Sovereign warning

Indian Express, 7th September 2012

There are fears that India’s sovereign rating will be downgraded in the near future. This may, however, not happen if the policy environment is better than it was a few months ago. The new finance minister and his team have already raised the hopes of both Indians and foreigners. If the government accepts the GAAR committee recommendations on taxation, and the Kelkar committee recommendations on fiscal consolidation, the policy environment will certainly look better. A diesel price hike, if implemented next week, as reports suggest, would also play a crucial role in preventing a downgrade.

There are two issues related to a downgrade. First, when good governance and fiscal prudence can keep India’s credit rating high, Indian companies are able to compete on an equal footing with the rest of the world. By adopting better policies both for its budget and for economic growth in general, the government can provide Indian companies a better environment. Second, at a time when India has a difficult balance of payments situation, it cannot afford to have lower capital inflows that could put further pressure on the rupee. Not adopting measures that would improve the rating, but simply criticising either the ratings agencies or the ratings mechanism, will be damaging for the economy.

Today, if India does see a ratings downgrade, it will make the cost of borrowing abroad higher. When borrowing is cheaper abroad, it is attractive to borrow in dollars. A ratings downgrade will serve to raise the cost of borrowing, thus imposing a private cost on companies that borrow in dollars. Even if an Indian company is as good as a comparable one, say, from China, if India gets a downgrade then the company has to pay more for its borrowing. In a domestic environment that is already difficult, imprudent fiscal policy imposes further costs on Indian companies.

Balance of payments data for the last two quarters shows a decline in foreign loans, both in external commercial borrowings (ECBs) and in short-term loans. In almost each quarter of 2010 and 2011, companies borrowed more than $6 billion. After the last quarter of 2011, when net foreign loan inflows were $8.5 billion, there has been a sharp decline. In the first quarter of 2012 (January-March), they fell sharply to $1.6 billion. They remained low, at $2.7 billion, in the following quarter.

There has been a decline in both ECBs and short-term loans. In ECBs, we see a sharp change in 2012. There were no net flows in the first quarter. In the second (April-June), they picked up, but were about half of the net flows in the last quarter of 2011. In short-term loans, the story is even more striking. From an average of more than $2.5 billion per quarter, they have fallen to less than $152 million.

The all-in-cost ceiling imposed on ECBs by the RBI allows borrowers to pay only 350 basis points above Libor for three- to five-year loans, and only 500 basis points above Libor for loans with more than a five-year maturity period. Only a handful of Indian companies are considered creditworthy enough in international markets to be able to borrow at such low interest rates. Those with explicit or implicit sovereign borrowing or those with significant international presence may be able to do so, but the bulk of Indian companies may not be able to borrow abroad at these rates.

In earlier years, two factors played a role in Indian companies being able to borrow more abroad. First, the Indian economy was doing well, sovereign ratings were higher and more companies were able to fall within the ceiling. But, equally importantly, a large number of companies borrowed through Foreign Currency Convertible Bonds (FCCBs). The Indian borrower gave the foreign lender two options-— when it was time for loan repayment, the lender could take back his principal and pre-negotiated interest dollars or he could choose to take his repayment in the form of shares of the Indian company at a pre-determined price, often the price prevailing at the time the loan was taken.

Although most companies would have found it hard to borrow at the low all-in-cost ceilings imposed by the RBI, it was possible for them to get foreign loans through FCCBs because it also included a bet on the apparently ever-rising Indian stock market. If the share price of the company was expected to increase, the foreign borrower would be willing to lend to the Indian borrower even when it would not have done so at the interest rate the company was allowed to pay. After the crisis, when stock prices fell, lenders chose the option of asking for the principal and the interest in dollars, rather than in shares. Today, expectations from the stock markets are not looking good enough to attract a lot of money through FCCB. If the RBI leaves the all-in-cost ceiling unchanged, a sovereign credit rating downgrade would make it more difficult for Indian companies to borrow abroad and take less foreign currency risk on their balance sheets.

At present, India is running a large current account deficit, to the tune of more than 4 percent of the GDP. In the April-June quarter of 2012, the current account deficit was $21 billion. Of this, $16 billion was financed by net capital flows. The bulk of capital coming into India in 2012 is portfolio investment. In the April-June quarter, $14 billion came in through portfolio investment. Only $2.7 billion came in through loans. Foreign currency denominated loans may not be the best option for financing the country’s current account deficit but at the moment, India needs to keep up with the flow of loans, given the pressure on its balance of payments. It can ill afford a downgrade.