The short-term impact of Standard & Poor’s downgrade of the United States to AA+ from AAA is likely to be minimal, but the long-term implications are huge.
The question now is whether America’s politicians find a way to put the country on a painful path to long-term solvency, or if this downgrade is but the first in a drawn-out sequence of deterioration.
Last week, conversations in New York and Boston with many experienced fixed-income chiefs at money-management firms made it clear that the debt-ceiling deal concluded on Tuesday had moved market attention to the credit rating agencies. Would they bless it as sufficient?
Fitch Ratings and Moody’s Investors Service said they would maintain America’s AAA rating, noting that the fluid political situation made it premature to consider a downgrade. S&P had been the most clear in stating what kind of debt reduction it needed to see from the debt-ceiling deal, and the deal clearly fell short.
That left many in the bond market wondering whether S&P might wait to see how the as-yet-constituted Congressional fiscal commission would fare, or even if it might be necessary to wait until the 2012 elections to determine where the US was headed.
S&P didn’t waste time, however, catching the markets off guard with its speed, if not its decision. Although the agency opened itself to political attack from the Obama administration for some errors in its calculations of US debt, those semantics didn’t address the real reason why S&P has taken away America's AAA status – the gulf between the two political parties makes it unclear the government will always honour its obligations, in full and on time.
Paul Coughlin, S&P’s global head of corporate and government ratings in New York, on Thursday told AsianInvestor that while the US has many strengths, its debt burden and the trajectory of that debt burden are problematic. The size of the fiscal deficit is now 9-10% of GDP. “The country is adding that burden to its debt every year,” Coughlin says.
He notes the deal struck early last week in Congress didn’t come close to reducing the rate of growing indebtedness, let alone set the government on a path to a balanced budget.
Asian observers may have come to this conclusion more quickly. Beijing-based Dagong Credit Rating cut America’s rating last Monday, to single-A. Such a move is in line with growing exasperation with Washington felt in China and other major holders of US Treasuries and other dollar-denominated financial assets.
The debt-ceiling crisis has led many investors to realise that US Treasuries, so long held up as the ‘risk-free rate’, do embed some level of risk, however slight. Moreover, investors are starting to realise that US Treasuries have always held risk – if not credit risk, then currency risk. After all, the steady drop in the value of the greenback has eroded central banks’ and others’ US Treasury holdings.
There is little sign now that this will translate into a meaningful change in portfolios. Fund managers say that, even where their mandates stipulate exposure to triple-A securities, they say clients have expressed unusual flexibility with regard to Treasuries.
Moreover, US Treasuries are still regarded as triple-A by two of the three major rating agencies.
The speed of the S&P downgrade may create some problems in specific cases, however, if investors and their fund managers haven’t had enough time to recalibrate either portfolios or their guidelines. Moreover, borrowers supported by the US government may now face higher interest rates, including municipalities, government agencies such as Fannie Mae and Freddie Mac, and US banks.
No one expects forced selling of Treasuries, however. Last week saw yields continue to fall, and – despite the surge of demand for Swiss francs and Japanese yen – there is simply no way big real-money accounts can diversify out of dollars.
For example, in the Barclays Global Aggregate Index, US Treasury market cap is over $5 trillion, while German bunds are $1.3 trillion. Not only is that a big difference, but China has over $1.1 trillion of US Treasury holdings, if not more. In other words, just China’s holding of Treasuries may be equal to or greater than the entire bund universe.
(In the index, the yen component is $7 trillion – but Japan is not triple-A, and JGBs are yielding around 1%, versus about 2.7% for 10-year Treasuries.)
There are also precedents of other sovereigns losing their AAA status, including Japan, Canada and Sweden, with very little repercussion on yields or liquidity. And the US has the additional advantage of printing the world’s reserve currency. Canada was even able to regain its AAA rating. So the trajectory remains the issue: A single rating agency lowering America to AA+ is only a meaningful problem if more downgrades are in the offing.
Asian governments are likely, therefore, to turn to longer-term solutions, as immediate alternatives to Treasuries are scant (and, in truth, there remains negligible chance of a US default). The most obvious task for Asian authorities is to grow their local-currency bond markets. Even before America’s debt-ceiling fiasco, this was deeply needed. Demand among Asian financial institutions and pension funds for long-duration instruments already dwarfs what Asian capital markets can deliver. The shock of the US debt-ceiling negotiations and now a credit downgrade may spur governments to hasten local-market development.
Ultimately, however, that is going to be a very lengthy, gradual process. Asian governments need to end their reliance upon US capital markets, which means ending their current economic model of recycling foreign reserves. The only reason they are such enormous buyers of Treasuries is to pursue mercantilist policies. Creating export powerhouses to feed Western consumer demand seems increasingly unrewarding in the wake of both US and European economic weakness.
The decline of the dollar, the unattractive yields available from Treasuries and now the realisation that ‘risk-free’ is a subjective notion, all make the cost of Asian mercantilism ever greater. Yet the official goal of the China Communist Party, of a 'rebalanced' or 'sustainable' economy more based on domestic demand, will be difficult to achieve in a short period of time, if it's possible at all in the current environment.
There is, in fact, only one way for China to finally break free of the US dollar. It has to let the yuan become a freely floating currency.