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BW Businessworld

A Sensational Plunge

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On the night of Friday the 5th of August, after the markets had closed, Standard and Poor's downgraded US debt from AAA to AA+. The US government had earned AAA grade in 1917, towards the end of World War I, and held it since then. The downgrade did not come without a warning. On 18 April, S&P changed the outlook on US debt from neutral to negative, meaning that the US budget outlook was worsening, and might require a downgrade of its debt. In August, it estimated that the debt-GDP ratio would rise from 74 per cent in 2011 to 79 per cent in 2015 and 85 per cent in 2021; that was enough to justify the downgrade.

S&P has made a business of credit rating; it rates thousands of firms, and sells the ratings chiefly to firms that want to do business with the rated firms. Rating governments is a small part of S&P's business. Some governments pay to be rated; S&P rates others without being solicited. Amongst those given an AAA rating without asking for one are France, Germany, Switzerland and the Netherlands. Amongst those who asked for one and got an AAA are Finland, Austria and Sweden.

China asked and paid for its AA- rating. India got one without asking for it. Its rating is BBB- for domestic and foreign sovereign debt, but BBB+ for transfer and convertibility; in other words, the chances of India reneging on payments to foreign traders and investors are less than of its reneging on its debt. Bangladesh's rating is BB. Greece's is CC, except for transfer and convertibility; presumably S&P believes that the European central bank will help Greece avoid default on private payments, since failure to do so would put the whole of European Union in jeopardy. Actually, so would sovereign default in Greece, but it would have looked ridiculous if S&P had continued to rate Greece to be as good as Bangladesh. But Greece is the only country to earn a C from S&P; the worst one can do in its eyes is B-.

Since S&P is so parsimonious in its use of Cs, it has only As and Bs to play around with. It stretches out its options by doubling and trebling the letters and using + and -; it thus has about 11 grades to play about with. It is not very generous with B- either. The countries that earned this grade are Belize, Granada, Equador, Jamaica and Pakistan. Just six of some 125 thus earned the bottom two grades. Does it mean that S&P is generous? It gave straight As to 46 countries, and mixed As to a few more. So it would look as if it was generous with As. But it might argue that the countries deserved As: that their economic management and circumstances justified the grades. Those who do not have so much trust in countries' economic policies can believe instead that these are good times which have lifted up so many countries; but that would be difficult to argue at a time when the global economy is going through such tough times.

However, it is important to remember that S&P is not in the business of grading countries for pleasure; it does so to sell the grades to businesses that want to trade with and invest in those countries. If one reads S&P's methodology, it sounds like hifalutin mumbojumbo. But its grades are an index of countries' creditworthiness. So a company that wants to invest in, say, Andorra, would take the interest rate at which it can borrow in its home country, add a premium based on the country's S&P rating, and add another premium based on the creditworthiness of the borrower to get the rate at which it should lend.

Indians may find it incomprehensible that their country, sitting on $300 billion of exchange reserves, should get the lowest investment grade, just above the highest speculative grade, and below Ireland and Spain, Europe's sick countries. S&P is explicit about why it grades India so low — it ticks off a list of maladies such as inflation, fiscal indiscipline and subsidies. The Prime Minister may consider these trivial, but S&P takes them seriously; the grades are its own, and it has the right to make up its own mind, however wrongly.

But India's sovereign rating affects the ratings of Indian companies; once they go global, this matters to them. That is one reason why so many of them are investing and setting up affiliates abroad; by establishing their presence in Canada or England, they get the benefit of those countries' sovereign rating. We common Indians have to live with our government; companies can leave it behind once they grow big enough. They go abroad and create jobs — jobs which would have been ours if our government had been more disciplined.

(This story was published in Businessworld Issue Dated 05-09-2011)