After the upgrade, can FM widen our smile?

Bond issuers from any country can never have a credit rating higher than their country’s rating.

 Arun Jaitley, upgrade, Moody's, bond, India, accountability, credit ratings
File Photo

The international bond market, with an outstanding volume of around $22 trillion, is the final arbiter of a country’s destiny. Bonds, unlike loans, can be traded, or “marked to market”. This makes trustworthy credit ratings, like Moody’s, critical to give pricing signals. Since there is a market, even discards are recycled. Discards are called “junk” bonds. Their outstanding volume is $1.3 trillion. They are traded at insanely high returns up to 12 per cent per annum as compared to AAA-rated bonds, where the yield is just four per cent. India had an investment grade rating of Baa3, which Moody upgraded, on 17 November, to Baa2 (stable outlook).

A sovereign credit rating reflects the country risk. It serves as a “glass ceiling”. Bond issuers from any country can never have a credit rating higher than their country’s rating. India has not issued a sovereign bond overseas thus far. But government-owned companies and private entities access the international bond market. This is one reason why the rating upgrade is welcome.

It is a win-win for India. The upgrade increases the incentive to invest in India. The Reserve Bank must be vigilant to sanitise the potential of such inflows to strengthen an already-overvalued rupee, which is hurting export competitiveness. But our stock market is already inflated in the aftermath of demonetisation by the surge of domestic savings, seeking refuge from a dull realty market. This may dampen the inflow of “hot money”.

The upgrade pulls us ahead of Italy (negative outlook) and level with Uruguay, Colombia, Spain, Bulgaria, the Philippines and Oman. We remain behind Panama, which has a positive outlook and can be upgraded to Baa1 to join Thailand, Mauritius and Slovenia. In the next level (A3) are Mexico, Malaysia, Peru, Latvia, Lithuania, Malta and Iceland. China floats high above at A1 — four rating segments above us.

The Moody’s rating methodology is complex. First, a country is fitted into one, of three possible levels, for each of the 25 indicators. These are then aggregated into 11 sub-factors using assigned weights. The sub-factors in turn are aggregated into four factors using assigned weights. There is a mechanism to “fine-tune” the final rating using qualitative assessments — this is where confidence-building measures help.

The highest weight — 50 per cent — is for the risk probability of default on interest payment or redemption of the bond. Risk is assumed to increase with higher levels of income inequality and lower scores on the World-Wide Voice and Accountability index (both reflective of political stability); higher reliance on external debt; higher borrowing need relative to revenue; weak banks; imbalance between foreign exchange receipts and expenditures and higher reliance on foreign investment.

Fiscal strength gets a weight of 25 per cent, related to lower nominal and trend line of debt to GDP levels and lower interest payments relative to revenue and to GDP.

Institutional strength has a of weight 12.5 per cent. Countries scoring higher in the World-Wide Government Effectiveness index; the Rule of Law index and the Control of Corruption index get higher marks.

Economic strength has a weight of 12.5 per cent. Higher real growth with lower volatility of GDP; higher nominal and per person national income and a better score on the World Competitiveness Index all ensure higher scores.

Labouring through this long explanation of the methodology becomes rewarding because it points us to a prioritised pathway for improving our credit rating.

First, remember that in today’s networked world, not only is it important to do the right thing generally but one must also push the right buttons. Our credit rating depends on our score in the five independent indices, mentioned above, relating to — voice and accountability, rule of law, government effectiveness, control of corruption and competitiveness. The Niti Aayog has demonstrated how our score and rank can be improved in the Doing Business Survey. Similar effort, in these five indices, can directly improve our overall credit rating.

Second, consider that four initiatives — (1) reducing inequality via direct transfers and NREGA to supplement low incomes; (2) funding investments through tax revenue and domestic private savings via financial inclusion and market development; (3) strengthening the resilience of our banks by shrinking the size and functions of weak banks and recapitalising the strong banks; and (4) increasing export earnings by removing the import bias for a “strong” rupee, can together improve one half of the overall score. These four areas should have a very high priority.

Third, stabilising the aggregate public debt to GDP ratio is necessary. This contributes to one-fourth of the aggregate credit score. Moody’s recognises that this ratio shall increase from 68 per cent in 2016-17 to 69 per cent in 2017-18.

It may even be higher, if real GDP growth this year is less than 6.7 per cent. State government debt has increased by ₹2.7 trillion (1.5 per cent of GDP) due to financial engineering in acquiring 75 per cent of the stressed assets of electricity utilities through UDAY (electricity restructuring) bonds. An additional source of stress is the proposed recapitalisation bonds, particularly if financed from public funds. Financing the capital needs of strong banks through private equity would be far better, even if government equity must be diluted to 26 per cent. At the very least, the market would force adequate internal restructuring. Sharply reducing the revenue expenditure by 10 per cent can bridge the “effective revenue deficit” (0.7 per cent of GDP) and release fiscal space for virtuous allocations. Revenue expenditure — other than interest and capital grants —is budgeted at ₹11.2 trillion this year.

The Moody’s rating methodology has evolved beyond the pure commercial intent of repaying lenders on time, to assess systemic sustainability and happy citizens.

The ball is now in the government’s court to navigate the tightrope between short-term welfare priorities and medium-term fiscal stability and growth. Political sagacity, restraint and technical wizardry in choosing the right boxes to tick will determine if the finance minister can widen our smile.

This commentary originally appeared in The Asian Age.




Sanjeev Ahluwalia