Impact of the recent negative outlook of various rating agencies on India

The higher you climb, the harder you fall.

Indian economy, enjoying a honeymoon period for the best part of the last seven years, has been hit where it hurts the most. S&P has downgraded India's rating outlook to negative from stable in April. It also downgraded ratings for 21 major Indian banks including SBI and ICICI and the top IT firms like TCS, Infosys and Wipro. Since then, it has been issuing continuous warning stating Indian rating might be downgraded from its present state, which is just a notch above junk. It has forecast the growth in current fiscal year to be 5.3%, down from 6%.

If everything above sounded like French, then here is the English translation. S&P is a financial services company, which is also one of the world's biggest credit rating agencies. It issues ratings to issuers of debts and debt instruments. These ratings are calculated based on a GAMMA score. This score measures the strength of a company's corporate governance practices as an investor protection against potential governance-related losses of value or failure to create value¹. It was in news last year when it cut US rating from AAA. And last month, it cut India's rating outlook. India's rating, BBB-, may go down another notch in another couple of years if actions are not taken immediately. Another credit rating agency, Moody's cut the rating of several Indian banks, like HDFC and Axis.

There are several questions that can be asked. Why the ratings deterioration? How would it make a difference? What can be done to correct it?

India has been in a state of economic slowdown for some time now. Ever since Euro debt crisis, the whole world has been facing the shock. India has gone into a rapid downward spiral since then. India's account deficit and fiscal deficit had burgeoned since then. Fiscal deficit, which was projected to be 5.1% of GDP and which was 4.6%  in the previous fiscal year, ended at 5.9%. This is perilously close the 6% mark, which is considered to be the benchmark. For the record, it was 7% during the dark days of 1991. Account deficit, as of now, stands at 4.5% of GDP. In nutshell, India has been spending well beyond its means, and this extravagance has now come back to bite. The current political gloomy scenario in the country, where reforms are not moving and legislations are slow, have been taken into account by the ratings agency before downgrade

This downgrade will worsen the already poor situation of the economy. The borrowing costs for both Indian companies and Indian banks will rise to compensate for the highly negative outlook. The banking system's bad loans might be bloated up, as a result. Bad loans have grown faster by three times than credit. These loans, which stood at 2.9% of total loans in March 2012, might rise to 4.3% by 2013. The normal accepted figure is somewhere between 3.3% and 3.5%. Banks, which are now relying heavily on mutual funds and insurance companies, have raised the risk of the complete financial system. The rising short-term borrowings of banks at 27% of the total and the sector's reliance on mutual funds has made things more tough². The foreign investments, which have been drying up swiftly, may be eroded even more quickly. This disinterest of investors in the Indian market may make the already weak rupee fall farther as the demand for rupee will weaken against dollar. This would make imports more expensive and push the inflation, which is already at an uncomfortable high level, north. The ratings cut, thus, is going to puncture India's reputation as a growth and investment destination.

The only good thing, if one wants to be optimistic, is that it might wake up the sleeping giant. The Indian government, which has been rightly accused of policy paralysis, may wake up and swing into action. One of the first motives has to be to reduce the behemoth figure of account and fiscal deficit. In the budget for the current fiscal year, the fiscal deficit target has been set for 5.1%, which in itself is a huge figure. Nevertheless, this target had been set on the basis of estimating the fuel, fertilizer and food subsidy at a very competitive and almost an unrealistic amount. To meet these levels, the government will need to pull up the prices of petrol, diesel, and LPG. So far, it has hiked the prices of petrol and LPG. The petrol hike has been rolled back partially after widespread protest. However, the price of diesel need to be raised immediately. The government is losing around Rs.14 per litre on diesel and this amount needs to be brought down to achieve the subsidy targets. That the government is considering raising the tax on diesel cars instead of increasing the fuel price reflects poorly on them. The raising of duty on gold import has done a world of good to its imports, as they fell by more than 30% in the first quarter of year. The decrease in imports reduces the current account deficit. Also, gold as an import is useless. It just lies dead in vaults, without providing any value addition. The government also needs to attract the foreign investments in the form of FDI and FII. Instead, during the budget, the finance minister had imposed capital gain tax on offshore transactions involving Indian assets with retrospective effect from 1962. The Supreme Court cancelled all the licenses issued for mobile networks. Both Uninor and Vodafone have protested. Another budget provision, the General Anti Avoidance Rules (GAAR), is creating a poor impression of India. Such incidents can only send a negative picture to prospective investors. The government needs to push for reforms like pushing the cap for FDI in multi brand retail, opening pension fund for foreign investors. Tax reforms like Direct Tax Code and Goods and Services Tax need to be implemented.

Such moves might improve the economic stagnation of India. The impact of the downgrade may make the government become proactive and come up with healthier reforms. This, in turn, might push up growth figures, attract foreign inflows, push down inflation which may lead to the much awaited rate cuts by the RBI.

As they say, learn from yesterday and hope for tomorrow.