The US Debt Downgrade and Its Impact-VRK100-15Aug2011

The US Debt Downgrade and Its Impact

Rama Krishna Vadlamudi, Hyderabad               August 15, 2011

Since the beginning of August 2011, financial markets around the world have been very volatile due to surfeit of fears and uncertainties. The biggest event that has impacted the markets is the Standard & Poor’s downgrade of the United States’ Government debt from AAA to AA+ on August 5th. However, the other two rating agencies, Fitch and Moody’s have retained the AAA rating for the US on August 2nd. In reaction to the S&P’s downgrade, equity markets and commodity markets have fallen heavily with increased volatility. However, gold price has surged by around five per cent as it is considered as a safe haven asset amidst debasement of paper currencies by several countries.

After the demise of the Soviet Union in 1991, the US had become the most powerful nation in the world. It has lost the superpower status politically after some serious blunders in Iran, Iraq, the Middle East and Afghanistan. Now, with mounting debt problems and credit rating downgrade, the US has been losing its predominance in the world economy also. One thing is sure: the US economy is on a decline and the repercussions will be felt across the world.

Here is an analysis of the issues behind the downgrade and its impact on markets:

Why has S&P downgraded the US credit rating?

After closing of market hours on 5 August 2011, S&P had downgraded the US long term sovereign rating from AAA to AA+. The reason cited by the credit rating agency for the downgrade is that the debt deal brokered by US lawmakers is not sufficient and expressed its doubts about the ability of US lawmakers to bring down the US debt level. S&P is concerned that US political parties are not working in tandem when it comes to fixing the US economy and bringing about fiscal consolidation. It’s first time in 70 years that any rating agency has downgraded US’ AAA-rating. The downgrade has not come as a total surprise. In April this year, Standard & Poor’s had first cautioned that there was a possibility of US downgrade if the US lawmakers did not agree for a deal over raising the statutory US debt level and bringing down the debt over long term.

What is the difference between AAA and AA+ rating?

According to the standard definition of S&P:

AAA : Extremely strong capacity to meet financial commitments. (Highest Rating)

AA+ : Very strong capacity to meet financial commitments (just below AAA)

As can be seen from above, AAA is the highest rating and AA+ is just below AAA. And still AA+ rating is considered as one of the best credit ratings in the financial world. Other countries that are having AA+ rating are Belgium and New Zealand, as per S&P.

What is the US debt deal?

The US Congress had on August 2nd approved a plan to raise the US debt level from the current USD 14.3 trillion in the short turn while bringing down the overall deficit by USD 2.4 trillion over the next 10 years. S&P is of the opinion that this USD 2.4-trillion debt reduction is not sufficient and it prefers a USD 4-trillion deficit reduction instead.

What are reasons for the high level of US Government debt?

The United States of America has been living beyond its means – meaning the country has been spending more than its earnings – for more than a decade. At the end of president Bill Clinton’s term, the US has enjoyed huge budget surpluses. But after George Bush took over as president in 2001, the US economy has been hurtling toward one disaster after another. Economists and market pundits have been warning the US about its debt burden for almost a decade. Due to the excessive spending, the US Government debt has mounted to a record USD 14.3 billion in May this year.

How is the US Government funding its fiscal deficit?

As the budget expenditure exceeds its revenues, the US Government every year raises huge money by selling its Treasury Securities and funds the fiscal deficit. The bonds are bought by various foreign governments that are having huge export surpluses. Some of the biggest holders of the US debt are: (in USD billion) China - 1,160; Japan – 910; the UK – 350; Brazil – 210; and Taiwan – 150. India holds USD 41 billion in US treasuries. Other investors in the US government debt are banks, pension funds, sovereign wealth funds and individual investors.

Will investors sell US treasuries now?

A substantial portion of the US debt is held by central banks around the world. They may not sell their holding of US treasuries as they do not have any worthwhile alternative investments to buy at this point of time. Large holders of US debt, like, China, Japan and the UK may hold US treasuries grudgingly for the time being unless a credible alternative to US dollar emerges, which is a remote possibility as of now. Of course, investors have been moving to the Swiss Franc and the Japanese Yen for some time now. The euro is having its own problems. The dollar is relatively stable against major currencies till now.

What is the importance of US treasuries?

--- Till the S&P downgrade, the US treasuries are considered as benchmark securities for various classes of assets across the world.

--- It is a practice in the financial world to benchmark several securities against the US treasuries.

--- Every country will have its own risk-free interest rate. However, the US treasuries are treated as risk-free across the world.

--- With the downgrade, the US treasuries have lost some of their sheen and this will create problems for asset valuation models.

Why are the US economy and dollar so important to the world economy?

--- Till the S&P downgrade, the US dollar was considered as safe to hold it for long term

--- For several decades, the US debt has attracted investors due to the US’ stable growth

--- Much of the world trade in merchandise exports and services is done in dollar

--- The US dollar has become a reserve currency for the world

--- The reserve currency status has become questionable now

--- The US has 43 per cent weight in the MSCI Index, an index of global stocks

--- About one-fourth of the world’s GDP comes from the US

--- About 20 per cent of the oil is consumed by the US

--- Much of the world’s wealth is concentrated in the US

What steps should the US Government take to bring down its huge debt burden?

The following steps will help the US to cut down its debt levels:

--- The US Government should raise taxes without hurting the poor

--- The US Government should cut its wasteful expenditure, like, defence and others.

--- The Government should stimulate the economy through various measures

How does the downgrade impact US economy?

Theoretically speaking, if a country’s debt rating is downgraded the country’s interest burden will increase as the cost of raising money goes up. As such, US Government bond prices should come down and yields should go up. The US companies will have to pay higher interest rates when they raise money abroad for their needs. But it reality, this has not happened. After the downgrade, the benchmark 10-year US Government Treasury yield decreased by 20 basis points – meaning bond prices went up. This aberration is due to the fact that investors selling equities and commodities have moved the money to US Government debt causing the US bond prices to go up. However, in the medium to long term, the downgrade will hamper the ability of the US Government to sell its bonds to investors. Fund houses, like, PIMCO, have completely offloaded their US treasuries in March itself. Already the US economy is slowing down and the downgrade may further put pressure on the US growth. Overall, the downgrade is negative for the US.

What is the reaction of the US Government to the downgrade?

The US Government has said that the S&P’s analysis was hasty. It further said that S&P has made a USD 2-trillion error in its calculations. President Obama has thundered, “…the US still enjoys AAA rating!” The US Federal Reserve has said that it would keep the US interest rates at the historic low level of 0 to 0.25 per cent till the middle of 2013. The US Fed’s announcement had temporarily brought some relief to the markets.

How have the investors and marketmen reacted to the downgrade?

Several economists and marketmen have long argued that the US has been sinking into an abyss as far as the fiscal deficit is concerned. On the contrary, some argue that the US will bounce back from its debt pangs provided the US political parties act in a bipartisan way. Several experts have been criticizing the credit rating agency, S&P for downgrading the US credit rating. They are of the opinion that the rating agencies are acting like tyrants. It is clear from the debt burden controversy, the Republicans have been blackmailing the US president (who is a Democrat) as the former enjoy majority in the House of Representatives. In the Senate, the Democrats have majority. The Republicans are not allowing the US president to raise taxes which is necessary to reduce the debt burden. China has condemned the US for its “debt addiction” and exhorted the US to fix its debt problems. China will be adversely impacted by the downgrade as its holds a substantial portion of its foreign exchange reserves in the US Treasuries.

Which countries are enjoying AAA rating as of now?

The countries that are still enjoying AAA-rating, the highest credit rating, are: Australia, Austria, Canada, Denmark, Finland, France, Germany, Guernsey, Hong Kong, the Isle of Man, Liechtenstein, Luxembourg, the Netherlands, Norway, Singapore, Sweden, Switzerland, and the United Kingdom. (Source: S&P)

What is the impact of the downgrade on Indian markets?

There are two ways to look at the issue. The issues that are plaguing the world economy are confined to the sovereign debt problems being faced by the US and Europe. To that extent, countries, like, India, China and Brazil are not impacted by the US downgrade. If one believes this assertion, India should do well going forward and it will continue to receive more foreign money in the form of portfolio inflows from foreign institutional investors (FIIs) and foreign direct investment (FDI). Another view is that India cannot remain immune from the global developments and India’s economy is pegged to global growth. However, one needs to take a balanced view on this. As Indian economy continues to be driven by domestic consumption and strong savings, India’s national income is likely to grow at reasonable rates even though its export sector (IT exports, textiles, etc.) may be adversely impacted due to the slowdown in the world economy.

What is the impact on Indian Rupee?

Indian Rupee has depreciated against the US dollar after the downgrade as the FIIs have been selling the Indian equities. In the long term, Indian Rupee should appreciate against the US dollar as: (i). our interest rates are much higher than those in the US, (ii). we are expected to grow much faster than the US, and (iii). the US will find it very difficult to fix its debt burden which may cause the dollar to fall further in future.

What should Indian equity investors do?

Due to inflation, slow policy reforms, tepid profit growth by Indian corporates and problems in implementing projects, Indian stock markets have already lost more than 20 per cent from their peaks last year. In the last three weeks alone since the unexpected hike in interest rates by Reserve Bank of India on July 26th, the benchmark Sensex has lost about 2,000 points or 10.8 per cent. In view of the above, long-term investors will be better off if they keep their cool and not resort to panic selling provided they hold quality stocks in their portfolio. In the stock market, a good nervous system is much better than a good head. If they are over exposed to sectors, like, information technology, they may reduce their exposure temporarily. However, investors need to watch the global developments carefully as there are several rumours about a possible downgrade of other countries’ credit rating.