It is all over the media – Fitch has downgraded its rating outlook to negative. What is this all about ? This article 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 – Fitch has mentioned that it has downgraded its rating outlook and not the actual rating, which is actually the next step after change of outlook. Lets see on a step by step basis on what Fitch is, what is a rating and the consequences of a downgrade.
Credit Rating Agencies (CRA)
These agencies 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 and ICRA are the reputable CRAs. In short CRA tend to review the financial position of entities to identify their credit worthiness or 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. For example, would you find a person stepping out of a BMW, carrying an iPhone, having less / no loans and a good bank balance financially credible compared to a person who lives in a dilapidated house (no offenses meant), burdened with loans ? This is what CRAs do for all the entities they monitor by employing highly skilled credit experts whose job is to constantly monitor the financial position of the entities.
The end product of a CRA is reflected in the form of a Credit Rating. It is generally a rating scale which reflects the credit worthiness of the entity. Generally these scales are in the form of alphabets and numbers. Take an example of Fitch’s rating scale :
|AAA||Best quality companies, reliable and stable|
|AA||Quality companies, a bit higher risk than AAA|
|A||Economic situation can affect finance|
|BBB||Medium class companies, which are satisfactory at the moment|
|BB||More prone to changes in the economy|
|B||Financial situation varies noticeably|
|CCC||Currently vulnerable and dependent on favorable economic conditions to meet its commitments|
|CC||Highly vulnerable, very speculative bonds|
|C||Highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to pay out on obligations|
|D||Has defaulted on obligations and Fitch believes that it will generally default on most or all obligations|
|NR||Not publicly rated and not Rated|
* source Wikipedia
So when a CRA says that they have downgraded an entity, it would mean shifting down lower in the table of their Ratings. In our example above, it would mean from BBB to BB or from AAA to A. It would entail that the respective entity has deteriorated and the entity can no longer sustain the benchmarks of the respective credit grade. And take my words for it, the credit grades are really powerful in the financial world !
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 below mentioned map aims to summarise India’ comparitive grade vis-a-vis other countries in the world. It would be evident that we need to go a long way before we can compete with the developed western markets such as USA, UK, Germany, etc. Even amongst the so called BRIC nations (Brazil, Russia, India & China), China is ahead of India. You may have heard from spiritual leaders – don’t look at the people who are well off, look at the people who are worse off and it would give you a comfort. Well, over here, unless we compare ourself with other well off countries, we are all set for a Red Rating in the future…
How are the Ratings Used in Practise ?
Probably this is the least publicly known aspect around how are the CRA ratings used in practise. End user do not use the CRA as a part of their daily lives (except in case of the CRA doing individual credit ratings such as CIBIL in India. For more details individual credit ratings, you may want to refer Improve your Credit History – Timeline of Your Current & Future Financial Image). This article tends to focus more on the corporate & country rating agencies.
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 ‘x’ million / billion dollars in India, the respective investment bank would want to analyze if India is credit worthy to give good return on the money invested by the bank. In order to perform the analysis, financial institutions build complicated credit analysis decision models which take into consideration the Credit Rating issued by various reputed CRA. Amongst the most used CRAs are S&P, Fitch & Moody’s.
Hence if Fitch tends to downgrade a particular country’s credit rating, it would also probably feed into the credit analysis models of all major financial institutions across the globe putting pressure on the credit worthiness of India across all banks and financial institutions in the world ! And the consequences can be any or all of the following :
1. 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 and as a result no one would want to offer credit facilities (such as foreign currency loans) at the same rate of interest before the downgrade situation. 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. Needless to mention that this would mean that India would have to pay more in terms of the unproductive interest payments !
2. Less allocation of investments – International investment banks & pension funds diversify their investment allocation across different countries to reduce the risk of excessive exposure of single country on the overall portfolio and to prevent a particular country’s economic conditions materially influence upon the health of the overall portfolio. The credit rating of a country widely influences how much percentage of funds an investment bank would invest in that 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 or countries having a poor credit rating.
3. Less Private Equity – Similar to point 2 above, Private Equity firms would refrain to invest in a country which gets downgraded due to increased risks of operating in that country.
4. Flight of Capital Outside India – If a country gets downgraded, international investment banks would revisit their investments in such country and it is very possible that they may decide to sell of their holdings in the downgraded country and invest it in other countries. This would involve a flight of capital from the country screwing up the Balance of Payments position of India.
5. Stock Market Sell Offs – As a direct consequence of sell off by international financial institutions of their holdings in India, the stock markets tend to bleed eroding the wealth of millions of investors who have invested in the markets.
6. Currency Depreciation – If India’s credit ratings would be downgraded, it would indirectly result in further depreciation of Indian Rupee for obvious reasons. Investors would find India as a more risky investment destination and would result in less demand or rather reduction in demand for Indian currency – hence posing additional pressures on the currency. For more details on currency depreciation, please read Rupee Depreciation- – How Does it Affect YOU.
7. Less New Business Ventures – Would you want to open a new business in a place where there are more economic risks associated with the operations ? Same happens with Rating Downgrade, making India a more risky destination. Why would foreign corporates want to open their businesses in India if they can find a lesser riskier location (such as China) to open their new business venture ?
8. Less Employment – Reduced Operations or lesser new businesses counts down towards poor job prospects in a country. This doesn’t reflect overnight into the economic situation of the country. It may take a couple of quarters before you would start to feel the pinch of it by not finding an appropriate job to take your career to the next level. Many companies on a cautious stance would reduce the job vacancies or put a hold on the existing job vacancies (check out Infosys delaying the joining dates of its recruitment for this year).
9. 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.
10. Reputation Damage – Well this should be have been the first issue associated with a Rating Downgrade of a country. Why shouldn’t it be ? US was downgraded by S&P from AAA to AA and they created a havoc questioning the rating models used by S&P and their internal Quality Assurance procedures – obviously it stood upon the goodwill of the US economy ! No one would want their credibility to be tarnished – and one of the aftermaths of a downgrade is a hit to the financial good will of the country. No doubt the finance ministry tends to give a press release / clarification to react upon a downgrade news.
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. Isn’t that a part and parcel of the regular economic cycles ?
What is currently needed in India are a series of conscientious steps to from our Government to clear the hurdles which are acting as bottlenecks in the growth path of the economy. Many of these hurdles are just because of whims and fancies of the politicians. Others require a long term policy action to improve the infrastructure of the economy to sustain long term growth which paves the path of Indian economy from a developing economy to a Developed Economy !