The Hindu Business Line : Avalanche of repercussions

Righteous indignation about the S&P rating serves little purpose when the question the action dares to ask, even if in a whisper, whether the government has a plan to provide more services or if it would be happy to manage a `surcharge economy' remains unanswered, says G. Ramachandran, looking at the effects of the downgrade.

QUITE predictably, the Government and the private sector have dismissed the lowering of India's local currency credit ratings by Standard & Poor's as `totally unjustified'. It is difficult to accept criticism related to past performance. It is also difficult to pay attention to forecasts of weaknesses that could seriously jeopardise the future. But it is normal to feel invincible and to reject views and inferences that expose the poor performances of the past. It is easy to shred to pieces any evidence of present weaknesses that could adversely affect the future.

It is not surprising that government, industry associations, banks, analysts and economists have unanimously rejected the S&P decision to lower the long-term local currency credit rating to double-B-plus from triple-B-minus and the short-term local currency credit rating to single-B from A-3. But it is most heartening that the Government and private sector have come forward to jointly `own' the economy. They would have had opposing views had S&P been a domestic institution. S&P is an international institution; its decision has been regarded as an attack by external forces.

There would have been a division if S&P had downgraded the foreign currency sovereign credit ratings. But S&P has affirmed India's double-B long-term and single-B short-term ratings. This routine affirmation has been accepted with little overt enthusiasm. If the loss of an investment-grade rating on local currency debt were a routine occurrence, India's downgrade would have been ignored with little overt concern. But a local currency ratings downgrade is indeed rare.

S&P began assigning local currency sovereign credit ratings in 1990. Only seven other countries have suffered a downgrade since then. India is the eighth. Everyone has been stung. A counterattack based on denials and obfuscation has been orchestrated: Has not the Indian economy performed better than almost all other economies in the world since 2000? Has S&P scrutinised all relevant data pertinent to inflation, currency reserves and growth? Are interest rates not low enough in India to service domestic debt? How can S&P know more about us than we do? Has S&P not failed grossly in sending out warnings about other economies in the past? Is S&P applying pressure to hasten divestment?

The downgrade does not show the country's economic management in a good light. But it cannot be denied that S&P has nothing more than its reputation at stake if it has wrongly rated India's standing. All rating institutions face the problem of mis-estimation. There is as much peril in overestimating credit standing as in underestimating it. A rating institution that frequently mis-estimates credit standing would be soon out of business. S&P is not immune to this. If S&P had been an effete force, the latest downgrade would have been ignored. The counterattack shows otherwise.

There is more at stake than reputation if rating changes were ignored. The view is that S&P has underestimated India's local currency credit standing. Countries seldom feel their credit standing has been overestimated. But the perils of feeling underestimated are significantly graver than the perils of feeling overestimated.

India is most likely to pass up an opportunity to reboot its economy even as its rivals continue to heartily retool theirs, especially their public sector. The world would not lose sleep if bruises earned in business mar S&P. A billion and more people would certainly lose sleep if India ignored the legitimate issues underlying the S&P downgrade

S&P is not ATP

S&P's ratings are dissimilar to the rankings of tennis players. Rankings given by the ATP (Association of Tennis Professionals) are based on past performances. The ATP methodology can be replicated because it is objective. The ATP model is based solely on past scores. It makes no forecasts nor does it use any forecasts of performances. ATP rankings are not predictive; they are intended to reflect past performance. ATP rankings are not challenged because the past cannot be undone.

By contrast, ratings by ratings institutions involve the usage of input variables related to past performance and to forecasts of future performance.

Ratings involve the future and are intended to be predictive. They are intended to be indicators of prospective performance of economies and companies. This is their principal purpose, but ratings can fail to indicate prospective performance. There can be genuine disagreement over the forecasts used in the models; the models can be challenged too because they use forecasts.

The past cannot be altered and if the new S&P ratings are `totally unjustified', they could be so for two reasons: Flawed models and mis-estimated variables. The Government and the private sector could have either challenged the local currency credit rating models, or offered their view of the future values of the input variables used in the models. They have done neither.

To be sure, S&P could have grossly mis-estimated our economic future when determining that `continued large fiscal deficits, along with a languid pace of economic reform, would lead to a further rating downgrade'.

The likelihood of a further downgrade has enraged everyone, but few know if S&P has mis-estimated. To know if it has mis-estimated, we need our own models and estimates. All that we have are past data.

Shaky past, shaky future?

The past data are not too heartening. Past decisions and discussions pertinent to fiscal management show that the economy has merely a small magnitude of financial resilience. Skirmishes with infiltrators in 1999, rescue and rehabilitation of earthquake victims in 2001 and relief efforts to soften the blow of the 2002 drought have somehow involved the imposition of tax surcharges or at least their discussion.

For a nation with long land and sea boundaries, the defence of its borders should be a routine affair. For a nation with a large geographic spread, earthquakes, floods, droughts and avalanches should be normal occurrences. The fact that major events at the border and inside the nation have to be funded through surcharges does not show the nation in a good light. India has a tattered safety net, and its fiscal and physical governance provide little room for repairing the safety net in the near future.

Since all taxes on a net-net basis are paid by the private sector, the resilience of the economy is wholly predicated on the ability of the private sector to pay taxes and to bear surcharges.

The private sector is the net-net source of more than 97 per cent of savings and taxes that support investments in public infrastructure and the public sector's services. But the private sector is dependent on the public sector, that is, the government sector, to reboot itself from time to time and to be profitable enough to pay taxes and surcharges.

The public sector includes the village administration offices, government schools and hospitals, railways, water resources, district officials and the police, regulators, courts of law, and the armed forces.

The list is not exhaustive but it also includes Air India, Indian Oil and other public sector units (PSUs). The scope and relevance of the public sector is enormous and PSUs constitute a very small part of the public sector. Hence, the obfuscation of the issue by making a reference to PSUs and disinvestment is unwarranted.

Moreover, the lifetime real option value of PSU disinvestment is less than Rs 18,000 crore (Business Line, March 9, 2001). The real public sector is the government, and it determines the vitality of businesses and households.

If the private sector cannot be profitable, the public sector would not have the fiscal resilience to defend the borders, provide relief to citizens when necessary and invest in infrastructure that could make the private sector profitable. There is indeed a chicken-and-egg problem here. The question then is what the public sector has done in the past to boost the profitability of the private sector and what plans it has for the future.

Total costs, total services

The public sector has done little in the last decade to make such investments that contribute to the vitality of the private sector. A large part of its revenues has been applied towards the payment of interest on borrowings and towards paying for the fixed costs of maintaining government.

The government has yet to explain what its future spending as a portion of the total economy would be, and how such spending would boost the profitability of the private sector and, thereby, total revenues.

The government has yet to explain why some taxes and costs continue to be high while related services have been privatised wherein users pay fees for the usage of services. Are some government services being paid for twice? Are some costs being borne by the private sector where there are no services? Would these not destroy the private sector and the public sector in the long run?

The real issues that underlie the downgrade go beyond PSUs and interest rates. They pertain to costs and how the costs incurred by the aggregate public sector have an impact on the vitality of the private sector.

Since the private sector is the sole source of revenues and profits to the public sector, the interests of the economy and the government would be served better if the government could better serve the economy at a lower cost. This is the fundamental issue, and its relevance is a constant at any interest rate.

The government can provide high quality services to the total economy even if interest rates are over 25 per cent. It can fail to provide any services to the total economy even if interest rates fall below 5 per cent. The recent S&P downgrade dares to ask, even if in a whisper, if the government has a plan to provide more services or if it would be happy to manage a `surcharge economy'.

(The author is a financial analyst. Feedback may be sent to indiagrow@sify.com)

Send this article to Friends by E-Mail
Comment on this article to BLFeedback@thehindu.co.in

Stories in this Section
Still in the pipeline

Earth Summit stymies UN

Make India a hard state

Avalanche of repercussions

Is micro-credit a macro trap?

Good governance and independent directors

FDI conundrum

B-school teaching