Moody's downgrade of India's sovereign debt had been on cards for months

The decision of Moody’s to downgrade India’s sovereign debt, both in rupee and forex — from Baa2 to Baa3, the lowest investment grade status — had been on the cards for months, despite hectic behind-the-scenes lobbying by officials to avoid a downgrade. In that sense, it is hardly a shock. Moody's has also downgraded India's local-currency senior unsecured rating from Baa2 to Baa3, and its short-term local currency rating from P-2 to P-3.

The outlook on India's rating would improve to stable if policy actions raise confidence that growth will rise to sustainably higher rates than Moody's projects. However, rising economic and financial risks would lead to further downward pressure on the rating.

Markets often discount anticipated events in advance. And this has been anticipated since November 2017, when Moody’s upgraded India to Baa2 and warned it would downgrade again if expectations for reform were not met. “The expectations were that effective implementation of key reforms would strengthen the sovereign credit profile through gradual but persistent improvement in economic, institutional and fiscal strength. Since then, the implementation of reforms has been relatively weak and has not resulted in material credit improvements.”

By December 2019, India had suffered another four quarters of falling GDP growth. That was before the pandemic impact, and Moody’s statement makes it clear that the pandemic only amplified existing problems with India’s credit profile. When the rating agency assigned a negative outlook tag in 2019, it came closer to a downgrade.

GDP growth declined from a high of 8.3 per cent in 2016-17 (fiscal ending March 2017) to 4.2 per cent in fiscal 2019-20. Moody's expects the economy to contract by 4.0 per cent in fiscal 2020 due to the pandemic and lockdown. This will be followed by a bounce-back to 8.7 per cent GDP growth in 2021-22 and closer to 6.0 per cent thereafter. In the longer term, growth rates are likely to be lower than in the past due to a persistent weak private sector investment, tepid job creation and an impaired financial system.

This is actually a relatively optimistic judgement. Other estimates suggest even deeper contractions. Nomura, for example, expects a contraction of 5.2 per cent in 2020-21. Fitch expects a 5 per cent contraction, and so does S&P.

Nevertheless, despite the anticipation, the downgrade will have some negative impact. Since it’s a sovereign downgrade, it impacts the cost of debt for the government. Also, certain foreign institutional investors don’t have a mandate to invest in instruments below a given investment-grade. They may choose to pull out.

 

The downgrade will also impact sentiment, at least somewhat, which could mean a sell-off in equities in the near future. It will probably mean a rise in yields on government debt and it could lead to some sell-off in treasuries by certain categories of conservative foreign portfolio investors (FPIs). In turn, that might mean a weaker rupee.

The bond market is more likely to see a sustained long-term impact from the downgrade than the equity market. There will be bright spots across sectors as the lockdown lifts and individual businesses will receive selective equity investments. Every bond issue will be impacted, however, if sovereign debt is priced lower. There is already a problem of crowding out of private debt by the mountain of government debt. If the pool of potential debt investors becomes smaller, the crowding out is more pronounced.

Moreover, Moody’s expects the government debt (states and Centre combined) to rise from 70 per cent of GDP to around 84 per cent. In addition, there’s persistent stress among banks and non-banking financial institutions constraining credit. Low growth will further weaken asset quality and the health of banks and NBFCs.

In comparative terms, India has been a laggard among Emerging Markets in 2020. While markets everywhere have taken a hit, India is among the worst performers. It imposed the harshest lockdown, giving no warning to citizens, completely stalling the economy, putting over a hundred million lower-income people out of work. The downgrade just makes the task of economic recovery a little more daunting.


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