Moody’s upgrades India’s sovereign bond rating after 14 years

—the rationale

Moody's Investors Service has upgraded the Government of India's local and foreign currency issuer ratings to Baa2 from Baa3 and changed the outlook on the rating to stable from positive. Moody's has also raised India's long-term foreign-currency bond ceiling to Baa1 from Baa2, and the long-term foreign-currency bank deposit ceiling to Baa2 from Baa3. The short-term foreign-currency bond ceiling remains unchanged at P-2, and the short-term foreign-currency bank deposit ceiling has been raised to P-2 from P-3. The long-term local currency deposit and bond ceilings remain unchanged at A1. According to the Moody’s PR on 14 November 2017, a rating committee was called to discuss the rating of the India, Government of. The main points raised during the discussion were: The issuer's economic fundamentals, including its economic strength, have not materially changed. The issuer's institutional strength/ framework have not materially changed. The issuer's fiscal or financial strength, including its debt profile, has not materially changed. The issuer's susceptibility to event risks has not materially changed.

The decision to upgrade the ratings is underpinned by the expectation that continued progress on economic and institutional reforms will, over time, enhance India's high growth potential and its large and stable financing base for government debt, and will likely contribute to a gradual decline in the general government debt burden over the medium term. In the meantime, while India's high debt burden remains a constraint on the country's credit profile, Moody's believes that the reforms put in place have reduced the risk of a sharp increase in debt, even in potential downside scenarios. While a number of important reforms remain at the design phase, Moody's believes that those implemented to date will advance the government's objective of improving the business climate, enhancing productivity, stimulating foreign and domestic investment, and ultimately fostering strong and sustainable growth. Measures include the Goods and Services Tax (GST) which among other things, is expected to promote productivity by removing barriers to interstate trade; improvements to the monetary policy framework; measures to address the overhang of non-performing loans (NPLs) in the banking system; and others which work towards fostering stronger institutions and a more formal economy.

Moody's expects real GDP growth to moderate to 6.7% in the fiscal year ending in March 2018 (FY2017-18). However, as disruption fades, assisted by recent government measures to support SMEs and exporters with GST compliance, real GDP growth is expected to rise to 7.5% in FY2018-19. Longer term, India's growth potential is significantly higher than most other Baa-rated sovereigns. While India's high debt burden remains a constraint on the country's credit profile, Moody's estimates that the reforms put in place have reduced the risk of a sharp increase in debt, even in potential downside scenarios.

The upgrade comes within five years of India being classified as one of the "fragile five" economies, struggling with high twin deficits in fiscal and current accounts. Since then a combination of policy decisions and external factors has worked in favour of an upgrade. The Finance Ministry has held on to the targets for fiscal deficit, while the current account has been bolstered by a period of low oil prices followed by a resurgence of global trade. India’s position in the World Bank’s Ease of Doing Business rankings jumped up by a record 30 notches to the 100th spot recently with relevant policy easing. The upgrade has been termed overdue by some as India was earlier in the same risk category as a number of economies with far worse macro-economic performance. Indeed a Bloomberg Economics model had predicted an upgrade based on the divergence between actual ratings and CDS implied credit ratings.

—the benefits

The sovereign rating is an indicator of the government’s ability to meet its financial obligations. Sovereign credit ratings give investors insight into the level of risk associated with investing in a particular country and also include political risks. An upgrade thus lowers the cost of borrowing for the sovereign as it is associated with lower risk. In Moody’s rating, scale, bonds rated Baa3 and above are considered to be investment grade, meaning, these bonds are likely to meet the payment obligations better. India was at the lowest rung of the investment grade until it received this upgrade. The Indian government, it may be noted, does not fund its deficits via offshore commercial bond markets. External debt as a percentage of the Central Government’s total liabilities was at 6.2% in 2015-16. The entire public debt of India is funded via the domestic Rupee (INR) bond market. Foreign investor participation in the bond market, though increasing is very little, and tightly regulated through quotas. However, there are certain other benefits to be derived from a sovereign upgrade.

Sovereign ratings also act as the benchmark for other issuers of debt in the country. Effectively, sovereign upgrades or downgrades can affect borrowing costs for companies, individuals and any entity looking to raise money overseas. Moody’s upgraded some Indian corporate entities, mostly public sector companies along with the sovereign upgrade. This would result in reduction in cost of borrowing for Indian companies looking to raise financing from offshore bond markets. In fact, Reliance recorded the tightest ever spread for an Indian issue over US Treasuries in the offshore market soon after the upgrade.

The sovereign rating is an important indicator of the country’s financial and fiscal health. Foreign investors looking to commit money to direct investments, portfolio investments or local bond markets will all tend to look to the sovereign rating for a quick assessment of the country’s prospects. A ratings upgrade gives out a positive view on policy and builds incremental confidence in foreign investors. A higher rating can increase the range of investors, for example, drawing in global Pension and Life Insurance firms that have minimum ratings criteria for investing. Incrementally higher foreign flows tend to bid up INR too, making investments in a host of other Indian financial assets like equities and real estate more attractive to foreign investors.

—and the caveats

Moody’s mentions that a material deterioration in fiscal metrics and the outlook for general government fiscal consolidation would put negative pressure on the rating. The rating could also face downward pressure if the health of the banking system deteriorated significantly or external vulnerability increased sharply. The upgrade has come in at a time when a gamut of short and long-term indicators has started to worsen. Given the emerging signs of quickening inflation and a widening current account and fiscal deficit a lot of policy balancing is in order.

S&P Global Ratings and Fitch Ratings, who now rate India a notch below Moody’s, hold the view that for an upgrade, India would have to address its weak fiscal balance sheet and weak fiscal performance. S&P Global Ratings, while acknowledging India’s stronger growth prospects and the country’s achievements on the reforms agenda, noted that its ratings were constrained by India’s low wealth levels, measured by GDP per capita. This and the income inequality hidden behind it, is indeed a macro-economic indicator which, on its own, needs far greater policy attention and careful planning than it has received so far.

Sources include:

https://www.moodys.com/research/Moodys-upgrades-Indias-government-bond-rating-to-Baa2-from-Baa3--PR_374998

https://economictimes.indiatimes.com/markets/stocks/news/moodys-upgrade-is-just-a-milestone-in-indias-development-journey/articleshow/61719739.cms

Government’s Rs. 2.11 trillion bank recapitalisation— Sufficient to cover stressed assets but no quick fix

The government, the largest shareholder will recapitalise the banks it owns by infusing an unprecedented amount of Rs. 2.11 trillion (US$32 billion), of which Rs. 1.35 trillion will be through recapitalisation bonds. Infusion of capital would help to fast-track the resolution of non-performing assets (NPAs) and take Indian PSBs closer to global capital adequacy norms. The move is expected help economic recovery with the revival of flow of credit to business and industry, and particularly foster medium and small industries growth and employment generation.

Public sector banks require capital mainly because of a sharp rise in NPAs in the last decade due to delays in repayments from sectors like power, steel and infrastructure. The gross NPA ratio reached 9.7 per cent in FY17, up from 7.8 per cent in FY16. Including loans that have been restructured the ratio of stressed loans rises to 12% of total banking sector loans. Weak credit discipline in banks, right from the appraisal to sanction stage, was recognised, by the RBI, as one of the main bank specific factors in the build-up of stressed assets. Swift, time-bound resolution or liquidation of stressed assets was recognised as critical for de-clogging bank balance sheets and for efficient reallocation of capital and a multi-pronged approach taken.  The Asset Quality Review (AQR) exercise undertaken in 2015-16 was a critical step in recognising the aggregate stock of NPAs across the banking system. Setting up of CRILC (Central Repository of Information on Large Credits) by the RBI in 2014, gave access to an aggregate view of borrower-wise and bank-wise exposures, to supervisors as well as lenders, to track the incipient stress in a particular account in a timely manner. The decision to do away with the regulatory forbearance regarding asset classification on restructuring of loans and advances effective April, 2015, was a significant step from the perspective of aligning the regulatory norms with international best practices. The system of ‘Prompt Corrective Action’ (PCA) ensures timely supervisory action in case banks breach certain risk-related trigger points. The enactment of the Insolvency and Bankruptcy Code, 2016 (IBC) puts a time limit of 180 days (extendable by a further 90 days) within which creditors have to agree to a resolution plan, failing which the adjudicating authority under the law will pass a liquidation order on the insolvent company (https://www.rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1044).

The necessity for capital infusion had also been emphasised by various rating agencies such as Moody’s, CRISIL and Fitch, as well by RBI insiders. Moody’s estimated that the external capital requirements for the 11 rated PSBs, over the next two years would be around Rs. 700-950 billion, factoring in the two main drivers of their capital needs—the need to comply with Basel III requirements, and for conservative recognition and provisioning of their asset quality problems. Such an amount is much higher than the remaining Rs.200 billion previously budgeted by the government for capital infusion until March 2019. Under Basel III norms, being implemented in phases between April 2013 and March 2019, banks need to have a core capital ratio of 8% and a total capital adequacy ratio of 11.5% against 9% now. Capital adequacy is a measure of a bank’s financial strength expressed as a ratio of capital to risk-weighted assets (CRAR). A number of single factor sensitivity stress tests, based on March 2017 data were carried out, by the RBI, on SCBs to assess their vulnerabilities and resilience under various scenarios. SCBs’ resilience with respect to credit, interest rate, and liquidity risks as also due to drop in equity prices was studied. A severe credit shock is likely to impact capital adequacy and profitability of a significant number of banks. Under a severe shock of 3 standard deviations (that is, if the average GNPA ratio of 59 select SCBs moves up to 15.6 per cent from 9.6 per cent), the system level CRAR and Tier-1 CRAR will decline to 10.4 per cent and 7.9 per cent respectively. At the individual bank-level, the stress test results show that 25 banks having a share of 44.4 per cent of SCBs’ total assets might fail to maintain the required CRAR under the shock of a large 3 standard deviations increase in GNPAs. PSBs were found to be severely impacted with the CRAR of 22 PSBs likely to go down below 9 per cent.

The government is yet to disclose details on the structure and pricing of the Rs. 1.35 trillion recap bonds, as well as how it will raise the rest of the cash. It is expected that banks will subscribe to these bonds and hold it on their books as their investment. The funds which will go to the government will be reinvested as equity in the same banks. The programme is expected to have minor impact on its target to shrink the fiscal deficit to 3.2% of GDP in FY18, because the government will probably classify the bonds as off-balance sheet items as per permissible accounting norms. However, the government still has to bear the interest cost; to service the debt it will need to at least bear a cost of Rs. 80-90 billion, according to various unofficial estimates. Apart from the recap bonds, Rs. 0.18 trillion will come from the budget, in line with earlier provisioning under the Indradhanush scheme, leaving Rs. 0.58 trillion to be raised from the market. Front-loading of bonds is expected to increase the equity prices of PSBs. Rating agencies have called the government’s Rs. 2.11 trillion PSU bank recapitalisation plan significantly credit positive. Post the announcement, the 30-share BSE Sensex gained 387.96 points to open on 32,995.28 and the 50-share NSE Nifty gained 113.45 points to open on 10,321.15. Both the indices extended gains with Sensex breaching the 33,000-mark to touch the peak of 33,117.33 and Nifty scaling a fresh high of 10,340.55. PSU Banks were leading the rally in early trade with the Nifty PSU Bank sub-index jumping 22.76 per cent Most public sector banks’ shares have surged more than 20% since the announcement by the MoF.

However, apart from the modalities of the plan, questions that arise relate to its actual effect on the bond market, on governance issues of banks and its actual impact on the economy. The bond market faces a formidable supply load, even in the face of excess liquidity now being managed by RBI. Such large scale financing, though executed over two years and possibly held on books, could nevertheless, hamper the ability of the biggest subscribers, the PSBs, to invest in bonds and may push up yields eventually when liquidity dries up.  A series of banking reforms are to accompany the capital infusion, however, doubts definitely arise about moral hazards of such bail-outs as past experience of the 1990s has demonstrated that banks have not been able to shore up their lending practices so as to stem further build-up of toxic assets. Further, at this stage there are uncertainties about the appetite of borrowers with large overcapacities on GST implementation, and hence capital freed up for lending may not have immediate takers and not have much of the desired effect on economic revival. Again banks too may prioritize asset resolution and provisioning over expansion. Hence, the measure announced should not be seen as a one-shot solution to the banking sector’s and the economy’s current aliments, but rather as an important part of an integrated process, which still needs much careful planning and monitoring at each stage.