DISEQUILIBRIUM: Goosey, goosey gander

Men of conscience don’t take stands which are suspect. The decisions then need to stand the test of a microscopic examination for virus and other anti bodies have to be taken with great circumspection and utmost comprehension. Above all, the decision should be able to withstand the test of public scrutiny. For one doesn’t take a blunt knife to surgery, you need a scalpel for precise cuts. In late October, S&P most unexpectedly upgraded Italy’s rating one notch, citing the country’s firming economic recovery on the back of rising private-sector investment and employment. The premier ratings agency stated that it was raising Italy’s sovereign credit rating from BBB- to BBB, with a stable outlook. Factors supporting the upgrade included improving economic prospects, expansionary monetary policy, reduced risks from its banking sector and expectations that the government would be able to make progress in reducing its “very high” government debt-to-GDP ratio. S&P analysts noted: “The stable outlook balances the potential for more-robust economic growth and further improvements in the monetary transmission mechanism over the next two years, against persistent political uncertainties and their potentially adverse implications for economic and budgetary credit measures.”

The sovereign rating for Italy to BBB was the first such increase by S&P for at least three decades. Italy’s GDP forecast for next year is 0.8 per cent and is expected to record 1.0 per cent growth this year. In its statement, S & P said, “In this context, the upgrade also reflects subsiding risks in the banking sector for the economic outlook, and expected further budgetary consolidation over our forecast horizon.” In what is eerily reminiscent of India, Italy’s banks have been ravaged by a prolonged economic downturn, leaving the sector groaning under hundreds of billions of euros of bad loans. The government had to intervene to save a number of lenders, while other banks looked to shift risky assets off their balance sheets. Smacking of deja vu.

Fade to black.

On Friday, the same S&P refused to improve India's rating to BBB, worried as it is about India’s debt. Italy, meanwhile seems to have got preferential treatment for its rating is one notch higher than India’s despite the European country’s ballooning debt. Italy has almost twice as much as India’s debt to GDP at 131.6 per cent against ours at 69 per cent (the public debt, the highest in the euro zone after Greece‘s, was targeted to fall slightly to 130 per cent of GDP next year from a targeted 131.6 per cent this year.) Moreover, Italy has a much smaller economy and extremely poor demographics, including a declining population and 40 per cent youth unemployment. Italy’s five year Credit Default Swaps is 117 vs 200 four years ago, though it hit 200 again earlier this year while India's is 72.5 vs 250 four years ago.

Theatre of the absurd. For the uninitiated, Credit Default Swaps (CDS) allow sellers to take on, or buyers to reduce, the default risk on a bond. At its most basic, the pricing of CDS measures how much a buyer needs to pay to purchase, and how much a seller demands to sell, protection against default of an issuer’s debt. CDS spreads, therefore, are one way the market rates creditworthiness. Widening spreads suggest increasing risk. S&P has relentlessly downgraded the euro zone’s third largest economy since 1988, when the credit rating stood at AA+. The BBB- rating, just one notch above junk status, had been in place since December 5, 2014. Both Moody’s and Fitch upgraded Italy’s rating in 2002, only to have to subsequently lower it later. Moody’s confirmed its Baa2 rating for Italy earlier this year, while Fitch cut the country’s rating to BBB from BBB+ in April.

Logic then says that what’s sauce for the goose is sauce for the gander. If S&P upgraded Italy despite these risks, then it should have done the same for India. After all, Italy is the world’s ninth biggest economy. Its economic structure relies mainly on services and manufacturing. Italy suffers from acute political instability, economic stagnation and lack of structural reforms. Prior to the 2008 financial crisis, the country was already idling in low gear. In fact, Italy grew an average of 1.2 per cent between 2001 and 2007. The global crisis had a deteriorating effect on the already fragile Italian economy. In 2009, the economy suffered a hefty 5.5 per cent contraction — the strongest GDP drop in decades. Since then, Italy has shown no clear trend of recovery. In fact, in 2012 and 2013 the economy recorded contractions of 2.4 per cent and 1.8 per cent respectively.

Considered part of the derogatory — PIGS — Portugal, Italy, Iceland, Greece and Spain, Italy is an errant bad boy of Europe, known for lousy public finances. The unemployment rate has increased constantly in the last seven years. In 2013, it reached 12.5 per cent, which is the highest level on record. The stubbornly high unemployment rate highlights the weaknesses of the Italian labor market and growing global competition. Another challenge is presented by the difficult status of the country’s public finances. In 2013, Italy was the second biggest debtor in the euro zone and the fifth largest worldwide. 

 Last week at an interface with editors convened by the finance minister Arun Jaitley who brought along three of his principal trouble shooters — Finance Secretary Hasmukh Adhia, DEA Secretary Subhash Garg and Chief Economic Adviser Arvind Subramanian — volubly argued the point that the rating agencies practice a peculiar insularity with a deep sense of bias against developing countries. Moody’s during its recent upgrade highlighted the fact that vulnerabilites were reduced since foreign ownership of Indian debt was just 4 per cent. Tough and systemic bias against developing nations like India stood out as the comment of the day for me and the recent S&P announcement mirrored this theme. The reasons given for status quo — rating agency S&P, reaffirmed (unlike Moody’s) India’s rating at BBB-, with a stable outlook due to concerns on a) significantly high fiscal deficit and government debt levels and b) low per capita income; overpowering the a) implementation of strong reforms and b) relatively high GDP growth. And how does Italy do on these parameters, I rest my case.

In any case, it was a cosmic happenstance that both Moody’s and S&P came to review India’s sovereign rating within days of one another. I have empirically proved that this bias that finance ministry mandarins have spoken about is right on the money. CEA Subramanian has been constantly railing against the lack of recognition for India’s structural reforms efforts, particularly those in the immediate past, but to no avail. In May this year, he averred strongly during a lecture in Bangalore, “In recent years, rating agencies have maintained India’s BBB- rating, notwithstanding clear improvements in our economic fundamentals (such as inflation, growth, and current account performance). At the same time, China’s rating has actually been upgraded to AA-, even though its fundamentals have deteriorated.” Subramanian, a former economist at the International Monetary Fund (IMF), had also said the ratings firms’ methodology is “one of the most egregious examples of compromised analysis.”

There is no consistency in ratings though there is a pattern in the prejudice. In September for instance, S&P Global Ratings cut China’s long-term sovereign credit ratings by one notch to ‘A+’ from ‘AA-’ saying its prolonged period of strong credit growth has increased its economic and financial risks. Partisanship is visible in the latest S&P ratings for India where a much warranted upgrade was not given. India has survived brutal catechism in recent times and while PM Modi may not have undertaken deep seated reform till say six months back, the one thing he has provided is stability and change in mindset. From untangling the knots left behind by the decadal loss of UPA to finally moving with alacrity to fix economic pain points, India is once again gathering consumption momentum after the twin setbacks of DeMO and GST in rapid succession. India found itself deep in the middle of an alphabet soup This too needs to be appreciated by these agencies. Actually last November itself, S&P shut the door in our face when it failed to give the upgrade,  ruling out an upgrade for India over the next two years even as it affirmed the stable outlook on the country’s ‘BBB-’ long-term and ‘A-3’ short-term sovereign credit ratings. “The outlook indicates that we do not expect to change our rating on India this year or next, based on our current set of forecasts,” S&P said in a statement laying down the conditions for a ratings upgrade. Clearly, there is a disconnect between what the investors are saying and what the ratings are saying.

Reminded of an old nursery rhyme — Goosey Goosey Gander, Wither Dost thou Wander S&P?

Sandeep Bamzai