Page 118 - ES 2020-21_Volume-1-2 [28-01-21]

Does India’s Sovereign Credit Rating reflect its fundamentals No! 101

Box 4: Methodology for Stress Test

We conducted a stress test on forex reserves amongst countries which have partial capital account
convertibility and availability of data in India’s sovereign credit ratings cohort.
Firstly, we calculated the country-wise coefficient of variation (CoV) of month-end forex reserves
across the period February 2008 – November 2020. Secondly, we calculated the standard deviation
(SD) of forex reserves for these countries by multiplying the CoV with current foreign exchange
reserves (end-November 2020). Thirdly, we calculated forex reserves net of short term debt. Finally,
we divided the forex reserves net of short term debt by SD to arrive at a stress test estimate.

Forex Reserves Net of Short Term Debt
Stress Test estimate = (-)
Standard Deviation of Forex Reserves

Countries with more comfortable forex reserves can withstand larger negative standard deviation
shocks. Hence larger negative value of stress test estimate suggests better forex reserve position.

This stress test estimate is reported in Figure 32 for select countries in India’s sovereign credit ratings
cohort with partial capital account convertibility and where forex reserves net of short term debt is positive.

3.34 India’s sovereign foreign denominated debt is met through India’s forex reserves. Since
India has partial capital account convertibility, this implies that private foreign denominated
debt also needs to be met by either private export earnings or India’s forex reserves. Figure
32 shows a negative correlation between sovereign credit rating and the stress test (see Box 4)
amongst selected countries with partial capital account convertibility in India’s sovereign credit
ratings cohort. India is rated much lower as compared to its stress test estimate of -2.8, which is
third highest in its cohort. This implies that India’s forex reserves can withstand a negative 2.8
standard deviation shock even after meeting its short-term debt obligations, including those of
the private sector, validating its ability to pay debt obligations. Given private export earnings,
India’s large forex reserves are in fact an underestimation of its ability to repay its short-term
obligations. Yet India’s sovereign credit rating is BBB-/Baa3, failing to capture this high ability
to pay debt obligations!

Figure 32: Sovereign Credit Ratings and Stress Test

A + -3.5

A -3.0
-2.5
A -
-2.0
BBB+
-1.5
BBB
-1.0
BBB - -0.5

0.0
Peru Russia India Thailand Colombia Morocco Bulgaria Mexico Indonesia Uruguay Poland China Croatia Chile Hungary Malaysia Kazakhstan

Credit rating Stress Test, RHS
Source: Bloomberg, Datastream, World Bank and Survey Calculations