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Capital markets overreact to U.S. credit downgrade

By Chen Ningyuan: 0 Comment(s)Print E-mail China.org.cn, August 11, 2011

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Credit tumble [By Jiao Haiyang/China.org.cn]

Standard & Poor's recently downgraded the U.S. government's credit rating from the top-notch AAA to AA+, the first time in the credit's 70-year history. The new AA+ rating means S&P now views the U.S. Treasury as less credit-worthy than treasures in the United Kingdom, Germany, France, Canada and Australia.

In the terms of repayment capacity, there are no essential differences between an AAA rating and an AA+ rating. U.S. financial data shows that its national debt isn't worse than the nations retaining S&P's AAA accolade, especially when taking into account those countries' economic strength and currency stability.

The reason the U.S. got downgraded is not a financial crisis, but rather a venting of market dissatisfaction with the snail's pace of U.S. political compromise. For the U.S. government, the debate on lifting the debt ceiling is inevitable. Without it, government spending and borrowing would see little restraint.

Over the past half century, the U.S. government has raised its debt limit 74 times, which means on average Congress has approved deals to raise the federal government's debt ceiling 1.48 times a year. None of these deals were delayed as long as this year's. One might expect a credit downgrade under such circumstances.

However, it's also unexpected that the rating agency downgraded the U.S. credit rating in earnest. What rating agencies really care about is the debt ratio and repayment ability. The agencies hold little doubt about U.S. soundness on either of these factors. Moreover, the U.S. isn't the only one to run huge fiscal deficits. There are many other developed economies with the same problem.

The impact of the U.S. credit downgrade appears huge. The global capital market has fallen off a cliff. But the markets may not be correct. It may be overreacting to a number of landmark events.

S&P's rating calculation is not flawless. Calculation of revenue and expenditures is very complicated. Even in the case of the U.S., whose budget is open and transparent to the public, S&P may not be able to fully make sense of it. On this point, the U.S. government and S&P have an open debate.

From the perspective of capital market investment, until today, there is no tradable financial product with the volume and credibility to replace U.S. government bonds as the top choice of global investors, including sovereign wealth funds such as the one that manages China's foreign exchange reserves.

This is certainly not an optimal configuration, but it is the long-established pattern. The S&P's downgrade can be pessimistically summarized as the end of risk-free U.S. Treasury bonds and the arrival of an era of risky U.S. Treasury debt.

But this isn't entirely a bad thing. We all know that a bond rated AAA has higher coupon rates than that of AA+. The S&P's downgrade may affect interest rates on U.S. national debt. This might not be a bad thing for countries that hold a massive amount of U.S. debt. The greater benefit may be a push for the U.S. government to constrain its budget.

It is still too early to talk about the overall risks of buying U.S. bonds, because at the moment, no one has the power to challenge dollar hegemony. The only safe conclusion is that dollars are no longer risk-free.

(This article was first published in Chinese and translated by Li Huiru.)

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