As India faces the prospect of being the first BRICS country to lose its investment-grade credit rating, investors have already delivered their verdict: to them, the country already trades at "junk", which should temper any ensuing market reaction.
Credit default swaps suggest India is already a bigger investment risk than emerging markets such as Vietnam and more than double the risk of fellow BRICS Brazil, Russia, China, and South Africa.
Overseas portfolio investors have also been conditioned to low expectations for a government that has long disappointed on fiscal reforms - the key factor in whether or not India averts a ratings downgrade.
Given its sizeable foreign exchange reserves and low overseas debt, a ratings downgrade would not trigger financial turmoil. Still, it would be humbling for a country with big aspirations to sit at the top table of emerging economies.
"I am not going to sell my positions, as India is going to get downgraded. I do not treat or regard India as an investment-grade country," said Kenneth Akintewe, who helps manage around $7 billion in Asian fixed-income assets at Aberdeen Asset Management.
"The rating agencies have tended to move behind the markets, and markets have priced in that eventuality long before the rating agencies do anything," he said.
Standard & Poor's was the first credit agency to cut India's sovereign outlook to negative in April, followed by Fitch Ratings in June. Both have India at BBB-minus, the lowest investment-grade rating.
Citing a fickle government that lacks the strength to push through fiscal reform, S&P put the odds of a downgrade within two years at one-in-three. Fitch said the risk of a ratings cut was greater than 50 percent in 12 months to 24 months.
The key concern is the fiscal deficit, which overshot a target of 4.6 percent of GDP by 1.2 percentage points in 2011/12 and is expected to swell to 6 percent of GDP in the current year to March 2013.
A drought due to a disappointing monsoon season will push the government to spend more on relief for farmers. Rural demand for cheap fuel to drive irrigation pumps and tractors is further delaying a promised increase in subsidised diesel prices, which the government concedes is vital to fixing the deficit.
S&P's warning caught government officials and domestic investors flat-footed, although CDS markets were already pricing India at junk levels.
The cost of protection against default for State Bank of India, widely considered a proxy for the sovereign because the country has never sold overseas debt, was already trading above 300 basis points when S&P issued its warning.
The S&P warning sent SBI's five-year CDS above 380 basis points by late May. It later came down, in what could be a preview of the reaction to expect if India gets downgraded.
At around 320 bps, SBI's five-year CDS is factoring in a much greater risk premium than junk-rated countries such as the Philippines and Vietnam, though that also partly reflects concerns about bad debt on SBI's balance sheet.
The CDS is almost twice as expensive as Indonesia's five-year equivalent, eventhough Moody's and Fitch rate the Southeast Asian country at investment grade.
Buying into India
Typically, a country can take a big hit when its sovereign rating is cut to junk as investment houses with mandates barring them from higher-risk investment withdraw their capital.
However, in India, foreign investment penetration is low.
Foreign investors own only about $20 billion of the country's roughly $500 billion bonds outstanding -- or in line with government caps.
And despite the prospect of a ratings downgrade, foreign investors have continued to build positions since the S&P and Fitch statements. They bought a net $1.7 billion in government debt between May and so far in August, bringing their total net purchases for the year to $4.8 billion.
In stocks, foreign investors have reversed course since the beginning of July, buying a net $2.8 billion to bring their year-to-date buying to $10.3 billion.
Nor have foreign investors stopped buying into Indian overseas debt, as a string of state-owned banks including SBI and Indian Overseas Bank have shown.
These lenders are backed by India's guarantee and thus would be directly affected by a sovereign ratings downgrade, yet they have attracted strong demand for their dollar bonds - albeit at premiums of nearly 400 bps over U.S. Treasuries.
No big deal
Ratings agencies acknowledge certain strengths that mitigate against a downgrade.
India has low external debts, including private-sector debt, and its $289 billion in foreign exchange reserves is enough to cover all of the country's debt maturing over the next 12 months.
At 16 percent of GDP, Moody's Investors Services says India's total private-sector external debt is "relatively low".
"Individual firms' foreign debt repayment troubles are unlikely to lead to the sort of domestic demand collapse or deleveraging seen in countries with more significant private-sector external leverage," Moody's said in June, when sticking with a stable outlook on India's rating.
That is not to say India would escape unscathed if it was downgraded to the junk status it held until Moody's first upgraded the country in 2004.
Some selling is inevitable if India's credit rating is downgraded, partly reversing the foreign inflows this year and pressuring a current account deficit already at a record 4.5 percent of GDP.
Indian firms holding short-term debt, which has risen to half of foreign exchange reserves in 2011/12 from 42.3 percent in 2010/11, would likely face redemption pressures.
A downgrade would also have a reputational impact on the beleaguered government ahead of general elections in 2014.
But a downgrade, should it come, is unlikely to spark a sustained selloff.
"Normally these rating moves will not make much of a difference," said Andrew Kenningham, an economist for Capital Economics in London.
"These rating agencies will highlight what is happening and reflect what the market mood is anyway and so do not really provide any new insight about the fundamentals."