India’s 4-year journey till rating upgrade commendable

Rating upgrade will have beneficial impact on India Inc's borrowing

After over a decade, Moody’s has upgraded India’s sovereign rating by one notch to Baa2 from Baa3. The rating upgrade comes on the back of continued progress in the nation’s economic and institutional reforms.

Moody’s also changed the outlook on the rating to stable from positive. A series of reforms such as the new monetary policy framework, Goods and Services Tax (GST), measures to check the banking sector’s bad loans ratios, demonetization, the widely debated Aadhaar biometric system, and the Direct Benefit Transfer system were the key drivers of this rating upgrade.

Well-deserved upgrade

No country was insulated from the global financial crisis and in the advent of this crisis, India loosened its purse strings so as to tide over the adverse impact; adopting an expansionary fiscal policy.

However, these measures came with their own set of consequences; putting India on an inflationary path. In addition to this, significantly higher commodity prices (oil), higher gold imports and appalling growth in exports deteriorated the external balance as well.

All these factors put India in the fragile-5 economies in 2013, a period well known as the ‘taper-tantrum’ period. The weak macroeconomic fundamentals made India vulnerable to external shocks. Nevertheless, the bold (to some extent unconventional) measures taken by the RBI (in 2013) to reduce India’s vulnerability to such shocks and also the government’s efforts to adhere to fiscal consolidation helped stabilize the economy by 2014. The absolute win on the political front in combination with positively evolving macroeconomic landscape brought about a change in India’s rating “outlook” in 2014 but not a rating upgrade (until now!). India’s macroeconomic fundamentals have changed considerably over the last four years and have turned (& remained) favorable.

Plus, the government has announced a string of measures/reforms which would have a positive impact on India’s economic growth in the long-term! In our view, the journey that India has travelled over these last four years is simply commendable and it was about time that a rating upgrade was awarded.

Bond Market Reaction & Our View

While a rating upgrade has been overdue, the timing of this upgrade was clearly a positive surprise. In fact, at a time when bond markets have been in a downward spiral and sentiments have remained sour, the upgrade has provided a positive tilt to the markets. At the opening itself, the 10Y benchmark opened well in the green, rallying by ~10bps.

While this update has provided a positive bias, the momentum might not sustain as overhangs such as elevated crude oil prices, oversupply (G-sec, SDLs, OMO Sales), fiscal slippage concerns, inflation trajectory and increased possibility of a status-quo on domestic policy rates might force yields to stay firm.

At the same time, the hardening of US yields in the run-up to a third rate hike in December is further exerting upward pressure on domestic yields. We note that, not only is India facing an upward pressure on yields, but also other EMs have seen yields on their sovereigns tread higher; however, the extent of weakness varies across EMs. India, in particular, is likely to see a cap on further slippage following the upgrade.

While India is not immune to external shocks, the FPI limit framework for investing in G-secs and corporate bonds has limited the impact of external shocks on yields. Thus, domestic factors have played a greater role in influencing the yield trajectory, lately.

Interestingly, the spreads on corporate bonds have actually witnessed some compression and today on this development corporate bonds have seen a similar positive momentum and traded at much softer levels.

The bond markets have given thumbs-up to the move despite the above mentioned overhangs. In the short-term, yields should trade around these levels and participants will track the MPC commentary around inflation and more importantly, the fiscal situation.

It would be interesting to see if the domestic rating agencies follow suit and upgrade companies in the ensuing months, particularly PSU banks in the backdrop of recap bonds. Meanwhile, Moody’s has also upped the ratings of Exim Bank, Indian Railway Finance Corp, SBI and HDFC Bank.

Nevertheless, a rating upgrade is more than symbolic even as investors have remained upbeat on India for a long time (even when it was at Baa3) as was evident in the robust capital inflows! Recently, China was downgraded by Moody’s (Sep’17), South Africa was downgraded by Moody’s (Jun’17), Brazil’s outlook was revised to negative from stable – all of this suggests that India would definitely stand to gain from this development as it bolsters investor sentiment and allows investors to invest (or add to portfolio) in Indian local currency bonds.

In fact, once some of the overhangs are behind us or even recede, the negative bias that has pushed yield on the 10Y north of 7.0% (from the levels of 6.50% seen around 3M ago), yields should recover to lower levels. The upgrade will also have a beneficial impact on corporate India’s borrowing, both onshore and offshore, as corporate will find it easier to borrow via the bond markets and diversify their investor base.

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