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Beyond the ratings blame game

Hemant Manuj

The recent downgrading of the local currency by a leading international rating agency has met with the predictable response of rejection by the government and a section of industry.

The explanation for the rejection has been that the macro-economic indicators for the Indian economy are at their best, and hence did not warrant any adverse rating movement at this time.

The response to the action of the rating agency needs to be understood and thought through, since it throws up several important issues on the strategy and direction of our policy-makers.

First, let us look at the reasons we cite for ignoring the downgrading action. It has been said that the inflation and interest rates are at their lows, forex reserves are at a high and our economy is growing at a relatively high rate compared to most other countries.

While some of these may be debatable in terms of their being genuinely positive factors, this rationale sounds almost like reading just one side of a corporate balance sheet and immediately drawing conclusions on the credit standing of the corporation.

The other side that is being missed is the means of financing the assets and the growth, and whether it is sustainable.

Anyone with the basic skills of analysing a balance sheet would know that excessive leverage with a low return on capital is a potent combination for leading a business entity into bankruptcy.

The same principles apply to the sovereign balance sheet, and this leads us to consider the size of the borrowings and the returns generated by the Centre and the states on such borrowings.

Therefore, any conclusion on the credit standing of the local currency would have to be based on a comprehensive analysis of the fund flows of the Central and state governments, including the guarantees provided by them.

The increase in leverage of the government balance sheet is evident from the fact that the domestic liabilities as a proportion of gross domestic product (at market prices) has increased secularly between 1996-97 and 2000-2001 from 49 per cent to 56 per cent for the Centre and from 18 per cent to 24 per cent for the states.

Similarly, the interest payment-to-GDP ratio of the Centre has worsened from 3.8 per cent in 1990-91 to 4.6 per cent in 2001-02 (Source: RBI publications)

Second, to buttress the argument of the insignificance of the credit rating action, it is being cited that the equity, debt and currency markets have not reacted adversely to the announcement by the rating agency.

This smacks of ignorance of the functioning of financial markets. Financial markets are forward-looking and are usually more efficient in terms of pricing the positives or negatives than most other institutions are, including credit rating agencies.

The pricing of these markets are based not only on the current macro-economic indicators, but also on their perception of the direction of these indicators. The markets may not always agree with the perception of the credit rating agencies.

However, in our case, these markets have already reacted adversely, and much earlier than rating agencies have, to the slowdown in economic policy reforms.

For instance, the equity markets, which have already been at their lows, do seem to have priced in the negative triggers, including the uncertainty created on account of the decision in the last Cabinet Committee on Divestment meeting on the postponement of divestment of the oil companies.

Thus, the markets have actually led, rather than disagreed with, the credit rating agencies as regards the recent downgrading.

Not all the weakness in the equity markets can be attributed to global markets. This becomes clearer on looking at the currency markets.

Since May 2002, while the rupee has appreciated against the dollar by 1.3 per cent, it has depreciated against other currencies, like the euro, by 1.9 per cent.

Third, it is said that various actions have been initiated by the government in order to bring stability to the financial markets, and that these have been ignored by the rating agency.

While there has been some action, a lot more is still required in terms of financial sector reforms.

The bailouts of the financial institutions can, at best, reduce the short-term turbulence in the markets, but to achieve a sustainable turnaround, suitable incentive patterns for the institutions to function efficiently and generate a net positive value need to be devised.

In fact, the term 'bailout' is a contradiction in terms, since it appears to suggest a movement towards recovery, but the implication of a negative incentive for efficient functioning could lead the institution into a deeper crisis.

The suitability and effectiveness of the measures taken by the government need to be weighed in terms of cost-benefit analysis and watched for indications of good results for the rating agencies or the markets to reflect these aspects.

Finally, credit rating agencies that have lately been the subject of some debate on the effectiveness - or even veracity - of their rating actions are judged by market participants on the accuracy of their predictions.

Therefore, it may be morally difficult for them to significantly deviate from their rating conclusions, which are based on empirically tested models.

The inputs for these models would be based on data as well as actions, lending a high degree of confidence to their outputs.

In other words, these models would ignore statements of intent, or even promises, of issuers with a poor track record of implementing their previous policy statements.

It is in this context that, as a matter of sound economic strategy, the government needs to under-promise and over-deliver, not vice-versa.

The economic strategy of the government will beget different responses in the political context and in the credit markets.

While the electorate has boundaries of choice, the same is not true for credit markets. Rating actions or, in a wider context, the responses of financial markets are, most likely, to be determined solely on the basis of analysis of the actions of the government and their expected results.

What is of more significance to the agencies is that the overall resolve of the government to implement policy reforms, compared to short-term failures.

Policy-makers need to identify and recognise the problematic issues at hand and act on their solutions, even at the cost of ignoring the motive of the source of the message.

Tardiness in our pace of action on the economic front may be shielded in these times of weakness in the global economy, but will be prominently flagged once the global economy recovers. Delays will lead to losses for us even as competing economies utilise this time to gear up for better days ahead.

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