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Monday, Feb 10, 2003

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Moody's upgrade — Uplifts the mood but raises questions

S. Venkitaramanan

RATING agencies such as Moody's and Standard & Poor's have become fixtures on the international financial scene. This is particularly true as global investment, which depends on their ratings, is an important part of the balance of payments of various countries.

Time was when India did not depend much on international resource flows, such as portfolio and direct investments. But, with the opening of the economy, India has been sustained by some inflows of this type, though they are not critical. After all, the rating agencies are only doing their dharma and it does no good to get exercised overmuch when their assignment goes wrong.

The latest news on this front is both comforting and jarring. The good news is that Moody's Investment Services has "upgraded" India's foreign currency rating from Ba2 to Ba (albeit a dubious grade, below investment level).

Recall that Moody's had downgraded India to Ba2 (sub-investment) grade in 1998 in the wake of the Pokhran nuclear tests.

Moody's has seen it fit to review the situation in the light of India's steadily improving forex reserves and the current surplus, and has upgraded the rating. "Better late than never", should be our first reaction.

What is, however, jarring is that in spite of the upgrades, the agency still keeps India in the sub-investment grade. In Moody's lexicon, "Ba" bonds are adjudged to have built-in speculative elements and are characterised by "doubtful protection of interest and principal payments".

It is strange that this characterisation comes at a time when India's record in terms of pre-payment of foreign debt has been impeccable. I must, however, point out that the rating game is a peculiar one in which the raters tend to go overboard with their caution. They hate to be caught on the wrong foot. They had a bitter experience in the Asian crisis when they rated wrongly economies such as Thailand and South Korea.

But India's performance on the external front has been acknowledged by all observers to be spectacular in recent years. Despite evidence that our increased forex inflows are sustainable, Moody's has decided to give us a dubious upgrade. While the initial official reaction has been one of "it could have been worse", it seems essential that the nuts and bolts of the forex situation should be brought out in full before the rating agency.

The significance of a low rating for a bond issuer is, first, that investors abroad would tend to think twice before they invest in them and, second, that there is likely to be a rise in interest costs for lower-rated bonds. Investors in the US, in particular, are statutorily obligated to put their funds in investment-graded securities as certified by rating agencies.

Access to foreign funds also becomes difficult with lower ratings. Sovereign rating is also the ceiling for Indian corporates. Fortunately, India Inc. does not need to access external borrowing so much these days in view of abundant domestic liquidity at low rates.

The RBI has recently come out with a timely study titled The Accretion to Foreign Exchange Reserves in India, Sources, Arbitrage and Costs. It goes to strengthen the perception that India's external front is quite healthy and promises to remain so in the foreseeable future.

The major sources of accretion to reserves, which grew $18.3 billion this fiscal up to January 17, 2003, are brought out in the Table. The RBI study establishes that the inflows are clearly sustainable.

Turning first to the current account, which encompasses the difference between total exports and imports, it is creditable that it has turned into a surplus, thanks mainly to rising exports of goods and invisibles, viz. services. This has happened in spite of the global slowdown and the appreciation of the rupee, which affects both exports of goods and services.

The RBI study stresses particularly that the increase in reserves is primarily due to NRI deposits attracted by arbitrage. While it is true that Indian interest rates on NRI deposits are attractive compared to the low rate prevalent in the US, the UK and Europe, the RBI study tries to argue that this alone is not the explanation. The growth in deposits has remained steady over the last two years.

While the existence of arbitrage — the pull of interest differentials — cannot be denied, the sustainability of NRI flows is amply borne out by the fact that the level of NRI deposit inflow has remained more or less at the same level in the last three years.

The interest rate offered for FCNR (B) deposits ($10 billion out of $27 billion) is 25 basis points below Libor, shutting out possibilities of arbitrage, which come about only when intending investors borrow abroad and invest in NRI (B) deposits. At least, in respect of FCNR (B) deposits, arbitrage is ruled out.

The RBI stresses the fact that India's reserve position is supported mainly by non-debt creating inflows, viz. the current account surplus which, in turn, is fed by remittances, which are likely to be sustained. Given the current world scenario, these have a good chance of persisting in the near future.

The RBI study rightly argues that reserve accumulation is almost costless. And the return of around 4.5 per cent on forex reserves is at the right level in the current low global interest rate structure.

Nor does Moody's itself seem to discount the fact that India's forex situation is sustainable on this basis. In fact, Moody's is also reported to believe that foreign currency flows are sustainable and the factors bolstering India's external liquidity are likely to sustain over the next two to three years.

Why, then, has Moody's still clouded the issue by retaining India in the sub-investment grade and not raised the rating to what India's external situation duly deserves? Why the dubious sub-investment upgrade? In Moody's view, if it is not the forex situation that is at fault, it has to be something else.

The rating agency brings to fault the domestic fiscal situation — a difficult argument. India's public debt is more than amply met from domestic sources.

There is no likelihood of sovereign external borrowing for meeting fiscal gaps. It seems quite unlikely that India's fiscal deficit will spill over into its external account. Hence, there is little justification for its dubious grading of India on the external account.

Rating agencies come and go and their downgrades and upgrades should not affect us unduly. But, the fact that Moody's latest decision — belated as it is — to upgrade India's grade falls short of what India deserves is definitely intriguing. In the rating game, "beauty" lies in the eyes of the beholder. It is little use quarrelling with the rating agency's grading.

While Moody's has belatedly recognised reality by its halfway admission of facts, it is not fair in its assessment. The world looks on ratings as a hallmark. It is gratifying that India's fortunes are not going to turn merely on whether Moody's revises its grades or not.

But the rating agency has to recognise that India is one of the best bets in the world today and the inflow of forex confirms it. Besides, as one of the fastest growing economies of the world, India deserves a better grading than Moody's has given.

Hopefully, Moody's will respond to various comments offered by the Government and the RBI, besides other analysts, and react positively. The latest news on the rating front should, however, place us on our guard. We should not rest on our oars.

Even on the forex front, we should spare no effort to make the rules and procedures friendly to exports and capital receipts.

In this context, the Kelkar proposals on income-tax, which recommend the dilution of export-friendly exemptions on software and other export earnings, deserve to be rejected.

There is no case for rocking the forex boat at this stage. In fact, we have to see how best to increase the incentives for such earnings to be brought home in a legitimate manner. The tax regime should be, above all, friendly to inflows that seek India as a destination.

We should also see to it that the fly in the ointment — the fiscal gap — is addressed as pragmatically and as prudently as is possible. The ratings by such agencies as Moody's and Standard & Poor's should serve as alarm signals. We should do our best and then see what Moody's does.

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