India will have to avoid another downgrade to junk status
On June 02, Moody’s Investor Services downgraded India’s sovereign rating from Baa2 to Baa3. In addition, outlook for Indian sovereign debt was also changed to negative from stable.
Why the rating downgrade?
Clearly, COVID-19 was the trigger for the downgrade but there have been structural concerns for some time now. Firstly, GDP growth has struggled at 3.2% in Q4 and full year growth at 4.1% for FY20 puts India in a tight spot versus China. The bigger concern is the expectation of negative growth in FY21, despite a sharp recovery expected in Q3 and Q4. Moody’s has also expressed concerns over the fiscal deficit, which is expected to shoot up from 3.5% stated in the Union Budget, to above 6%. Weak revenues and the need to boost spending could widen the deficit further.
Markets were unperturbed
However, the stock markets appeared to ignore the downgrade as the Nifty and the Sensex persisted with their rallies. One reason was that the COVID-19 was a global pandemic and the growth concerns in India were only part of a global problem. Secondly, Moody’s had upgraded India’s ratings in 2018 on the hope that growth would pick up. Hence, it was more like a return to status quo. Above all, liquidity has ensured that the stock market performance can diverge from macros for sustained periods.
Impacts rupee and borrowings
However, the two likely implications of a rating downgrade cannot be ignored. The first impact will be on the cost of borrowings. A weak rating will raise the cost of funds for Indian firms in the global market. Even in the domestic market, the impact is felt indirectly as a lower rating could entail aggressive spending by the government. This could spike the fiscal deficit putting further pressure on the bond yields in the market. This could raise the cost of funds by 50-75 basis points with a major risk for companies with vulnerable balance sheets. The second impact will be on the INR. Any downgrade usually results in an immediate spike in selling in debt paper by the FPIs. That could weaken the rupee to a large extent.
Avoid further downgrades
Baa3 represents the lowest investment grade and that is the rating assigned by Moody’s, S&P and Fitch. Any downgrade from here will push India to junk status and that is what India needs to avoid. Junk status would not only impact borrowing costs and the INR but would also stall FDI flows into India. That could be a disaster for the “Make in India” plans that the government is counting on. While growth is harder to manage, the primary focus will have to be on keeping a check on fiscal deficit. That will at least ensure that chances of further downgrade are mitigated!
