The downgrade of the United States' triple-A rating by Standard & Poor's
has elicited a bunch of largely predictable reactions. They can be grouped into
broadly two categories:
The first group of ''patriotic'' Americans who question the validity of the
S&P's action on Friday on the basis of either the agency's fuzzy math or
its less-than-exemplary history. (See my article
S&P adds its own footnote to the crisis, April 20, 2011).
The second group of non-Americans who have either called for the US to rein in
its deficits (like China) or expressed alarm at the development (like the
Europeans).
Both groups are somewhat correct in their assessment of the current state of
affairs, even if their views appear mutually
contradictory. It can also be said that both groups are almost entirely wrong
with their assumptions of how this particular fork in the global financial
crisis road needs to be navigated.
Let us start with a few facts that are largely irrefutable:
1. In the matter of correctly rating the future quality of debt currently on
issue, S&P has about as much credibility as an Indian politician calling an
anti-corruption drive.
2. The downgrade from triple-A, the highest rating, to double-A plus is itself
immaterial in terms of the actual probability of default over the next 25 years
or so.
3. However, the downgrade does have the effect of removing US debt from the
eligibility criteria of many central banks and other cross-border regulators
based on current rules. It is a moot point that such rules may be altered to
deal with the situation.
4. The US is no longer an exemplary sovereign in terms of its risk profile,
although the question is raised that if the US is no longer triple-A, do any of
the other holders of the coveted title have any greater credibility?
5. China's foreign exchange rate intervention was the single-largest factor
behind the mortgage crisis of 2007 - which is not to say that it was either the
proximate cause nor indeed the major swing actor.
6. Europeans have much more to lose from a US downgrade, seeing as it resumes
the race to the bottom between the two currencies (euro and dollar).
Even with all the factors that clearly make the case for ignoring the ratings
downgrade, it is important not to be glib about the action itself - as some
analysts have been, criticizing the action itself, rather than examine the
practical implications of a downgrade more carefully.
The outlook
Middle Eastern markets were sharply down on Sunday, the first day of trading
anywhere in the world after the US downgrade was announced late on Friday.
Asian stocks followed suit, with most indices having wiped out their gains for
2011.
The most important metric from a risk management perspective is the realization
- or the need thereof - that the global financial system has now entered an
entirely new phase; one that presents uncharted territory into which market
participants are forced to sail without the benefit of an anchor.
Protests to the contrary notwithstanding, chances are high that international
investors will reduce their holdings of US debt as a result of the downgrade.
This may not take the shape of a selloff in current holdings, but rather a
reduction in future asset allocations.
If accompanied by denial of the sort seen in Japan since the late-1990s, it is
highly possible that US deficits continue to balloon and as with Japan cause a
structural reduction in US growth prospects; eventually pushing bond yields
down rather than up as US investors continue to purchase treasuries in
preference to risk assets.
This will be exemplified as ''evidence'' of the rating agency action not having
an impact on debt costs even if the argument completely misses the point of
what eventually occurs.
My personal expectations of a reduction in US structural deficits is markedly
different from that of many analysts. Firstly, I do not repose much faith in
the positive demographic story painted by such people (more on that later), and
secondly, I do not believe that either of the two major political parties has
the ability (let alone the willingness) to aggressively address the issue of
structural deficits.
This situation augurs for a continued fall in the US dollar's purchasing power
- either through a renewed commodities bubble or an eventual increase in
(retail) inflation as exporters start passing on costs to US consumers even if
overall demand continues to decline.
If S&P and the other agencies apply the same metrics that produced their
cautious outlook on US credit ratings, it is likely that many European
sovereigns will be downgraded in short order - including the likes of France
and Belgium. While it is possible that the United Kingdom and Germany escape a
downgrade over the next 12 months, that eventuality isn't cast in stone either.
For example, a further weakening of the UK economy - which appears quite likely
- would cause an immediate downgrade.
Even as Europe sinks deeper into the mess of its own making, the outlook for
emerging markets is getting cloudier. Far from being the engine of global
growth, emerging markets could become a structural drag as central banks
attempt to cool down inflationary pressures (like in India) or asset bubble
fears (as in China).
US demographics
There is significant debate about the demographic profile of the US. Even as
its existing population exhibits the same aging profile as the indigenous
European population - the object of much criticism among those who base their
long-term analysis on the measure - the key differential remains the issue of
immigration.
It is here that I have significant differences of opinion with those calling
for a rising US population accompanied by stable demographics - ie a stable
base of taxpayers. There are two sources of immigration: firstly the skilled
laborers who leave countries like China and India in search of greater
opportunity and secondly the base of unskilled and poorer people who seek an
entirely new livelihood in the US.
Ever since the crisis in 2007 and the divergence in growth between developed
and developing markets, the first category of immigration has declined
anecdotally. Meanwhile, the number of economic migrants has also declined as a
result of the significant rise in home ownership-related bankruptcies among
Hispanics and Southeast Asians. The current state of the US financial system
doesn't bode well for this source of demand.
Future prospects for US immigration thus depend very much on the negative
scenario for emerging markets playing out - in other words, it would take the
decline of China and India for immigration to the US to revive. If on the other
hand through the mechanism of internal demand these economies continue to
create adequate growth, the outlook for US immigration declines
proportionately.
The downgrade of the US doesn't present the application of the old investment
axioms relating to ''buy on rumor, sell on fact'' (in this case applied in the
reverse due to the negative nature of the news). Instead, there is a greater
realization that new rules apply in the markets now.
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