The sanctity of Sovereign Ratings

Over the last three to four months we have seen a number of rating agencies coming out
with their concerns on the rising fiscal deficit position of India and have indicated that they have put India on a rating watch for a possible downgrade.

Not let us look at this issue dispassionately. The combined Fiscal Deficit for the Central and State governments in India for the year 2008-09 is expected to be in the region of 10-11% of GDP after taking into account the oil and fertilizer subsidies, the pay commission award, various social schemes of the government of India and the farm loan waiver. The tax revenues of the government are also much below forecasts. This is expected to remain at the same level for the current year which has started on 1st of April 2009 mainly due to falling revenues due to the economic slowdown and tax cuts by the government as well as higher government spending. This is despite the fact that the subsidy on oil and fertilizers is expected to fall significantly due to the sharp fall in the prices of these commodities over the last six months. The Indian economy is still expected to grow at 6-7% in the current financial year.

Now let us go and look at the large global economies and the state in which they are. Let us first look at the biggest culprit in the entire economic slowdown drama; you guess it right it’s the USA. The GDP of the US is around $ 14 trillion and is expected to fall in the current year by around 2-3%, have an almost 0-1% growth next year and then go back to a growth of around 2-3% per annum over the next ten years ( under an optimistic scenario). The budget deficit of the US in the current year is expected to be around $ 2 trillion which the government there is projecting should fall to $ 500 billion after 4-5 years. This in my view is an extremely optimistic projection given the state of unemployment, extremely low savings rate and low investment rate. Consumption demand which accounts for a majority of their GDP is slowing down rapidly. Besides this the US government and Federal Reserve are pumping in huge amount of money into financial companies in that country which is outside the budget deficit

The second largest economy is Japan, which as it is has not been showing a growth over the last 10 years. This is a country which has a severely aging population. Here the GDP is around $ 5 trillion. Japan is very much dependant on exports for its economic growth and its exports have been falling at nearly 40% month on month over the last three months. It’s GDP declined by more than 10% in the last quarter. The Japanese Government has announced a stimulus package of $ 250 billion which is nearly 5% of GDP. The Social Security benefit liabilities in Japan are rising rapidly due to an ageing population where a majority of people are expected to be above the age of 45-50 going forward. Japans public debt is already the highest in the world and is expected to move up sharply in the current year. Japans GDP is expected to decline 3-4% in the current year and 1% next year.

Similarly if we come to Europe, Britain is one of the worst sufferers of the economic crisis and the GDP decline here is expected to be around 3.5% over the current year. The British government and central banker have been the most liberal in announcing large fiscal stimulus packages and also undertaking huge bank bailouts and has taken the lead in printing money to revive their economy. With a GDP of nearly $ 2.7 trillion the British government borrowed $ 146 billion last year and is expected to borrow $ 230 billion in the current financial year. The Fiscal deficit for the current year in Britain was expected to be around 10% earlier which has just been raised to 12% in the current week.

Standard and poor’s rates the USA as AAA with stable outlook, UK as AAA with Stable outlook and Japan as AA with stable outlook. Moody’s rates all three countries Foreign Currency ratings as AAA.

Now coming to the main point of this article, should ratings of countries like India be put on watch or should the ratings of all these countries be downgraded. Let us take the current year and look at some statistics. India’s GDP is around $ 1 trillion and that of the US $ 14 trillion. Indian government will borrow a total of $ 80 billion in excess of its revenue in the current year and the US government will borrow around $ 2 trillion extra.

The key here now is to look at who will have a greater capability to repay it. For this it is important to see some facts –

Demographically India is one of the youngest countries in the world and has a majority of its population below the age of 30. This population will earn more and contribute more to tax revenues going forward. As such tax revenues of the Indian government over the long run will grow quite rapidly. Demographics and the addition to the working population itself can grow tax revenues in India by over 20% per annum over an extended period of time. Unlike this there is very little hope for the tax revenues in countries like US, Japan, Britain etc to grow.
Tax compliance in all the developed countries is as it is very high and it is very difficult for it to go up. In a developing country like India tax compliance will grow rapidly over the next 10-15 years.
Savings rate in India is at nearly 35%; in the US it was negative last year and is now at 3-4%, in Britain it is in single digits. Japanese saving rates are believed to be high but giving the ageing population reduces its relevance.
15 years from now India’s GDP is expected to be around $ 5.5 trillion and of the US $ 25 trillion. As such an incremental borrowing of $ 80 billion for this year is just around 2% on the incremental GDP 15 years from now. Whereas for the US it is around 18% of this incremental GDP.
India has a much more stable and sound financial system and the financial system in the Western economies will take at least 3-5 years to stabilize. This will lead to suboptimal GDP growth in these countries for an extended period of time.
-Countries like Britain who have lost competitive advantage in most manufacturing, services and where consumers are going to be under lot of stress are unlikely to see any significant economic revival over the next 10 years.

In a nutshell, although there are a lot of other points which can be made, the key is that if the ratings are to be downgraded, first it should be the Western economies which are the stressed economies and then countries like India.

Even when companies are evaluated for ratings it is companies that have poor earning prospects, high debt levels and poor cash flows are downgraded first( i.e. Western economies). Companies that are likely to grow strongly and have improving cash flows are not downgraded but actually upgraded over a period of time (i.e. emerging economies like India).

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