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S&P's Downgrade of US 'AAA' Rating


Investors around the world were greeted today with larger-than-usual headline news about S&P’s downgrade of the US sovereign credit rating from its gold-standard ‘AAA’ status to ‘AA+’.

Although the fundamental drivers of this decision have been in play for a while now, the S&P report does serve as a trigger to contemplate the implications for Indian business and financial markets in general.

The factors driving the decline in value of the US$ were accelerated when the QE programs were initiated by the US Federal Reserve as a response to the economic crisis of 2008.  This downgrade may further speed up the process as capital is pulled out of US Treasuries and perhaps, the US altogether.  This would result in wholesale selling of US$ and declines in its exchange rates.

Let’s think about some of the longer-term implications for India:

BUSINESS IMPLICATIONS

The implications mentioned below are likely to play out IF the US$ weakens substantially relative to the INR (as I expect) over the long run.  This would happen, assuming the RBI would not intervene to maintain US$:INR exchange rates.  If the RBI did intervene, the Indian economy is likely to face even higher inflation pressures from higher commodity prices (denominated in US$) resulting in higher interest rates, falling growth etc. – that scenario appears unlikely to happen to its fullest extent.

Exports/Imports: 

Indian companies with exports to the US will likely experience declines in INR-denominated revenues as their exports become pricier to US customers as a result of a relatively weaker US$.

On the flip side, companies importing products, services, capital goods etc. denominated in US$ will likely see a reduction in INR-denominated expenses.

Commodity prices:

Commodity prices (forming the bulk of raw material costs for most industrials) should have a net neutral impact since US$-denominated price rises would be offset by a weakened US$. 

Financing:

US financiers (Private Equity, Funds etc.) will find it more difficult to make the same financing commitments in INR.  The capital inflows, however, are likely to be stronger as a result of capital flight from the US (see ‘Market Implications’ below).

Foreign Debt (FCCBs etc.):

Debt denominated in US$ would become easier to redeem because the INR would be able to buy a lot more US$ than it can now.

Demand:

Overall demand for products/services is unlikely to be affected much since domestic demand drives a significant proportion of revenues for most Indian companies

Supply:

Supplies denominated in US$ for Indian markets will become more competitive with Indian products/services.  Although the US doesn’t produce many competitive products/services for Indian markets, this could aid other suppliers who denominate their products/services in US$.

MARKET IMPLICATIONS

Long-term:  My view is that these developments are likely to be a net positive for Indian financial markets over the long run.  All financial markets compete for global capital and the expected long-term decline in the value of US Treasuries - a very substantial avenue for global capital as a ‘safe haven’ - would be positive for other financial markets and India, having one of the highest expectable real GDP growth rates over the long run, is likely to be a direct beneficiary.

Short-term:  Nobody can really predict short-term market movements.  I would hazard a guess that there may be some initial shock.  This is not because the market didn’t know about the underlying factors (the market is a discounting mechanism) – it is because legal factors dictating the investment policies of large financial institutions (banks, insurance companies, sovereign funds, pension funds etc.) in ‘AAA’ securities may trigger capital outflows (despite exception clauses for US Treasuries).  This may also be offset by US Federal Reserve purchases of bonds – in fact, Ben Bernanke (Chairman of the US Federal Reserve) has stated his intention to continue to do this in the face of the S&P downgrade.

OVERALL

Despite the headlines and apart from the negative implications discussed above, this event shouldn’t materially alter the aggregate long-term business values of Indian companies.  This is because one of the most fundamental drivers of a significant proportion of future values of Indian companies is the long-term expectation of India’s real GDP growth, which varies between 7% and 10% (based on consensus economic estimates) over the next 10 years or so.  This expectation is unlikely to be materially dented by events currently playing out in the US.

See S&P Report here: http://www.ft.com/intl/cms/af2c4fac-bfc2-11e0-90d5-00144feabdc0.pdf
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