India’s Credit Rating Crisis

We've all seen those annoying PaisaBazaar.com ads telling us to check our credit scores. While we often tune them out during our favorite shows, they actually share important info that goes beyond personal finance—it affects entire countries too.

So, what's a credit score? Think of it as your financial report card! It helps banks figure out how reliable you are when borrowing money. They consider factors like your income stability, past debt management, and repayment habits to decide if they should lend to you and at what interest rate.

Just like individuals borrow from banks, sovereign countries and governments need credit too. When a government's spending exceeds its revenues, it borrows money to cover the gap. This "debt" helps fund essential programs and services, even if the government doesn't have the money upfront. The credit can come from other countries, international organisations like the IMF, or even from people like us through government bonds.  We’ll get to that in a bit. To give you an idea of how much debt countries take relative to their GDP, here’s a graphic:

The analogy to the credit score for countries is known as the credit rating. Today, there are 3 agencies that determine this rating for various countries, namely, Fitch, Moody’s and Standard & Poor’s. While each rating agency may have different approaches to arrive at a conclusion, in general the information can be interpreted in only one way. You may ask, why does any of this matter to me? I’m a tax-paying citizen of this country, as long as the services I’m paying for are provided to me, why do I care what my country’s credit rating is?

Let’s put some numbers into perspective. 

1. S&P and Fitch rate India at BBB-, and Moody’s at Baa3—both the lowest investment grades. Anything lower, like BBB-, is considered speculative, meaning a high risk of default. Despite this, India has never defaulted on its debt, while the USA, which has defaulted four times, enjoys top credit ratings.

2. India has been the fastest-growing economy in the last decade, despite challenges like COVID-19, the Russia-Ukraine war, and the Israel-Palestine conflict. Foreign direct investment has surged by about 60% since FY 2014-15, reaching $71 billion. Yet, the credit outlook remains bleak.

3. India’s national debt is projected to be $2 trillion in FY 24, while the USA’s debt ceiling stands at $31 trillion. Despite being the world’s fifth-largest economy, India is rated at the lowest investment grade—something normally reserved for much smaller economies. Similar exceptions include China, rated A-/A2 in 2005, and India’s current BBB-/Baa3 rating.

Ironical? Precisely. This affects you, your country’s reputation at the global level and what proportion of the money you pay/lend to the government is used efficiently for the purpose intended. How? Government bonds. 

Let’s assume the government issues bonds with a coupon rate of 3% per annum with a maturity period of 30 years. Think of a government bond as a contract between you and the government, where you are the lender and the government pays you a certain interest over the tenure of the bond, and repayment of the principal at maturity. Let the amount to be raised be 10,000 crores, and each bond unit be priced at 1 crore rupees. This effectively means that if 10,000 people buy this government security at Rs. 1 crore per unit, each of the bond-holders will receive a coupon payment of (3% of 1 cr. / year) 3 lakh rupees annually. At the end of 30 years, the bond-holders will receive their principal amount of Rs. 1 crore as well. 

Here’s the catch! Government bonds can be traded among investors in the secondary market. Now, assume that India is raising money through these bonds for a mega infrastructure project, and the news of a downgrade of India’s credit rating by the rating agencies just popped up. Investors panic, sentiment changes. The bondholders' trust on the Indian government to repay their principal amount after 30 years will decrease. The same bond that was bought at Rs. 1 crore will start selling in the secondary market at a lower price, say at Rs. 50 lakh. However, the coupon rate of the bond as set by the government remains the same. Therefore, if you purchase the same bond from another investor at Rs. 50 lakh, the effective yield you get out of the bond is doubled i.e 6% per annum (simply because you’ll now be earning 3 lakh p.a. on an initial investment of 50 lakh). This raises the very pertinent question,

“The next time the government wants to raise money through sovereign bonds, can it offer the same coupon rate of 3% p.a.?”

Well, they can, but the willingness of investors to buy that security would have significantly reduced. This is because there is a financial instrument trading in the secondary market at a lower initial price, and offering double the coupon rate. As a result, India is forced to increase the coupon rate on any new bonds it wishes to issue. Thus, the government loses thousands of crores in interest payments alone. That, as you may have guessed, is not efficient utilisation of your money that you’ve lent to the government. All because, the global credit rating agencies decided to downgrade India’s credit rating. 

This is not something new. The Indian government has been lobbying against these credit rating agencies and their opaque evaluation rubrics since years. The key argument being, that most of the parameters used to determine ratings are not quantitative, but qualitative. This opens up exposure to a lot of questions, primarily centred around the lack of transparency about these “qualitative” points. Moreover, CRAs are hesitant to downgrade high-rated countries (typically advanced economies) even if their macroeconomic fundamentals deteriorate since rating agencies desire stability in their rating assignments. The fact that the same evaluation is done for developed as well as developing countries is further problematic. Take a look at Moody’s evaluation metric. The number of qualitative assessments done is alarming. 

India's sovereign credit ratings don't align with its fundamentals. Despite being within the cohort of countries rated between A+/A1 and BBB-/Baa3 by S&P/Moody’s, India stands out as an outlier across various parameters. Recently though, continued pressure by the Indian government led to a minor improvement in outlook by the S&P from “stable” to “positive” in May 2024. The ratings, however, continued to remain the same.

Credit ratings gauge the probability of default, reflecting the borrower's willingness and ability to meet obligations. India's impeccable sovereign default history underscores its willingness to pay. Moreover, its ability to pay is supported by its minimal foreign currency denominated debt and substantial foreign exchange reserves. These reserves are sizable enough to cover short-term private sector debt as well as the entire stock of external debt, with an additional buffer for significant negative events.

Though credit ratings may miss the mark on reflecting fundamentals, their influence on FPI flows in developing countries can be significant and even damaging. A shift towards a more transparent and objective approach is essential for fostering stability and resilience in global financial systems, prompting us to rethink the role and impact of credit ratings in today's interconnected world.