Tuesday, January 8, 2013

Forcing policy changes by threat

Fitch Ratings , the international rating agency has reiterated its negative outlook for India and has warned of a downgrade. The agency complains that structural reform process is sluggish. This is the era of policy making by threat. The agency is concerned over
a)India's economic and fiscal outlook
b)Sharp slowdown in growth
c)persistent inflationary pressures
d)weaker public finances.

Probably these are concerns, but should the government choose to cut back spending to ensure that the fiscal deficit is contained, it will impact the already fragile recovery , and should the central bank increase rates to cut out inflation, it will affect growth. Less taxes may help growth, but will increase the deficit. Cut rates to spur growth and you have the threat of inflation picking up again. Look anywhich way, the Goverment cannot really do much. And this is after the spate of 'actions' taken by the Government.The fact is that we will need to live with this situation till global growth rates pick up. What the agencies would desire is a cut in subsidies (which is only huge in absolute amounts - in relative terms it is not really as big a problem as it is potrayed to be), lowering of taxes and a cut in rates. They forget that this country has a population of 1.2 billion and all that we have been taking in terms of growth has not been very inclusive. NSSO data clearly shows that the growth has not resulted in increased employment - it is a jobless growth.These policy prescriptions by Fitch or S&P will only aggrevate the problem. Running a country is not like running a company. And that is where the problem is.

Ratings are statements of opinions and the track record of thees agencies in rating corporate bonds is decent. What is questionable is their ability to rate other issues (their track record in rating mortgage backed securities is disastrous) and sovereigns. Sovereign debt rating is almost entirely unsolicited and the ratings and policy prescriptions of the three big agencies Fitch Ratings, S&P and Moodys has played a major role in accentuating the EU crisis, forcing governments to consider placing curbs on the timings of release of such un-solicited ratings and curbing ownerships. There is nothing to prove that these agencies have been successful in predicting crises.

What happens is that rating changes affects the ownership pattern of sovereign bonds - as most institutions. Because most institutions have allocations for bond holdings based on the ratings of the bonds, when a downgrade happens, it results in a huge sell off.... well that is what is supposed to happen in theory. But when US had its AAA ratings stripped, its bonds rallied ! Bloomberg reports that 'Predicting the consequences of a rating change by S&P or Moody’s may be little better than flipping a coin, with yields moving in the opposite direction than suggested 47 percent of the time, according to data compiled by Bloomberg in June on 314 upgrades, downgrades and outlook changes going back to 1974'....

So should the Government worry ? Reforms are required. But we should make haste slowly. Policy should not be made under threat.

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