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Rating agency Standard & Poor’s ruined countless summer holidays on Friday when it downgraded America’s credit rating for the first time, citing weakened policymaking as a contributor to the move to AA+.
The announcement’s timing allowed the news to sink in during the weekend, but Asian markets will be at the forefront today as investors react to America’s downgrade from triple-A. In Hong Kong, stocks had started to recover by the end of last week after a three-day losing streak, but are expected to head back down again today amid turbulent trading conditions.
Markets across the Middle East have already felt the effects, with Saudi Arabia’s Tadawul stock index slumping 5.5% on Saturday. Even so, the shock of S&P’s decision could be short-lived, at least in equity markets.
The other two rating agencies, Moody’s and Fitch, have so far kept their triple-A ratings on US debt and, while the timing of the downgrade was a surprise, markets were expecting it at some point. Indeed, the timing could probably have been much worse. Nothing has materially changed in America’s fiscal position during the past few days to prompt S&P’s decision — instead, it is based largely on political failures.
That much was obvious after the Treasury Department pointed out a $2 trillion mistake in S&P’s analysis of the government’s fiscal position on Friday, ahead of the announcement. The rating agency disputed the error but emphasised that the debt-ceiling debate had created significant policy uncertainty, which was the more important point.
“The downgrade reflects our view that the effectiveness, stability and predictability of American policymaking and political institutions have weakened at a time of continuing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011,” said S&P in its original announcement of the downgrade.
“Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilises the government’s debt dynamics any time soon.”
The political nature of the downgrade mitigates any serious short-term effect on financial markets. After all, the most important reason for holding US debt remains unchanged: “Foreign central banks maintain a large share of their FX reserves in [Treasuries] because it is the deepest and most liquid bond market,” said Ajay Rajadhyaksha, head of US fixed income strategy at Barclays Capital, in a research note. “This is unlikely to change due to a ratings downgrade.”
The same principle applies to the use of Treasuries as collateral, which some commentators fear could come under pressure from the downgrade. But it is liquidity rather than ratings that drives their use as collateral and the risk of knock-on bank downgrades is not an immediate concern, noted Rajadhyaksha, given that most are already several notches below triple-A.
In time, it could be the dollar that suffers most. Its position as the world’s reserve currency is undermined by a downgrade, and that could add momentum to a general diversification away from the US. “Foreign investors have supplied 30% to 40% of non-financial credit creation in the US over the past few years. An increase in the pace of diversification should be an economic drag, as domestic savings would have to rise to pick up the slack,” said Rajadhyaksha.
Such an outcome is doubtless a cause for concern in Beijing, where Chinese officials are worried about the value of the country’s foreign reserves — which it has to maintain to suppress its own currency. Chinese politicians have kept a diplomatic silence so far, but state news agency Xinhua published a strongly worded editorial during the weekend that chided America for “living beyond its means” and called for an end to America’s ability to hold the global economy hostage.
“International supervision over the issue of US dollars should be introduced and a new, stable and secured global reserve currency may also be an option to avert a catastrophe caused by any single country,” said the Xinhua report.
In reality, the dollar is a long way from losing its reserve status — thanks in large part to China’s own huge purchases — and the downgrade is not likely to cause an immediate crisis for the US, but it is too early to say how the decision will affect America’s global position in the long term. Growth would be the best cure, and some economists are reporting promising signs on that front. Summer holidays might be a washout this year, but perhaps Christmas will bring merrier tidings.
