Rating revision and equity values: A linkage?

B. Venkatesh

STANDARD and Poor's has revised the outlook for India's sovereign rating from positive to stable.

Some contend that this triggered the free fall in equity values.

Is there a linkage between the rating revision and equity values? Since equity values are driven more by sentiment, a linkage exists if perceived. So, what is the rationale for perceiving such a linkage?

The rating revision indicates the country's economy is not in good shape. For instance, the fiscal deficit is still a problem as is the external account deficit. This means a constant pressure in the forex and the domestic credit markets. Why?

An external account deficit means the forex inflows are not enough to support the outflows. This means the demand for dollars will always be more than its supply in the forex market. Likewise, a large fiscal deficit means the Government is unable to meet its expenditure from its receipts. This means it has to borrow large sums from the domestic credit market.

So, how do these factors affect equity values? Consider the forex market. More demand than supply for dollars will lead to a fall in rupee value.

Now, a fall in the rupee affects the FIIs as converting rupee investments will fetch lesser dollars. There is, hence, a likelihood that FIIs will sell and take some money out of the country to reduce further losses when the rupee falls. And evidence suggests the equity values fall when FIIs sell.

Next, consider the domestic credit market. When the government borrows large sums, it creates a competition in the credit market, pushing up interest rates.

When rates rise, equity markets are likely to fall. Why? For one, companies' borrowing cost increases, meaning lower profits and therefore, lower equity values. For another, fixed-income investments become attractive, prompting investors to sell some stocks and move into the bond market. More supply than demand due to the selling will push down equity values.

While none of these events have yet materialised, a perception of the likelihood of their happening has, perhaps, pushed down equity values.