S&P, Moody’s and Fitch are three main rating agencies that provide sovereign ratings. While each one may have different weightages for components used in arriving at the final rating, the overall process and methodology followed by most is similar. The process explained below is as followed by S&P and derived from its publicly disclosed documents. Also, most of them generally follow each other when one of them changes or revises a rating.
Mainly, there are 5 broad categories that are looked at while arriving at a rating.
1. Political – the political system, its effectiveness, stability of system, etc.
2. Economic – the system being followed (socialistic/capitalistic), long term growth prospects, etc.
3. External – the ability of the country to influence and get influenced by global economic systems, level of interaction with agencies (IMF/WB), dependence of local economic and social conditions on external factors, etc.
4. Fiscal – the fiscal situation of the country, % of public debt (foreign/local), etc.
5. Monetary – the monetary system in the country, its effectiveness, flexibility to make changes in monetary tools, etc.
Each category is given a score on scale of 1 (strongest) to 6 (weakest). (it is obvious that each category is assigned a score based on lot of qualitative aspects apart from the quantitative methods that they may have)
After that, the scores of ‘political’ and ‘economic’ categories are combined to form ‘political and economic profile’. This is generally a long term in nature and less subject to change since the political and economic systems change over decades. If there is some positive development on one of this categories, the sovereign’s rating can change significantly for the better on a sustainable basis.
The scores of remaining 3 categories – external, fiscal and monetary – are combined to form ‘flexibility and performance profile’. This is more short term in nature and can keep changing according to the current fiscal and monetary situation of the sovereign.
Now these two profiles are combined to arrive at an indicative sovereign rating on the foreign currency rating. So a sovereign which has both profiles strong would have a rating high above A whereas both weak would be below-investment grade (BB+ and below). There are
As can be seen in the table above, the ratings move downward as the profile scores become weaker.
The above rating arrived at is only an indicative rating. After this, the agency makes special qualitative adjustments to the rating called as ‘exceptional adjustment factor’. This is basically where the qualitative aspects (read political and economic ramifications of a particular rating action, influences, lobbying, etc.) are decided and is entirely up to the rating committee. The adjustments can be either positive or negative or neutral. (In short, even countries like US and other higher A rated sovereigns might be somewhere near A or AA on the indicative rating scale. However, because of their pre-eminent status in the global economic order and their ability to influence world economy through direct and indirect action, they have higher than justified ratings)
The rating arrived at after the special adjustments is foreign currency rating. The rating on domestic currency rating may be one or two notches high in order since the sovereign can influence the domestic aspects through the powers vested with it.
India’s situation at present
India currently has a rating of BBB- which indicates that it falls somewhere in the centre on each scale. The two categories that are most vulnerable to a downward rating action are the external, fiscal and political categories in that order. Considering the current scenario, the probability of a downward revision or change in outlook to negative is more than 50% if the fiscal deficit increases beyond their revised downward expectations or the political scenario worsens in case of fractured mandate after the general elections. Considering the newly introduced Food Security Bill, there are chances that rating may be downgraded after 2014. Substantial attempts to correct the fiscal situation were taken in late 2012 and in the first half of 2013. Fitch rewarded the actions and steps by revising its outlook back to Stable from Negative earlier. However, it is S&P that will be the key in future.
The most crucial factor now is the external environment. Increasing Current Account Deficit (CAD) and Trade Deficit have led to massive rupee depreciation which is preventing decline in inflation and rate cuts. It can become the biggest potential trigger for the ratings downgrade in the medium term.