVID shock.