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Outdated standards

S&P is downbeat on India,but rating agencies must reset their models to understand emerging economies

Written by Janmejaya Sinha |
June 1, 2013 1:03:12 am

S&P is downbeat on India,but rating agencies must reset their models to understand emerging economies

On May 29,credit rating agency Standard and Poor’s upgraded Reliance’s rating to BBB+,while last week reaffirming its BBB- rating for India with a negative outlook. This means India has a one in three chance of getting downgraded in the next year. S&P has argued that India’s fiscal deficit and government borrowing are uncomfortably high,and unless action is taken,a junk bond status,that is,a non-investment grade,is inevitable. While this keeps the pressure on the Indian government to keep up the momentum around economic policy action that has been initiated with the return of P. Chidambaram as finance minister,it is worthwhile to reflect on how a reset in global models and thinking is still awaited.

A few years ago,I had argued that in 2008 many companies that had a higher rating than India — Lehman brothers,Merrill Lynch and AIG — went bust. All these companies had a rating of A. The speed at which they went bust has been recounted too many times to bear repeating — suffice it to say that the raters did not cover themselves in glory. Actually,from 2007,when the world was getting a bit nervous about some instruments that the raters had certified like the Collateralised Debt Obligations (CDOs),S&P had maintained that it had downgraded just 1 per cent of sub-prime residential mortgage-backed securities,and that none of those downgrades affected the triple-A bonds. They went on to add that defaults had hit only 3 per cent of the mortgage tranches they had rated. So they had not been nervous about the certificates they had issued. The very next year,this had all changed and they had new recovery assumptions for structured finance CDOs revealing that,for any deals rated A or lower,recoveries were likely to be zero,while recoveries for AA-rated slices of such deals would be at best 5 per cent.

Here’s another example. In 2010,S&P had India at exactly the same place,but it rated Italy and Spain at the AA level with Portugal and Greece ranked significantly above India in terms of credit rating. We all know what has happened since. Even today,India has a debt to GDP ratio of 49 per cent while Spain has a debt to GDP ratio of 86 with a negative growth rate,a fiscal deficit of 7 per cent,with the same S&P rating. Italy has a higher rating of BBB+ with negative growth rate,a debt to GDP of 127 per cent and a fiscal deficit of 3 per cent. If we look at India’s growth trajectory over the last 15 years,it is an impressive 7.5 per cent per annum and the last 10 years this growth rate has actually accelerated to 8 per cent. Today,India’s 5 per cent must compare with less than 2.5 per cent for Brazil,Russia,South Africa and the negative growth rates in much of Europe. Despite the ratings in 2012,India received FII flows of $24 billion from institutional investors. So investors are using internal judgement rather than that provided by rating agencies. However,many institutional investors will not be able to invest in India should it get downgraded to junk status because their internal rules may not allow it.

Where is the problem? What is going on? The rating agencies are not being able to reset their models to take account of the seismic shifts in the global economy. Our thinking is still being set by the past. The disparities in per capita between countries surged so dramatically in the last 100 years that understanding the new emerging economies requires intelligence that the old jaded models used by these agencies cannot display. If you take 1799,1899 and 1999 and compare the per capita GDP of the top five nations with the bottom five,you would find that the ratio went up from 4:1:to 5:1 to a whopping 60:1. This made countries in the top-end (the 60-ish bracket),the incumbents,get beneficial thinking and the ones close to the bottom,scrutiny,pity and some contempt. The rapid changes started only in the last 15 years with the rise of China.

The fact is that,given the nature of this shift,it is unlikely that anything can prevent China from becoming the top global economy in 15 years,and that however India does — it is unlikely to grow at less than 5 per cent and most probably will grow at 7 per cent over the next two decades,with ups and downs — it will become the third-largest economy in that period. The implications of this are just about sinking in,but the accompanying reset required in theory is still not currently underway. There are numerous examples of this,just today,Forbes magazine ranks Sheryl Sandberg of Facebook as more powerful than Sonia Gandhi in the world — which world? It is difficult to truly appreciate that the consumption needs of about 600 million young people born on mobiles,TVs and social media will permit any democratic polity the luxury of ignoring them. But how do you imagine this future — do we anticipate that we will smoothly get all the policies in place and build the infrastructure,social and physical (I wish),or will we unfortunately sway,with ebbs and flows,but ultimately see a sustained erosion of established vested interests,so that the young can struggle to a better future? I believe the latter. This requires an understanding far beyond the abilities of mid-level raters in S&P,who only know how to operate models created in the past. Thirty years from now,their models will have been reset. A trifle late I’d say.

For India,the good part of this is that there will be no place for complacency,and we may be goaded into doing what we are intending to but not being able to effect. Policy action will be the best response.

The writer is chairman of Boston Consulting Group in the Asia Pacific. Views are personal

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