Portfolio

The credit rating enigma

Maulik Tewari | Updated on March 12, 2018 Published on May 25, 2013

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It was just last week that Standard & Poor’s reaffirmed India’s sovereign rating at ‘BBB-’ with a ‘negative’ outlook. What does this rating mean and why do governments and investors obsess so much over them?

The rating world’s Big Three – Standard & Poor’s (S&P), Moody’s Investors Service and Fitch – give their opinion – in the form of a rating — on the credit worthiness of countries or companies or the riskiness associated with specific debt issues made by them.

A sovereign rating is an indicator of whether or not a Government will be able to fully meet its financial obligations or if a default is likely.

A rating agency makes the assessment based on certain factors and then assigns a rating which is typically expressed in letters such as A, AA, BB+, C, D. Besides, it also releases a rating outlook - a forecast on where the assigned rating is headed in the next six months to two years.

For instance, S&P’s highest ‘AAA’ rating indicates a strong capacity to meet financial commitments while its lowest ‘D’ rating indicates a payment default. As regards the rating outlook, ‘positive’ indicates a likely rating upgrade in future while ‘negative’ implies just the very opposite. A ‘stable’ outlook indicates that a ratings change is unlikely in future.

While deciding on a country’s sovereign rating, an agency would consider factors such as political risks, economic growth prospects, fiscal situation, external indebtedness to name a few. As these factors change, so would the rating. S&P has warned India of a future downgrade to ‘junk’ status if the Government fails to hasten the pace of reforms and keep in check the fiscal and current account deficits.

Implications of downgrade

A ratings downgrade simply means that the risk associated with investing in a country in general or a government bond has increased. A downgrade to junk – the lowest grade – can however have serious implications. It can substantially increase overseas borrowing costs for a government or worse still, shut out all access to borrowings in future. It can significantly slowdown the foreign investment inflows as the country is viewed riskier than before.

Trustworthy?

These rating agencies have, however, received a lot of flak in recent times. But with the way the agencies work, it would be too much to expect an absolutely honest rating.

They are paid for their ratings by the very issuers of debt whose creditworthiness they are going to certify. In fact, it was the assignation of a good rating to complex financial products that were actually worthless, which fuelled the US sub-prime crisis.

Without the blessings of the rating agencies, these securities could not have been marketed so widely. Even though questions have been raised about their credibility, we continue to rely on them. A necessary evil, you could say.

Published on May 25, 2013
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