How plausible is Q3 recovery?

Everyone invariably wants to believe that the Indian economy would on the recovery stage by 3rd quarter for 2009-10. However, in the current economic and political scenario this optimism has its own downside risks. Everyone wants to believe that the word recession has had its impact on India but not many realize that the worse is yet to come! We are yet to see the bottom, which we may witness in another 3-6 months.

Risk of a hung parliament in the next election (schedule of which could be announced within a week) leading to the political uncertainty and delays in policy responses could very well entrench the time to recovery path. The pre-poll survey by CNN-IBN predicts a Hung parliament in the coming Lok Sabha elections. The governing UPA is projected to get between 215 and 235 seats and the NDA to get 165 to 185 seats. Something which we witnessed last decade, in 1989, and 1996 elections when we saw 5 governments in 5 years (1989-1991: 2; 1996-1998:3), general elections being held at interval of one year rather than the five years (1989, 1991, 1992 and 1998, 1999).

Just the visualization of such a scenario sends jitters across the spine! No meaningful policy actions to counter the worsening economic scenario; coupled with political uncertainly; another round of elections could push us in long de-growth phase which we are yet to price in be it in the equity markets or other asset markets.

On the fiscal front, the deficit figure would be hovering in double digits for this and in the next fiscal. Recently, S&P changed it rating outlook on India from stable to negative in light of the worsening fiscal situation and reverting all the consolidation benefits of past several years. FRBM act have been kept on the book self for the time gathering dust and may not see the light of the day until the economy recovers from the doldrums!

On monetary policy front, market participants are betting at 100-150 bps rate cut by RBI। The recent GDP slowdown from earlier 9% to 5.3% in Dec quarter with expectation of further slowdown to below 4% in next two quarters could force to cut rates drastically, may be by over 200 bps in near term. We all believe that the monetary policy actions are more likely to bring India back on the growth trajectory faster than the fiscal stimulus packages being announced by the government straining its fiscal position severally. An estimate suggests that a 100 bps policy rate cut is better than the 200 bps indirect-tax rate cut. However, huge borrowing requirements of both the central and state governments would keep the pressure on the interest rates, despite monetary easing.

Corporate borrowing costs are unlikely to come off significantly under this scenario, straining both their BS and P&L। Dropping sales and increased cost has caught all the corporate on their wrong foot of expansionary mode. We are yet to witness large corporate defaults due to financial strains even in the highly strained sectors like automobiles, real estate, and metals. Recent downgrades of some of the major players in the sector by the rating agencies point towards the increased likelihood of such event in near future.

Rating credit rating agencies?

Credit rating agencies (CRAs) are once again in line of fire for unfathomed concerns: ratings are obligatorily through financial regulation, the CRAs operate in an oligopoly; there is conflict of interest, because they are paid by the issuers of the securities they rate, not by investors; and they are unaccountable because their ratings are deemed opinions and thus protected as free speech.

In terms of the issuer-fee conflict, we have heard a number of points made in the past by investors and CRA’s responses to them. Investors argue that since the fee does not get generated without a deal, being benevolent at issuance and revisiting the credit after the deal is in the market, makes perfect sense. This evidently creates an ostensible stress in the decision making process. Any rating action/assessments that prevents an issuer from accessing the market such as an unduly harsh opinion or demand (and transparent) set of metrics and forward expectations could imperil the deal, and hence no fee. That action presents additional risks since the CRA can always revisit later after the deal is in the market, describing this act of theirs as "surveillance of credits". CRAs fight hard to establish their “transparencies” by making their rating rational available for subscription and they even sell their rating models obviously with disclaimer!! And they call their ratings free, public good!

The CRAs are obviously in a tough position here. If they move too fast, they get lambasted. If they move slowly, they get lambasted. None of these issues can be comfortably palliated. Switching to an investor-pays system might seem the obvious answer, but it’s highly improbable that enough investors would cough up to make the business viable, CRAs fear this may put them out of business.

Another solution might be for them to be much more transparent about their criteria and expectations that are built into ratings so investors can better assess what the risks are when they rely on the ratings. For example, clear statements of time horizons for achievement of specific metrics, downside target ratios that would prompt a downgrade, expected growth rates for an industry, or any other tangible and quantitative yardstick that would improve the ability of the investor to make a more informed assessment.

More competition should help, but it might just as easily lead to a race to the bottom, as agencies vie to offer the best terms to issuers.

Making CRAs legally liable for their opinions would scare them out of the business.

The most beckoning reform, in theory, would be to end the regulatory dependence on ratings and let investors draw their own conclusions from “expert” opinions and market data, as they do with equity investment.

A more practical approach might be to let the CRAs get on with their house-cleaning while introducing a reform borrowed from the accounting industry: a board, made up of industry types, investors and academics, charged with policing their analytical techniques and governance.
Another reform is in offing! Indian CRAs seem to be moving in the direction of getting their act together. Recently CRISIL launched complexity level classification (simple, complex and highly complex) of capital market instruments reflecting the ease of understanding and analysing the risk elements in these instruments. Complexity levels help the investor determine the degree of sophistication and due diligence required to understanding the risk and factors involved in such instruments. Needless to say a simple financial instrument is nor necessarily less risky than a complex instrument. These complexity levels are being provided free of charge to all users. However, it would have been helpful if they also provided their rational for classifying one instrument as highly complex over complex/simple rather than just providing with the criteria. For example why Real Estate Investment Trusts are classified as highly complex and commodity futures as complex? Further refinements may follow, in all it’s a welcome move by CRA.

Credit Rating: National vs. Global Scale

Distinguishing national scale credit ratings from global scale ratings are of critical importance due to the potentially large difference in implicit default risk between the two scales. For example, a company's local currency bonds issue may get a global scale local currency rating and a significantly different national scale rating.

National scale credit ratings provide opinion on an obligor's creditworthiness (that is, issuer credit ratings) or overall capacity to meet specific financial obligations (that is, issue credit ratings), relative to that of other entities and specific obligations in a given country. In contrast to global scale ratings, national scale ratings are based on a comparative credit risk of active obligors, including the sovereign government, within one country, and exclude direct sovereign risks of a general or systemic nature. Given the focus on credit quality within a single country, national scale ratings are not comparable between countries.

National scale ratings typically provide a finer demarcation of credit risk among local obligors than is possible with global scale, as the latter spans the full range of global credit quality and incorporates international comparative risk factors, including direct and indirect sovereign risk considerations. National rating scales are of the most value where sovereign and other credit risks skew global scale ratings to low levels in the country and where local issuers and investors are predominant players on the domestic markets. Such a compression of ratings at lower levels is fairly common among the emerging market economies.

Sovereign risks (for example, direct constraints such as potential exchange controls) and country risks (for example, indirect effects from government policies affecting exchange rates, interest rates, taxation, regulations, infrastructure and labour markets) may compress the range of global scale ratings of obligors in the country, reducing or even obscuring differences in credit standing that would otherwise be evident in the absence of these sovereign and country risks. For example, sovereign and country risk factors in Mexico result in a narrow range of global scale ratings, with many of global scale ratings compressed in the 'BB' and 'BBB' rating categories. While the potential impact of sovereign risk is a critical consideration for cross-border financing, direct sovereign risks of a general or systemic nature, which affect most national obligors to a similar degree, are of less importance to local participants in the national financial markets who find that national scale ratings are useful in providing the most precise ranking of relative credit risk available for obligors within their country. Even though national scale ratings are meant to confer an opinion of relative credit risk within a domestic context that is not to say that they are fully isolated from sovereign risk considerations and other international comparative risk factors.

Key Characteristics of National Rating Scales
National rating scales exclude certain direct sovereign risks of a general or systemic nature, including the potential risk of foreign exchange controls. As a result, obligors and obligations with global scale ratings constrained by systemic, direct sovereign risk may have national scale ratings that are higher than the sovereign's rating on that scale, though such cases would necessarily be limited to countries where the sovereign's national scale (ns) rating is less than 'nsAAA'.
• National and global rating scales are broadly consistent in terms of the rank order (from highest to lowest credit quality) of ratings.
• National scale ratings are an expression of the relative creditworthiness of obligors and obligations in a particular country, and are based on a comparative analysis of that country's active obligors (this is in contrast to the all-encompassing international comparative context of global scale ratings).

Given the focus on relative creditworthiness, the strongest entities in the country, including the sovereign, often receive the highest possible rating on the national scale, provided the country is not experiencing an acute and widespread financial crisis that imperils the debt service capacity of even the strongest local debt issuers.

Underlying default risk differs from that of global ratings
The global scale and national scale rating usually imply substantial variations in the default probabilities associated with any particular rating category on the global and national scales. For example, the implicit default risk associated with a global scale rating of 'AA' could be significantly lower than the risk inherent to a national scale rating of 'nsAA'.

The difference in implicit default risk between global scale and any given national scale is a function of the degree of sovereign and country risks in the economy and, to a lesser extent, the distribution of credit risks among active obligors in the country. In order for the national scale to provide adequate differentiation in credit risks for obligors active in the local market, it follows that the higher the sovereign and country risks associated with the national economy, the higher the default risk that is embedded in the national scale. For example, a national scale serving an economy with medium sovereign risk and a predominance of low-grade, global scale ratings for active obligors (for example, Russia) would have lower global scale, local currency ratings corresponding to each category on the national scale than would be the case for a national scale serving an economy with low sovereign risk and a predominance of intermediate grade, global scale ratings for active obligors (for example, Taiwan).

It is important to note that the methodology underlying national rating scales results in a nonlinear relationship between the global scale rating grade and its corresponding national scale rating grades as one moves down the credit risk spectrum from high to low credit quality. That is, one cannot simply add a certain number of rating levels to a global scale local currency rating to determine the corresponding national scale rating. Rather, the degree of difference between the two rating scales in terms of the assigned letter-grade generally increases as one moves up the rating scale towards the strongest credit rating assigned in the country. For example, an entity carrying a global scale local currency rating of 'BBB' in a medium-risk sovereign nation may well be rated as high as 'nsAA' or even 'nsAAA' on that country's national scale, underlining not only the higher degree of default risk embedded in the national scale but, most important, the inherent quality of national scales to provide greater differentiation in credit standing, particularly at the upper end of the rating spectrum. On the other hand, the rating gap is smaller, if it exists at all, at the bottom end of the rating spectrum, pointing to the ability of national scales to provide an adequate warning of the risk of default.

Reflecting the increased scope for differentiation of credit risk, national scale ratings are more sensitive to changes in credit risk and, in turn, are likely to change more frequently and to a larger degree than global scale ratings. That is, a given change in the business or financial profile may affect an issuer's national scale rating but not its global scale rating, or alternatively may translate into a revision of both ratings but one that is more pronounced on the national scale.