S&P affirms negative outlook on India: How sovereign ratings are decided

Global ratings agency Standard & Poor's today has affirmed its BBB minus rating with a negative outlook on India, the lowest investment grade among the BRIC group of large emerging economies.

The country's large fiscal deficits and debt, as well as its lower middle-income economy, constrain the ratings, S&P said in its release on Friday. (Read story)

So how exactly does S&P or any other rating agency decide the sovereign rating? Let's try to find out the answer.

What are sovereign ratings?
A sovereign credit rating is the credit rating of a country or a national government. It's basically the evaluation of the capacity of a national government to pay its debt obligations. It also indicates the level of risk an investor is exposed to while investing in that particular country.

Parameters used for sovereign rating
Rating agencies take into account the economic risk and the political risk involved while assigning a sovereign rating. A careful analysis is done and based on the outcome a rating downgrade or upgrade is recommended.

The economic risk: This is the risk which is the measure of a nation's capacity to pay its debt obligations is the short term and the long term. While measuring the economic risk rating agencies take into account economic growth prospects, living standard, inflation rate, liquidity, income level, strength of currency and public debt burden (pensions to be paid, heath services cost, etc). Together with these factors high weightage is given to the monetary and fiscal flexibility applied by the country.

The political risk: As economic risk measures ability and capacity to repay debt, political risk is the measure of government's willingness to repay its debt obligation. This all depends on the stability of the government and the acceptance of economic policy goals. This risk is quite evident on the global trade platform and is indicated by the trust shown in the national financial system. Unlikely events like war and crisis enhance this risk. The unavailability of any legal alternative in case of default by a nation makes it even more important to analyze the political risk.

Conclusion
It's not an easy task to downgrade a nation's rating as a lot is at stake for both the parties. If the rating agency's assessment is correct, the whole financial market tailspins and if the assessment is not so correct, the future of the rating agency gets darker. But in any case as a smart investor, we should raise the red flag once such news flows into the market. It's time to be cash rich and keep away from risky investment instruments like stocks and commodities. Wait for the storm to subside and you will get a chance to purchase these assets at better prices.

InvestmentYogi.com is a leading personal finance portal.

Disclaimer: All information in this article has been provided by InvestmentYogi.com and NDTV Profit is not responsible for the accuracy and completeness of the same.