The Hindu Business Line : Raters propose, markets dispose

STANDARD & Poor's, the world's biggest credit rating agency, recently downgraded India's local currency debt to `junk'— enough to make our economic reformers wail that this is our comeuppance for not being serious about the fiscal deficit and second generation reforms.

The derating came almost exactly a year after both S&P and Moody's, the other credit rating giant, changed their outlook for the country's foreign currency as well as domestic obligations from stable to negative.

Last time, the bond market dipped briefly before yields continued their downward journey. On this occasion, it did not pay even the minimum courtesy to S&P's derating. The reward for the numero uno rater was a further rise in bond prices in utter disregard of their `junk' quality.

Of course, it is not as if credit raters always have the last word: Japan has seen several downgrades from its once prime position. Yet they have hardly affected its currency or bonds. Far from plunging, as many economists and analysts expected, the yen has held its own. The worst level it has seen against the dollar in recent times is 135; it even rose to around 115 whilst the downgrades were on.

Similar is the story of Japanese bond yields. They have sprung back after 10-year yields touched 0.66 per cent some years ago. But, at less than 1.2 per cent, 10-year JGBs are by a wide margin the most expensive in the world.

Thus, there can be (and is) a wide divergence in perception between raters and the market. Equity prices leading or lagging fundamental factors is more common (than uncommon). For this to happen to bonds and currencies is, at first sight, puzzling.

There is obviously some sort of "cognitive dissonance" at work. Japan is the second largest economy in the world and has the world's largest forex reserves. Its export machine still keeps grinding away (although the share is gradually eroding from nimble and low-cost competition from South Korea). It is impossible to believe that Japan will ever default on its obligations — domestic or foreign. After all, it is next only to the US in affluence. Nor does it suffer from any of the typical problems of poor countries — inflation, weak currency, political instability, etc. In reality, Japan suffers not from inflation but deflation increasing the real value of the Government's debt. The Bank of Japan is on a monetisation spree; nevertheless, the price level refuses to move up.

Again, we may be among the poorest countries of the world but we have something in common with Japan — bulging forex reserves and low inflation. This has given the cushion to the RBI to comfortably finance the Budget deficit with no ill-effects on inflation and interest rates.

Flush with liquidity, the market is lapping up Government bonds at unprecedented low yields. It cares not a whit about the financial condition of the Union or State Governments' as S&P exhorts it should do.

Will S&P be eventually proved right? Possibly, but for the wrong reasons. Indian bond yields will back up if the US and global economies revive and foreign bond yields, which are at lows, start rising.

The environment is not congenial for a recovery and, in the meanwhile, bonds offer a safe haven. Also, there is barely any foreign ownership of Indian bonds, removing the risk of an external sell-off.

The market obviously has a point when it ignores the S&P signal.

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