Understanding Credit Ratings

by Sreevidya Raman

And we’re back to the threats. Standard and Poor’s (S&P) has recently released a statement warning India that it will downgrade its credit rating to ‘junk’ if it does not follow through with the popularized reforms (FDIs in the retail and aviation sectors) in the next 24 months. To show how serious it is about the threat, the rating agency has elaborated further to say that chances of downgrading India’s rating are one in three.

Credit ratings evaluate financial bodies, specifically businesses and governments, based on their ability to repay loans and their probability of defaulting. In other words, the rating, made by credit rating agencies like S&P, represents the credit-worthiness of the financial body. The respective ratings are arrived at through a lengthy process of analyzing qualitative and quantitative data, much of which is not a part of public knowledge, and is specially gathered by the agency. It must be emphasized that the rating is not made through the application of a bunch of mathematical formulas, but is instead made by the agency, taking into consideration relevant information and by using their judgment and experience.

These ratings serve as a signal to lenders. A high rating says that the lender can invest bravely because probability of being paid their bond obligations is high, while a low rating sets off an alarm. Currently, investors seem to have bought Minister of Finance P. Chidambaram’s promise of carrying out the reforms, but clearly, analysts at rating companies are yet to be convinced. Chairman of the Prime Minister's Economic Advisory Council (PMEAC), C. Rangarajan, admitted that what the rating agencies say, does have an impact on cost of raising funds by Indian companies and borrowers, adding, "We need to convince rating agencies that India is a good destination for investment."

S&P explained why the threat of downgrading is so imminent:

Thus, according to S&P, the economic situation of the country can improve through more agreement and better coordination within the government on matters concerning liberalization. In other words, those in Congress who are anti-liberalization need to be convinced to change sides.

But what seems to have hurt India the most is the downgrading of Spain’s rating to bring it at par with India, at which point angry onlookers highlighted the difference between the two economies and the injustice in rating them similarly:

• Spain is shrinking, while India is growing at 6 percent.

• Nearly a quarter of Spain’s population is unemployed, while India’s Ministry of Labour and Employment claims an unemployment rate of a mere 3.8 percent.

• The two countries are at different stages of development. Spain has already left behind its developed market phase and is strongly heading downhill, while India is still an emerging market and has still quite a way to go before being considered a developed market.

There is one tragic similarity, however. Both are debt-ridden nations, with Spain at a debt-to-GDP ratio of 0.9. Although India is doing relatively better with a debt-to-GDP ratio of 0.68, the fear of the situation worsening in the face of slowing growth is very real.

But comparisons are useless. The only matter of importance is the country’s credit rating, and the only way we can avoid a further downgrading to ‘junk’ is by fulfilling the promises to reform. Otherwise, S&P will fulfill its own promise of downgrading, making it nearly impossible for India to borrow and grow. S&P’s threat is not to be taken lightly, following the 2008 crisis which left the reputations of credit rating agency in tatters, they have been extremely ruthless in downgrading, examples include stripping the US of its triple-A rating as well as a series of banks in Europe.

Thus, considering the significance of a downgraded rating and taking into consideration the negative signal such an action would send to potential investors, we need to act accordingly by confidently continuing the drive towards liberalization. Otherwise, the prospects of economic growth will dim and the ambitious goal to come on top as one of the world’s leading powers will become more challenging than ever.

References

Rangan, M.C. Govardhana. "Government Must Deliver on Reform Promises to Avert a Ratings Downgrade." The Economic Times. N.p., 2012. Web. 05 Nov. 2012. <http://economictimes.indiatimes.com/opinion/comments-analysis/government-must-deliver-on-reform-promises-to-avert-a-ratings-downgrade/articleshow/16859229.cms>.

"No Case for Lowering India's Credit Rating: C Rangarajan, PMEAC." The Economic Times. PTI, 05 Nov. 2012. Web. 05 Nov. 2012. <http://economictimes.indiatimes.com/news/economy/indicators/no-case-for-lowering-indias-credit-rating-c-rangarajan-pmeac/articleshow/17085459.cms>.