Beware of complacency

Improved rating outlook buys government time, that's all

The rating agency Standard & Poor's (S&P) changed its sovereign rating outlook for India from "negative" to "stable" last week. This is an unambiguously positive development for the economy. It essentially means that the agency puts the probability of India's rating being downgraded to speculative status - the "BBB-" that it currently has is the lowest in the investment grade - at less than one-third. However, there is a danger in reading too much into the move. To provide both historical and comparative perspectives on this, first, it must be remembered that S&P, as well as the other two global raters, Moody's and Fitch, provide unsolicited ratings for countries such as India, which are not issuing debt in the global market. Second, Moody's and Fitch have both had a stable outlook on India's rating for some time; S&P moved from stable to negative in late 2012. Third, all three agencies raised India's rating from speculative grade to investment grade during 2006-07 and, while the outlook by different agencies has moved down and up, the rating itself has remained intact through both the global upheaval and domestic travails.

There are both positive and negative aspects to the third factor. On the plus side, the constancy of the rating suggests that, notwithstanding the vulnerability on many fronts, the expectations were that reasonable and effective policy responses would materialise. In fact, the rationale for last week's move was precisely that the new government would be able to get to grips with two concerns, inflation and the fiscal imbalance. On the minus side, the rating is on the edge; a downgrade puts India in a category that will keep many investors away, because they are mandated to put their funds into investment-grade countries. It will also force some investors who are already exposed to exit. It is all very well for governments to pooh-pooh the rating agencies, but the reality is that the sovereign rating is an important criterion for many cross-border investment decisions.

Against this backdrop, the change in outlook certainly buys India some time. But it is important to extract the right message from the rating rationale. The report assesses the Indian economy on six criteria. On only one - external liquidity and international investment position - does it consider the economy to be in a position of strength. It provides a neutral score on two - monetary flexibility and institutional and governance effectiveness. The other three - economic structure and growth, fiscal flexibility and performance, and debt burden - are considered sources of weakness. The report cautions about the prospects of a rating downgrade - not just of a change in outlook - if these sources of weakness are not addressed, even as it expresses optimism about the government's intent and capacity to get to grips with them. The most prudent way to read the message from S&P then is to see it as extending the window of opportunity to get the reform process over a whole range of issues moving as quickly as possible. The change in outlook and the fact that all three agencies are now in sync on this will calm the nerves of foreign investors, auguring well for stability in capital flows and the exchange rate. But that window has to be used wisely and expeditiously.