MC Explains: US credit rating downgrade and its spillover impact on Indian market

The US suffers a decline in credit rating from AAA to AA+.

Like most other places, Indian markets began sneezing with the US going colder by about a percent on July 2. The 1,000-point correction on the Sensex seemed more of a knee-jerk reaction and analysts and fund managers seemed confident in India’s ability to take this blow without much damage.

The trigger for the fall was a decline in credit rating for the US – from AAA to AA+ - that recreated a move made more than a decade back by S&P Global Ratings. Fitch said tax-cuts and new spending initiatives, coupled with multiple economic shocks, have swelled budget deficits for the US, while medium-term challenges related to rising entitlement costs remain largely unaddressed.

Let us try to figure out what this kerfuffle is and how it can potentially affect India.

What is a credit rating?

When you apply for a loan, the banking or financial institution does a background check on your creditworthiness, that is, how likely are you going to pay back the loan taken along with interest charged in full. This background check is usually done by companies like CIBIL and Experian who maintain credit information on individuals. These companies assign a credit score for every person, which in the end determines if you will get a loan or not and, if yes, then what will be the interest charged on it.

Similarly, sovereign credit rating determines the creditworthiness of a government. All governments need to raise money through bonds and treasury bills to fund its activities. However, how easily a government will raise the money and what will be the cost is determined by a credit rating.

Who issues sovereign credit ratings?

Moody's, Fitch, and Standard and Poor's are the three biggest agencies in the world who issue credit ratings for governments. In essence, they measure the risk of default by a nation and assign a rating for that nation. A AAA rating means there is virtually no default risk while a lower rating such as CCC- will signify relatively higher default risk. These ratings give investors an idea of risk associated with buying bonds issued by the respective government.

What does the US rating downgrade mean?

It simply means that Fitch now sees more risk in US bonds and treasury bills. On the other hand, the US (ideally) will have to offer more interest, commensurate to the risks, on its bonds for investors to buy them.
Though one should keep in mind that the US bonds are still perceived as the safest in the world. Moreover, analysts also say that bond and sovereign credit default swap (CDS) – an instrument that is used as a hedge against government defaults – the market has discounted the rising risks mentioned by Fitch.

How does it impact the market?

The rating downgrade led to a sell-off in the US equity markets, reminiscent of a similar downgrade in 2011 by S&P. The sell-off spread to Asian markets as well when they opened for trading yesterday. European stocks also followed the trend.

Why did equity markets fall? Well, a downgrade in ratings means erosion of confidence in the economy of a nation, and its government. Such loss of confidence though may not directly hurt revenues of companies, may have have an impact on the sentiment of investors. Moreover, when a sovereign rating is downgraded, it eventually affects the cost of capital for companies, thus having an impact on the balance sheet. It is logical for American equities to fall, but not for equities of other countries. The fall in equities across markets was a knee-jerk reaction.

How does it affect India?

There's likely to be no direct impact on India. There has been no change in the credit ratings of India. The Indian bond market was also largely unaffected by the turmoil in the US. American equities, though, did see a sharp fall but even that was bought into.

"It can create a temporary risk-off moment for markets,” said Hiren Ved, Whole-Time Director & CIO, Alchemy Capital Management. “However, it has no long-term impact as we know that developed market governments are getting more indebted."

In 2011, when S&P took a similar action, Indian equities which were already on a downturn, entered a bear market territory, losing about 18 percent in the next 4-5 months. Analysts, however, say the situation is different this time.

The Nifty and other indices are either at their all-time high or close to it. Moreover, the market is in an uptrend. Macro outlook is also much stronger than 2011, when the economy was just coming out of the 2008 crisis and there was high inflation.

Analysts believe that the Indian market is likely to show resilience as earnings momentum, especially in midcaps and smallcaps, have been robust. Jaykrishna Gandhi, Head - Business Development, Institutional Equities, Emkay Global Financial Services, said Indian markets today saw the first round of correction breaking the important level of 19,560 and closing below that.

“The results season thus far has been mixed with 18 Nifty companies beating estimates and 15 missing. However, the mid and small cap space has seen earnings upgrades which has resulted in the continued rally in the space. The US markets overall remain in a bit of uncertain mode as valuations and a concentrated bunch of stocks have driven the market rally (largely driven by AI). For the coming week, we expect the Indian market to take a breather along with some global weakness,” Gandhi said.

Investors can also find solace in the fact that buying dip has continued as opportunistic traders jumped to grab stocks at lower levels. This also gives confidence that the crisis in the US may not have much negative impact in India.