On Tuesday, global credit rating agency Moody’s Investors Service downgraded the State Bank of India (SBI), India’s largest bank. SBI’s financial strength rating was lowered from C- to D+. The hybrid debt rating (for instruments combining elements of debt and equity) was also downgraded. “The rating action considers SBI’s capital situation and deteriorating asset quality,” stated Beatrice Woo, a Moody’s vice-president and senior credit officer, in a press release. “Our expectations that non-performing assets (NPAs) are likely to continue rising in the near term — due to higher interest rates and a slower economy — have caused us to adopt a negative view on SBI’s creditworthiness.”

When the global economic slowdown landed on India’s shores three years ago, exporters were affected. IT companies felt the pinch, but the banking system was well insulated. The Reserve Bank of India (RBI) saw ring-fencing the banks as its principal mandate. According to some, it would sacrifice the economy rather than the banks. In hindsight, it was the right thing to do.

This time, the RBI has been the sole defender of the economy. Inflation has been galloping. India’s food inflation, which had started going down in August, has started accelerating again. Under normal circumstances, the government and the RBI would have tackled this together. But Delhi is too busy trying to ride out the political storm to take any effective action. The government is under attack for a series of scams, particularly in the telecom arena. The minister concerned is in jail. An anti-corruption crusader has forced the government to give in to his demands for a LokPal (citizens’ ombudsman) bill. And senior Cabinet ministers have started quarrelling among themselves in public. In the process, reforms have been relegated to the backburner. Disinvestment of public sector units has been put off. And the government has made things worse by announcing that it will borrow $10 billion more than the budgeted figure.

The RBI has had only one solution to control inflation – to increase interest rates. It has done that 12 times in a row. But it doesn’t seem to have helped. Even so, RBI governor D. Subbarao says that he will continue raising rates.

The immediate impact is on industry, which is finding funds too expensive. As a result, asset formation has plunged. Today, even the government admits that the country will not be able to reach an 8% GDP growth rate.

The other big problem is that with higher interest rates, companies – particularly small and medium enterprises — and individuals are finding it difficult to repay loan installments. This adds to the bad loans or non-performing assets of lenders. This is exactly what Moody’s has cited as the reason for the SBI downgrade. “On the asset quality front, the bank’s NPAs, as of 30 June 2011, reached a three-year high of 3.52% of loans and $5.6 billion on an absolute basis,” said Woo. “For the system, the ratio was 2.3% as of 31 March 2011.” One should remember, however, that the NPAs looked under control until the first quarter of this financial year (in India, April-March) when a new chairman took over at SBI. He made provisions across the board – some of which could have been phased out – and profit after tax fell 99% compared to the corresponding period of the previous year. The problem in creating a clean slate (to build your performance on) is that others will read a more serious message in it.

In the middle of August, equity research house Enam Securities was saying very good things about SBI. “Impressive margin improvement and management’s confidence are key positives,” read an Enam research report. Following Moody’s downgrade, the share collapsed more than 6.5% to reach its lowest level in two years. “Moody’s downgrade punctures investor sentiment,” says HDFC Securities. The worry now is that RBI can sacrifice the banking system (and industrial growth) to control the economy. But the economy (essentially inflation) is in no mood to obey its dictates. King Canute of lore had an easier job in trying to control the tides.