Moody’s Investor Service, on Monday, reduced India’s long-term foreign-currency Credit rating to Baa3 from Baa2. Baa3 is the lowest investment grade – just one tiny notch above ‘junk’. The Credit rating agency surprised economists by keeping India on its negative watch, implying that it could cut ratings further. The action brings Moody’s ratings in line with the ratings from S&P Global Ratings and Fitch Ratings Ltd. (BBB-). In this article, we offer you a detailed insight into the history, implications and effect of the downgrade in ratings.

Sovereign Ratings History of India by  Moody's rating
Image: Sovereign Ratings History of India

History of the downgrade:

The Indian economy is currently facing one of its worst economic contractions ever. So the ratings downgrade is an obvious knock-on effect of the Covid outbreak, right? It turns out – No. Moody’s said India’s growth and credit profile were deteriorating even before the virus outbreak and those risks only became more pronounced now.

Moody’s has historically been the most optimistic about India in the past. The downgrade by Moody’s comes 22 years after it lowered India’s rating on June 19, 1998, in the aftermath of the Pokhran-II nuclear tests conducted in May, 1998.

In fact in November, 2017, Moody’s upgraded India’s Credit ratings to Baa2 with a “stable” outlook. The upgrade was based on expectations from a series of reforms including GST, Insolvency and Bankruptcy Code and the FRBM (Fiscal Responsibility and Budget Management) Act. Those hopes were belied. The onset of the coronavirus-induced lockdown has only made matters worse, which ultimately led to the downgrade in Moody’s credit ratings.

first downgrade by moody's in 22 years

Why did the downgrade happen?

Since the upgrade of ratings in November, 2017, implementation of Economic reforms has been relatively weak, according to Moody’s. The sharp deceleration in India’s GDP growth rates was because of inefficiency in policies and the loss in growth momentum. To make matters worse, India’s government debt burden has been rising constantly, coupled with rising stress upon the country’s Financial Sector. The decline in ratings is summarily, due to the following factors:

Weak implementation of Economic Reforms:

In November, 2017, Moody’s had upgraded India’s rating to “Baa2” with a “stable” outlook. At that time it expected that effective implementation of economic reforms such as the IBC, 2016 and the GST Act, 2017 shall improve the country’s credit profile and fiscal strength. Since the upgrade in 2017 however, implementation of reforms has been weak. This has been reflected by a sharp deceleration in India’s growth rates over the years.

Low economic growth

India’s growth is being labelled as an overestimate. The provisional estimates for 2019-20 were pegged at 4.2% — the lowest annual growth in a decade — and even these estimates are likely to be revised down further. This is further illustrated by the following chart-

A negative growth rate (contraction) expected in 20-21
Image: A negative growth rate (contraction) expected in 20-21

Deterioration in Fiscal Position:

Poor growth has been aggravated by worsening government finances. The central government failed to meet its target of fiscal deficit (essentially the total borrowings from the market) almost every year. This has led to a steady rise in total government debt. According to Moody’s, India’s estimated general government debt burden of 72% was quite high. This already high number is set to go up to 84% of the GDP within 2020, as the government will be forced to borrow more.

Amidst the pandemic situation, the Government has been allowing taxation & moratorium relaxations, and extension of payback period for loans. This too adds undue pressure on the country’s fiscal position, which shall further deteriorate the fiscal deficit position.

India’s debt to GDP ratio was close to 72% in 2020
Image: India’s debt to GDP ratio was close to 72% in 2020

Stressed Financial Sector:

Moody’s expressed concerns about the entire financial system. Since public-sector banks owned by the Government have been capitalizing at a slower rate, they are not expected to be at an imminent risk of failure. However, the private-sector banks and NBFCs have been putting a greater stress on the system, according to Moody’s.

Investors ignored rating changes:

The downgrade in ratings was not taken very seriously by investors. During Tuesday’s trade domestic equity indices traded with a positive bias with BSE’s Sensex ending up by 522 points – the fifth straight session of rally. In the currency market, the rupee fell only 6 paise lower to 75.60 against the US dollar, which was not a big deal, while 10-year bond yield was ruling flat at 6.04.

Historically, across several countries, ratings actions have had little impact on interest rates and currencies beyond the immediate term, said Edelweiss Securities. Besides, unlocking of the economy led to positive investor sentiments – thus leaving the downgrade in ratings completely ignored.

Downgrade ignores by investors – No material change in indices which was later implicated by moody's rating
Image: Downgrade ignores by investors – No material change in indices

Implications of the downgrade – The bigger picture

Ratings are based on the overall health of the economy and the state of government finances. Weaker economic growth and worsening fiscal health undermine the government’s ability to pay back. A downgrade in ratings means that the bonds issued by the Indian government, are now “riskier”.

Lower risk is better because it allows governments and companies of that country to raise debts at a lower rate of interest. When India’s sovereign rating is downgraded, it becomes costlier for the Indian government. Also for all Indian companies to raise funds because now the world sees such debt as a riskier affair.

India’s nominal GDP growth has been below 10% for the last 2 years and is expected to be so for at least 2 more years. The banking and financial sectors have been a mess and India’s job creation problem is turning the demographic dividend into a disaster. In such a scenario, Covid-19 was only the straw that broke the camel’s back.

No one really talks about 8% real GDP growth anymore. Many will kindly accept 5-6%. Moody’s expects India’s real GDP to contract by 4.0% in the current financial year. Thereafter it expects a sharp recovery in 2021-22. But over the longer term, it states “growth rates are likely to be materially lower than in the past, due to persistent weak private sector investment, tepid job creation and an impaired financial system”.