| When the rating goes wrong
The author is former governor, Reserve Bank of India
Rating agencies are an essentially American invention to smooth the process of investment. Investors, such as mutual funds and other public financial institutions, are expected to go by ratings given by recognized rating agencies. Indeed, investments are forbidden in securities issued by entities not graded as investment grade by rating agencies. The rating agency is an important procedural device to enable safety and security of investments in bonds. Rating agencies often grade entities at the latter’s request. The practice of suo motu grading of sovereigns has, however, been in vogue over the last decade or so. The rating game is not something which we can wish away. We live with it, as part of the process of rating that the agencies interact with the entities rated and classify their concerns. Much depends on the effectiveness of presentations made to the rating agencies. But, rating agencies are not infallible.
International rating agencies are still trying to live down their ignominious failure to assess the weaknesses of east Asian economies, like South Korea and Thailand, before the Asian crisis. Although they were not alone in their error, many investors blamed the rating agencies for the losses they suffered because of investing in over-rated bonds in Thailand and South Korea. The resulting caution has led to rating agencies being over-careful in giving ratings. This may be part explanation for the rating agencies’ conservatism in rating India. Perhaps prejudice has also something to do with it.
By now, India is used to the often temperamental and critical ratings given by rating agencies. Sometime back, we had occasion to encounter Standard & Poor’s downgrading of India’s domestic debt, primarily on account of high fiscal gap. There was considerable gnashing of teeth by those in authority. But, the rating by Standard and Poor did little to influence the flow of the Indian banking system’s resources into government bonds. The system seemed to say, “Thank you, Standard and Poor, we are doing quite well investing in sovereign bonds.” All the same, Standard and Poor was recognized to have raised some alarm in quarters concerned with India’s creditworthiness. The answer would come with Jaswant Singh’s forthcoming budget. Hopefully, it will reduce the flow of red ink that clouds rating agencies’ outlook on India.
The same fiscal black-mark seems to have come in the way of the rating agency, Moody’s Investors Services, giving a proper grade to India’s foreign currency rating. It has revisited the rating scene since it downgraded India in the aftermath of Pokhran when it gave India a grade of Ba2 (sub-investment). While it is right that Moody’s has raised India’s foreign currency grade from Ba2 to Ba, this is still a dubious honour. It is still below investment level. In Moody’s classification, “Ba bonds are those which have speculative elements and are characterized by doubtful protection of interest and principal payments.” It is, indeed, difficult to assess how Moody’s can justify its doubtful grade to India.
The grading is all the more intriguing since India’s foreign exchange reserves are booming and its current account is in a healthy state. India’s external debt is manageable and there have been consistent and successful attempts by India to repay costly debt. India, unlike China, the darling of foreign financial investors, has never had a record of reneging on foreign or domestic debt. Consider, for instance, the organization of American investors in China’s bonds, who are seeking redemption of billions of dollars lent to China before the communist revolution. They are now seeking the American government’s intervention to force China to redeem its debt by denying it fresh access to American financial markets. India has never defaulted. It is surprising that the presiding deities of Moody’s have expressed doubts about India’s repayment abilities.
All this appears incongruous when India’s reserves are touching an alltime high. Nor is it true that the accretions to reserves are built up of costly debt. A recent timely analysis published by the Reserve Bank of India, explaining the sources and costs of forex assets, reaffirms the arguments that Indian authorities have put forward — that the reserves have come mostly out of non-debt creating capital inflows and current account surplus.
An analysis of the accretions to forex assets during the recent period April-November 2002 shows that current account surplus alone accounted for $ 2.5 billion out of a total accretion of $ 12.6 billion. The healthy state of the current account shows that India’s exports of goods and services have been in excess of imports. It is creditable that this has happened in spite of a slowdown in the global economy, particularly in the software sector.
One line of criticism of the rise in reserves is that it depends on arbitrage, using high rates of interest offered by India on non-resident Indian deposits. While we are not denying that interest differentials do have a part to play to account for NRI deposits, arbitrage is ruled out in respect of an important item of the NRI deposits, namely the Foreign Currency Non-Resident Bank deposits, for which India offers an interest rate of 25 basis points below the London Inter-Bank Offered Rate. This accounts for $ 10 billion out of a total of $ 27 billion of NRI deposits. The possibilities of arbitrage — NRI borrowing abroad and investing in India — are ruled out because the borrowing rates would be higher than the deposit rates in respect of these deposits.
Further, the RBI study points out that the level of rest of the NRI deposit inflow has remained at about the same level over the last three years. The interest rate scenario has not impacted the level of these flows. Besides, taking an overall view, NRI deposits account for only $ 27 billion out of a total reserve of more than $ 70 billion. Any volatility in NRI deposits may not impact the reserves too sharply.
The fact is that India’s reserve accretions are due mainly to current account surplus and other non-debt creating capital flows, leaving aside the part contributed by NRI deposits. This would go to establish the sustainability of India’s forex position. The RBI analysis also attempts to answer the critics, who point out that the practice of keeping high reserves is costly since the returns are just around 4.5 per cent, given the low interest scenario worldwide. The RBI analysis seeks to make the point that given the major contribution to reserves arising from current account surplus and non-debt creating capital flows, the accretions are virtually costless. What is intriguing is that Moody’s has not taken all these positive aspects into account in giving us a dubious grade.
Moody’s response to this line of explanation, however, reminds us of the fable about the wolf and the lamb. If the forex situation is sustainable, Moody’s seems to argue, then India must be in the wrong on some other ground. Moody’s picks on the fiscal situation as a possible justification for its dubious grade for India’s foreign currency rating. This is inexplicable since there has been no resort either past or planned to external sovereign borrowing. India’s fiscal gap is more than fully subscribed by the Indian banking system. There is no prospect of India’s fiscal gap spilling over into external markets. Moody’s argument that India’s fiscal gap threatens its foreign currency ratings seems farfetched.
Moody’s rating is part of a ritual that rating agencies indulge in. Ratings are, however, important because they are the measure by which foreign investors assess India’s debt paper. Although the government of India does not intend to borrow, the ratings do govern the behaviour of investors in India’s corporate bonds floated overseas. The sovereign rating is more or less the ceiling for corporate debt ratings. Ratings matter because foreign investors tend to be wary of bonds whose ratings are low. Further, low ratings carry higher interest charges.
But, as at present, Moody’s ratings need not cause us concern. Indian corporate organizations should be more than happy accessing the Indian bond market where resources are abundant and available at reasonable rates. The Indian government is also not likely to face any serious handicaps because of the Moody’s doubtful grade.
All the same, the ratings serve an important function. They tell us how valuations are made in the international financial markets. After all, in the rating game, beauty lies in the eyes of the beholder. However much we may quarrel with the rating given to us, we have to live with it. The half-hearted upgrade by Moody’s would have, however, served a useful purpose if it alerts the government on its fiscal faultline and speeds up efforts to address this gap. Whether the fiscal gap is relevant or not to the foreign currency rating of India, it is important for India’s economic health. Moody’s may have mixed up its messages, but it has served an important role as a bearer of tidings about our fiscal weakness. We need to take the message seriously, notwithstanding the RBI’s valid explanations for our booming reserves and their sustainability.