The Economy will Benefit from Credit Rating Upgrade

Credit Rating

Moody’s upgrade of India’s credit rating to Baa2, coming as it does after the World Bank’s sharp upgrade of India’s ranking in Doing Business from 130 to 100, and the IMF chief Christian Lagarde’s remark that the Indian economy is on solid track, is a vote of confidence in India’s economic reforms from three of the World’s leading financial institutions.

Moody’s upgrade along with the recognition by the IMF chief and the World Bank sent out the clear message that the Indian economy is on the right track. It is important to appreciate the fact that presently there is a global recognition that the path-breaking reforms like the GST, RERA, Benami Property Prevention Act and the Insolvency and Bankruptcy Code are major transformational resets for a cleaner and more productive economy.

Recapitalization of the PSU banks is another major initiative to address the issue of stressed assets and to accelerate credit growth. The Moody’s report states that the reforms “would advance the government’s objective of improving the business climate, enhancing productivity, stimulating foreign and domestic investment and ultimately fostering strong and sustainable growth.”

The direct and immediate benefit of the rating upgrade is that it will reduce the cost of borrowings for government and therefore, is positive for the economy’s macros. Ratings upgrade will lead to lower credit risk premiums for corporates resulting in reduction in interest costs for those borrowing abroad. Normally, interest costs for overseas borrowings are LIBOR (London Inter Bank Offer Rate) plus 200-400 basis points depending on the credit-worthiness of borrowers. Ratings upgrade can reduce the cost of funds by 75 to 100 basis points for Indian corporates. It would attract more foreign capital flows into the economy, thereby reducing the cost of capital and accelerating growth.

The biggest positive of the ratings upgrade is the perceptional change about the Indian economy as an investment destination. Even though foreign investors have always viewed India’s growth potential as the best among Emerging Markets, poor macros like high fiscal and current account deficits and high inflation had negatively impacted the rating. Now, this will change.

Even though the Finance Minister has declared that he would stick to the fiscal deficit target, that would be quite a challenge this year. Moody’s has warned that deterioration in Debt-GDP ratio and inability to address the stressed assets of the banking system would invite a ratings downgrade. A negative fallout of the ratings upgrade would be the appreciation in rupee hurting the nascent recovery in exports.

Ratings upgrade, though highly positive for the economy, will have only marginal morale-boosting impact from the market’s perspective. The market, being ahead of rating agencies, has discounted all the positives that Moody’s has recognised now. Moody’s has only reaffirmed the fundamental logic that drives the present ‘hope trade’, which is that the economy is set for growth recovery.

This bull run, primarily driven by domestic liquidity, is likely to sustain for an extended period of time. Financialisation of savings and increasing preference for equity as an asset class are structural trends that are likely to get entrenched. This rising tide of domestic liquidity is likely to keep valuations at elevated levels. It is important to appreciate the fact that valuations are frothy in pockets of mid and small caps. Large cap valuations are higher than historical averages, but not frothy. There is a very high probability that growth will improve from the second half of FY 2018. If we achieve a GDP growth rate of 7.4 per cent in 2018-19, it can translate into a 20 per cent earnings growth. This will make large cap valuations fair.