The importance of the downgrade of the outlook for US long-term sovereign credit ratings from stable to negative by Standard & Poor’s (S&P) a few days ago lay not so much in a deep impact on global economic and financial conditions but a reaffirmation of the concerns that have been repeatedly voiced by a wide variety of stakeholders regarding the ballooning US sovereign debt. This also gives us an opportunity to review the current global economic architecture, which this newspaper has recently succinctly editorialised. To jog your memory, this change in the US outlook had been preceded by a sovereign ratings downgrade of Japan by S&P in December 2010 (Japan’s $11 trillion sovereign debt rating had been cut one notch to AA-), and earlier, by warnings from the other two large ratings agencies, Moody’s and Fitch in late 2010, of a possible adverse revision in outlook for the US.
Although the timing of the outlook downgrade was a bit of a surprise, the news was more or less taken in stride. After a brief drubbing in the interest rates and dollar currency markets, the environment has actually become more optimistic, reflecting the Quixotic functioning that characterise markets to the layman, with the US looking even more of a safe haven for global investors. The most significant effect of the revised outlook, desired if not credible, is probably the wake up call it has given the US government—that investors’ adverse perceptions might actually transform into voting with wallets if corrective fiscal steps are not initiated.
The ballooning debt and deficit of the US federal government (let alone the states and “munis”) has been discussed threadbare by analysts since 2009, in the immediate aftermath of the stimulus response to the financial crisis. The US’s parlous fiscal situation, relative to that of its developed nations peers, has been the cause of perennial concern, which has hitherto been alleviated by the strengths of a “high-income, highly diversified, flexible, competitive and innovative economy”, being the growth counterbalance to the inherent weaknesses of a predominantly consumption-led growth.
What is interesting in the aftermath of the outlook revision is speculation on the global consequences of an actual downgrade of US sovereign debt ratings and, particularly, the implications for India. To understand these issues, we need to understand the reasoning behind the outlook change. First, the US Treasury’s outstanding debt at end-February was $9 trillion (total public debt was $14.3 trillion). The deficit is projected to be $1.6 trillion for the current fiscal year. Second, the reliance of the US economy as a whole on external financing is exceptionally high, compared to, say, Japan, which uses its domestic savings pool. Third, the fact that US policymakers have been unable to reach an agreement on fiscal consolidation and have been dogged by implementation delays looks even worse compared to the ongoing and prospective fiscal austerity programmes in the UK and European countries. S&P projects general US government debt at 86% of GDP in 2013. Fourth, factoring in potential bailouts of the still floundering government-sponsored enterprises, Fannie Mae and Freddie Mac, might add a financial sector spanner in the fiscal wheel. Finally, throw in the fiscal pressures of long-term unfunded liabilities, and you can see the concern that ratings agencies and investors have with this picture.
The real significance of the downgrade in outlook is to prompt a rethink of the conditions that have permitted the US to run up a fiscal gap of this magnitude without a downgrade; other countries in a similar situation would have been downgraded in a flash. In essence, this is due to the status of the dollar as the dominant global reserve currency, despite the US dependence on external financing. The second was a need for the government’s balance sheet expansion in an environment, not just during the crisis, but even now, given the continuing deleveraging of consumer mortgage credit, even though corporate credit is slowly beginning to pick up.
Be that as it may, the consequences for global markets will be significant if a downgrade, however remote the possibility, actually happens. The first visible manifestation of the economic environment is the dollar weakening against the euro, the sole current pretender to an alternative reserve currency, even as China’s efforts to internationalise the renminbi gather momentum. The immediate impact would be a wholesale dumping of US securities, particularly by foreign investors who have hitherto financed the US consumption and global demand machine. This selloff inflicts massive damage on investors, whose portfolio managers have perforce to look at alternative assets to preserve the value of their investments. The effect on gold prices is immediately and starkly evident. The effect on commodity prices with industrial uses, such as copper, is even more insidious, as is silver.
We ultimately keep coming back to the fundamental question: if not the dollar as a reserve currency, then what? No other country’s financial and currency markets are sufficiently deep to absorb global savings. As Mr El-Erian of PIMCO puts it, the US is the source of a range of “global public goods”—the reserve currency, the most liquid government debt market and the “risk free” standard. A weakening of this would result in a fragmentation of global financial markets and a consequent loss of efficiency.
For India? The Chinese saying “in danger lies opportunity” might be the lodestone for charting India’s economic course, with financial sector and capital markets reforms paving the way for full capital markets convertibility, laying the foundations for the rupee to be an acceptable global currency
Although the timing of the outlook downgrade was a bit of a surprise, the news was more or less taken in stride. After a brief drubbing in the interest rates and dollar currency markets, the environment has actually become more optimistic, reflecting the Quixotic functioning that characterise markets to the layman, with the US looking even more of a safe haven for global investors. The most significant effect of the revised outlook, desired if not credible, is probably the wake up call it has given the US government—that investors’ adverse perceptions might actually transform into voting with wallets if corrective fiscal steps are not initiated.
The ballooning debt and deficit of the US federal government (let alone the states and “munis”) has been discussed threadbare by analysts since 2009, in the immediate aftermath of the stimulus response to the financial crisis. The US’s parlous fiscal situation, relative to that of its developed nations peers, has been the cause of perennial concern, which has hitherto been alleviated by the strengths of a “high-income, highly diversified, flexible, competitive and innovative economy”, being the growth counterbalance to the inherent weaknesses of a predominantly consumption-led growth.
What is interesting in the aftermath of the outlook revision is speculation on the global consequences of an actual downgrade of US sovereign debt ratings and, particularly, the implications for India. To understand these issues, we need to understand the reasoning behind the outlook change. First, the US Treasury’s outstanding debt at end-February was $9 trillion (total public debt was $14.3 trillion). The deficit is projected to be $1.6 trillion for the current fiscal year. Second, the reliance of the US economy as a whole on external financing is exceptionally high, compared to, say, Japan, which uses its domestic savings pool. Third, the fact that US policymakers have been unable to reach an agreement on fiscal consolidation and have been dogged by implementation delays looks even worse compared to the ongoing and prospective fiscal austerity programmes in the UK and European countries. S&P projects general US government debt at 86% of GDP in 2013. Fourth, factoring in potential bailouts of the still floundering government-sponsored enterprises, Fannie Mae and Freddie Mac, might add a financial sector spanner in the fiscal wheel. Finally, throw in the fiscal pressures of long-term unfunded liabilities, and you can see the concern that ratings agencies and investors have with this picture.
The real significance of the downgrade in outlook is to prompt a rethink of the conditions that have permitted the US to run up a fiscal gap of this magnitude without a downgrade; other countries in a similar situation would have been downgraded in a flash. In essence, this is due to the status of the dollar as the dominant global reserve currency, despite the US dependence on external financing. The second was a need for the government’s balance sheet expansion in an environment, not just during the crisis, but even now, given the continuing deleveraging of consumer mortgage credit, even though corporate credit is slowly beginning to pick up.
Be that as it may, the consequences for global markets will be significant if a downgrade, however remote the possibility, actually happens. The first visible manifestation of the economic environment is the dollar weakening against the euro, the sole current pretender to an alternative reserve currency, even as China’s efforts to internationalise the renminbi gather momentum. The immediate impact would be a wholesale dumping of US securities, particularly by foreign investors who have hitherto financed the US consumption and global demand machine. This selloff inflicts massive damage on investors, whose portfolio managers have perforce to look at alternative assets to preserve the value of their investments. The effect on gold prices is immediately and starkly evident. The effect on commodity prices with industrial uses, such as copper, is even more insidious, as is silver.
We ultimately keep coming back to the fundamental question: if not the dollar as a reserve currency, then what? No other country’s financial and currency markets are sufficiently deep to absorb global savings. As Mr El-Erian of PIMCO puts it, the US is the source of a range of “global public goods”—the reserve currency, the most liquid government debt market and the “risk free” standard. A weakening of this would result in a fragmentation of global financial markets and a consequent loss of efficiency.
For India? The Chinese saying “in danger lies opportunity” might be the lodestone for charting India’s economic course, with financial sector and capital markets reforms paving the way for full capital markets convertibility, laying the foundations for the rupee to be an acceptable global currency
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