A Baa3 rating is not in sync with Moody's bullish assessment of India

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Ratings agency, Moody’s Investors Service, on October 5, revised India’s credit rating outlook to stable from negative, on healthier prospects of the financial sector, cutting potential impairment to the broader economy.

This should, ideally, be good news for an economy that is showing tentative signs of bouncing back from the devastating effects of COVID-19, and regain its lost status as the world’s fastest-growing major economy.

But there is still a minor matter to reckon with. India’s credit rating was, however, unchanged at Baa3, the lowest investment grade.

Simply put, a credit rating evaluates the creditworthiness of a borrower. Corporations and governments issue bonds to borrow money. When you buy a bond, you are lending your money to someone — the government or a private entity who promises to repay within a specified tenure.

Credit ratings, in that sense, represent the ability of the bond issuer to repay. A higher rating implies that the bond issuer has a lower likelihood of defaulting on payments. There are no specific mathematical formulae. Agencies use public available information, historical trends, discussions with government officials, and future outlook to determine credit ratings.

These ratings are used by individuals, and entities that purchase the bonds issued by companies, and governments to determine whether the borrower will repay as promised.

Bonds that have higher credit rating are also known as investment-grade bonds. Bonds that have very low credit rating are known as junk bonds, because of a stronger likelihood of default.

Despite brighter macroeconomic prospects, a string of policy reforms, and a fast recovering financial sector that had been snowed under a piling rubble of bad loans of non-performing assets (NPAs), India’s credit rating remains tantalisingly close to the ‘junk status’.

This is a bit of a puzzle that requires more explaining with a greater degree of statistical, and illustrative rigour. Over the last five years, Moody’s rating decisions on India’s sovereign credit profile broadly resembles a zigzag pattern.

In November 2017, it upgraded India’s sovereign rating to Baa2 with a stable outlook, commenting that the raft of structural reform measures that the government had initiated would buoy overall growth prospects. In November 2019, it revised the outlook to negative from stable with a Baa2 rating. However, in June 2020, it downgraded India back to Baa3, the lowest investment grade with a negative outlook. In October 2021, it upgraded the outlook to stable from negative, but maintained the Baa3 sovereign rating.

S&P Global Ratings and Fitch Ratings have also assigned India the lowest investment grade but with a stable and negative outlook, respectively.

Ideally, one would assume that the relationship between outlook and the ratings would be axiomatic, and would not pull in opposite directions.

This begs a few questions. If the outlook is bullish, shouldn’t it be accompanied by a ratings upgrade? What are the underlying factors that go behind a ratings action? Is there a formulaic approach to calculating ratings that negates biases of opinion?

In effect, a sovereign credit rating is a rung or a number of a scale. An outlook, on the other hand, is a commentary. According to Moody’s, "solvency in the financial system has strengthened, improving credit conditions which we expect to be sustained as policy settings normalise. Bank provisioning has allowed for the gradual write-off of legacy problem assets over the past few years."

It said that the various economic relief measures announced by the government over the past year and a half, if implemented effectively, would be credit positive, and could lead to higher potential growth than expected.

One of the biggest measures that the government has taken in recent times has been to bury the ghosts of retrospective tax nine years after it came into force, through the Taxation Laws Amendment Bill.

Perceptions play a big role in influencing individual, and institutional decisions. This is more so in the case of investment decisions where billions of dollars are chasing islands of global growth. If the economy is gathering speed, if the macro fundamentals have bolstered, if banks are getting back to the pink of health, if structural reforms are moving down the right path at the right pace, a ratings upgrade too should have been actioned.