'US debt downgrade'

The political compromise forged in Washington last week made it possible for the US government to escape debt default. But one of the three major credit rating agencies – Standard & Poor – nonetheless made a decision to downgrade US sovereign debt rating from the highest credit rating of AAA to AA+.

This move was unprecedented. It is also controversial. Since the credit ratings of sovereign debt began, the US had enjoyed the highest rating on its credit. A credit rating of AAA means that the borrower is almost certain to be able to pay its debt obligations.

On surface, this credit rating downgrade is no financial catastrophe. But while a credit rating of AA+ is still very high, this makes US Treasury debt lose its prime quality as the best investment instrument in the capital market.

“Immediate implications on the US economy.” The credit rating downgrade adds complication and uncertainty on the future of the US economic recovery which has been weak so far. With the credit rating downgrade, some of the fundamentals affecting US credit worthiness are put to question.

Will this cause a double dip recession? Most likely the answer is no. But unwanted volatility to the financial markets has resulted. It raises the bar toward a achieving a good economic recovery.

A credit rating downgrade leads to a rise in the yield of US bonds (known in the market as US Treasuries). This means a rise in interest rates. In view of the added volatility, such a rise in interest rates however mild could add an element of distress on American consumers and businesses in their daily transactions. This is fodder to the threat of slowdown of economic recovery.

“The safe haven function remains strong.” The relative position of US Treasury debt remains strong. It has been the safe haven investment of choice and will continue to remain so. For its sheer size, the US Treasury debt has provided a large level of comfort and stability of value to the savings of institutions with a high wealth position. US Treasury debt is where the large savings of pension funds and of other institutional investors are parked for stability of value and for liquidity.

There are few alternatives for safe haven investments: – gold, the bonds of triple AAA firms and of other triple A governments, including those of supra-national institutions and banks. But none of these alternatives can match the volume of US Treasury debt that is supplied to the market for debt at the moment.

Gold and other commodities are the refuge of investors from financial uncertainty. Major currencies are also competing alternatives. As a result, there has been a continued boom in gold prices to unprecedented heights in recent times. US financial and economic difficulties have also led to the appreciation of stronger currencies against the US dollar.

These are the trade marks of uncertain times. Such alternative investment instruments are also very volatile compared to those of US Treasury debt holdings.

“International financial implications.” What happens in US economy and finances have their impact felt across the world as US Treasury debt is held world-wide. Many central banks hold US Treasury debt as part of their international reserves for capital preservation ad marketability.

Other countries own 30 percent – or $4.3 trillion – of the total US Treasury debt of $14.2 trillion in May 2011. China holds $1,159.8 trillion and Japan, $912.4 trillion. Other significant holders of US debt are the United Kingdom, $346.5 billion; oil exporters $229.8 billion, and Brazil $211.4 billion.

Philippine holdings of $23.6 billion represents more than one-third of the country’s total international reserves.

Such substantial exposure of foreign governments lends a stabilizing influence on the safe haven investment function of US Treasury debt. Japan immediately made the comment, in support of international financial stability, that it will continue to buy US debt as part of its program of sustaining its international reserve position.

Holders of US debt will make noises about the need for a new international reserve currency. China, in reaction to the US fiscal problems, has made grumbling comments about the US putting its fiscal house in order. One could take this as part of the escalating assertion of China in its engagement of the US on bilateral economic issues. Despite this, it is likely to hold on to US Treasury debt as one of its safest holdings of foreign money.

Given that Europe is facing very serious economic troubles of its own, the euro is not an alternative to the US dollar as a reserve currency at the present time. Its own Euro zone debt crisis involving some countries is threatening to become a full scale economic problem for that region and the world.

“The stock markets.” The implications on the stock markets appear clear cut as far as theory goes. Any fall in price of bonds results in yields to rise which makes bonds more attractive to stocks. Investors therefore shift their funds from stocks to bonds and the price of stocks will fall. Part of the scenario of stock prices follows this plot.

Asian and European markets fell in the immediate aftermath of the credit downgrade. In fact, even prior to the credit downgrade, the expectation of a possible downgrade might have accounted for the drop in stock prices then.

The reaction in Wall Street however represents far greater volatility than expected. On the same Monday, but later in the day Wall Street time, the Dow index fell by 634 points or a 5.55-percent drop in the index. This was far deeper than that experienced across the world including Asia.

Thus, the economic drama in the US is still unfolding before calm sets in.

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