US Rating Downgrade - India Perspective

I feel following is the likely impact on certain key Macroeconomic parameters of India on account of downgrade of US Long Term Credit Rating from AAA to AA+ by S&P.

Impact on Currency
As the credit rating of US been downgraded, there would be a definite impact on its currency. Considering that US has become a riskier place that it was a few days back, the US$ would no more be treated as much a safe heaven as it was treated earlier. As a result, the demand for US$ would reduce to a certain extent. This should escalate value of INR relative to US$.

Impact on Exports
As the INR appreciates, its exports become relatively seem costlier. Hence the India’s competitive advantage may be construed to be impacted negatively. However the US tax rates would undergo an upward revision, as a measure to cut the deficit by more than $2 trillion by 2013. This would increase the pressure on the US companies to reduce other costs. As a result, the US companies may resolve to outsource more to relatively cheaper destination like India. Hence India’s services exports, including IT exports, are expected to have a positive impact.

Impact on Imports (mainly crude)
Given that USD is likely to depreciate, the imports (which are mainly denominated in US$) would become cheaper and more affordable. The same would be the case with the India’s crude imports.

Impact on Inflation
Considering the fall in crude prices, the Indian government would do good if they take a decision to reduce the fuel prices. This should also help in reduction in inflation. However, considering that Indian currency is expected to appreciate relatively, there is a strong possibility of moderation in inflation.

Impact on the India’s US Treasury Holdings
India has invested $41 billion in US Treasury Bonds. Assuming all the investments made by India are in 10 year US Treasury bonds. Presently, the 10 year treasury rates are quoting at 2.7% p.a. Considering that due to the downgrade the long term treasury rates are expected to increase by 70 basis points (Source: News Item on Jul 27, 2011 at Bloomberg’s website by Michael J. Moore and John Detrixhe U.S. Downgrade May Cost $100B a Year: JPMorgan), India’s investments in US are expected to diminish in value by about $2.7 Bn. However this is a notional loss. It can’t be safely assumed that RBI wouldn’t just sell these investments. Considering the increased yields/ rates, the value of the bonds on maturity would not alter.

Further, it is worth noting that the US short term rating has not been downgraded and continues to remain at A1+, the best credit rating. Hence the impact on the short term rates/ bond prices is expected to be minimal.

Impact on equity markets and FDI
India is now relatively less riskier a place of investment that it was a few days earlier. Hence, there should technically be an increase in FII and FDI into India and shoot up the equity markets.