Rating agencies like Standard & Poor's (S&P), Moody's and Fitch do a detailed study of countries and companies and assign rating to them. A rating reflects the risk involved for an investor while investing in a country or company. A good rating means that the risks of default with the company and country are minimal. While a lower rating means that the risks of default (paying back principal and interest) is higher.
What does a downgrade do?
A downgrade by the leading agencies means that the risk of default, while paying back debt has increased. This means that if Indian companies want to borrow money through various instruments from aboard, the cost of the funds (through interest) increases, because the risk has increased. When the cost of funds increases, it could hamper the ability to pay back.
There could also be a flight of capital away from the country/company, as the rating gets lowered. This could also affect the currency adversely.
India's rating by S&P
India moved to the investment grade rating in 2007 and has been stable at an S&P BBB-, but this changed in April with the stable outlook changing to negative by S&P.
The agency has now said that India was likely to be downgraded to junk status. A junk status means that cost of funds for the country and the company when tapping money from aboard is going to get costlier and it could also spark a sell off in the stock markets, as the country becomes a risky investment destination.