Standard & Poor's, the credit rating agency downgraded the long term debt of the United States in a rating action on Friday, last week, setting off a week of political jawboning and intense volatility across global equity, debt and commodity markets.
So, what exactly were the concerns of the analysts and S&P that led them to issue the downgrade and why did the markets react by actually buying US debt and selling equities across other markets?
The answer requires us to delve into the turbulent waters at the intersection of global finance, geopolitics and the domestic political compulsions of American political parties.
What is a rating action and why is it so important?
Standard & Poor's is a credit rating agency. They rate the debt of various corporate and sovereign entities. Usually, the issuer of the debt, pays S&P to rate the quality of the debt. Institutional investors across the world — mutual funds, pension funds, sovereign wealth funds, and hedge funds typically use these ratings, to make decisions on investing in the issuer's debt. Most institutional investors require the issuer of debt to get a rating from one of the big 3 rating firms: Standard & Poor's, Moody's and Fitch ratings in order for them to invest. Many funds have investment philosophies that specify a minimum rating that a debt issue must have in order for the fund to invest in it. Hence the market as whole usually uses the rating in making investment decision about the credit quality of the issuer. Although, the ratings are for debt -- since they take into account the future income stream of the issuing entity -- investors often use the debt rating of the issuer in valuing the equity of the issuer. In the case of the United States government, its AAA rating was a proxy for the prodigious $14 trillion GDP of the US economy as a whole!
The table below shows historical default rates for various grades of S&P municipal and corporate securities.
|Cumulative Historic Default Rates (Historical up 2007)|
As you can see the default rates for AAA rated entities is very low. Also, in practical terms the default rates of AAA and AA+ rated securities don't differ much (both are less than 2%). So, although the S&P downgraded the US, in practical terms it really doesn't mean much in terms of its repayment capacity.
An additional twist that US external debt has, is that, unlike India's external debt, it is denominated in US dollars; the currency that the US government controls. That is, they can payback the debt by simply printing dollars. In other words, they can inflate the debt away. Although this form of payment would not technically constitute a default, it is in effect an underpayment to the US government's creditors.
S&P's concerns on the political will to reduce deficits
So, in reality, nobody really doubts the ability of the US to service the debt. S&P's concerns stemmed from the way in which the debt was being financed — through deficits, and the concern that the two main political parties in the US don't seem to be agreeing on how to control the deficits.
US Deficits and monetary policy, and political gridlock
So, how did the US deficits get so high and why is traditional monetary policy not working and what exactly are US politicians bickering about?
The origins of today's crisis are, of course in the sub-prime housing market in the US, whose problems, snowballed into the financial crisis of 2008, when credit markets essentially ceased functioning. In response the US Federal Reserve, the primary implementer of monetary policy in the US, lowered short-term interest rates until they were close to zero. At this point, interest rates no long have an effect and the Fed had to resort to a series of unconventional policy actions, with such esoteric acronyms as TALF, QE1 and QE2. These policy measures were intended to inject liquidity into the market and induce commercial banks to start lending again, and kickstart the US economy. (See graphic.)
Unfortunately for the Fed, much of the money, which was in the form of bailouts for the banks wasn't used for lending, but was used up by banks to shore up their severely damaged balance sheets (in other words they simply invested the Feds money back in treasuries.) To offset the lower interest rates, and the sloshing liquidity in developed markets, many banks and investors channeled money into emerging markets such as China, India and Brazil, igniting inflation in these economies that were ill suited to absorb such massive capital inflows. They also hurt developing economies by driving up commodity prices, such as those of oil and gold, further exacerbating inflation in these economies.
To make matters worse, the US government didn't fully disburse the money allocated for economic recovery, for the simple reason that government agencies were overwhelmed. Both, Paul Krugman in his blog - The Conscience of a Liberal and Joseph Stiglitz in his interview, give a cogent summary of the events.
The solution to the problem, many Keynesian economists and their Democratic backers in the US Congress and the Obama administration argue, is to go through with the spending program and actually spend the money allocated for recovery and indeed expand spending programs and support for unemployed to stimulate economic recovery.
Republican opponents of the current administration, and neo-classical economists, argue that the solution is not more government spending, which would have effect of crowding out private investment driving the economy into further recession. They argue, that spending should be cut (their first targets being social programs they dislike), and taxes should be reduced to provide an incentive for private enterprise. The strident tea-party wing of the Republican Party is particularly strident in its advocacy of this position.
That then, is the basis for the political gridlock that enveloped Washington, and eventually manifested itself in Congress' refusal to increase the debt ceiling, and finally S&P's rating action.
What this means for India
As the wildly seesawing markets demonstrated this week, the implications for India and emerging economies are not entirely clear.
On the face of it, one would imagine that US debt downgrade and what it says about the US economy, would imply that India by contrast, with its 8% plus GDP growth rate would become a more attractive destination for global liquidity.
The ironic, short-term effect, though, of the US debt downgrade, was to actually make US treasuries more expensive! The reason is that a US debt downgrade implies a lowered ability for US to be borrower and purchaser of last resort that it had become during latter half of the 20th century. It in turn meant the developing economies -- especially Asian economies such as China, Japan and Korea -- that depended on exports to the US would be disproportionately hurt. In India, it meant that our bellwether IT companies would find it harder to grow their businesses in the US and the debt-crisis ridden Euro-zone. This was the driver of the brutal sell-off on the Indian bourses on Monday.
In the medium term though, the effects are not very clear. On the one hand, a slowdown in the global economy helps lower oil prices, which helps India. But on the other hand, FII and perhaps even FDI inflows into India might further exacerbate the already bad inflation situation, hurting the common man and driving down stock market valuations. The direction of the market in the medium term may then depend on how investors view the relative strengths of such macroeconomic counter-currents.
There seems to be a greater consensus, amongst economists on the long-term direction of the world economy. The emerging markets of Asia and BRIC countries, India included are going to have an increasingly greater share of global trade, driven by young dynamic populations that are slowly becoming wealthier. The US like its ideological predecessor, the British Empire, will no longer be the world's essential economy. So, if you are in the markets for the really long term, and you have the stomach for the violent eddies in the flow of global finance, your grandchildren may yet thank you for your investments.