US credit rating downgrade explained

PERHAPS the most confusing thing about the first-ever downgrade to the credit rating of the United States government is the way it simultaneously says everything, and nothing, about the future of the world economy.

In simple terms, a country’s credit rating is, like a personal credit history check, an assessment of the likelihood a country will make timely and regular payments on its debts.

All Standard & Poor’s has done is warn investors that if they invest in US Treasury bonds (effectively lend money to the US government) there is an increased risk they may not be paid in a timely fashion, or, indeed, at all.

It’s a conclusion available to even the most casual observer of US politics and the reckless debate about lifting the US government’s debt ceiling. Indeed, conservative Tea Party forces openly advocate the US government should do just that, and default on its debts.

But even so, Friday’s downgrade represents the opinion of just one of three major credit rating agencies. Moody’s still rates it as AAA – the highest rating available – as does Fitch.

Crucially, this means investors governed by investment rules stipulating they must only hold AAA rated assets are unlikely to be forced to sell their Treasury bonds and push up the cost of US borrowing.

Similarly, the biggest foreign holders of US Treasury bonds, China and Japan, are unlikely to sell out of US bonds altogether. What would they buy instead?

Indeed, perversely, by heightening market jitters, S&P’s downgrading of US government debt might spark an investor flight towards US Treasury bonds, increasing their price and lowering the yield payable on US borrowing, as investors seek the comfort of their old safe haven.

International investors have demonstrated a certain Stockholm syndrome-like relationship with US assets, falling in love with the very currency and bonds of the country that has caused them so much trouble in the first place. Having clung to the apron strings of the US government in times of uncertainty for decades, this could prove a hard habit to break.

That is why the US dollar tends to rally in times of uncertainty (US bonds must be bought in US currency). This will limit any increase in US government debt servicing costs.
So in the short term, the credit downgrade potentially means next to nothing.

However, from a longer term perspective, the embarrassing removal of the US government’s prized AAA rating says everything. It serves as a stark reminder that the situation is bleak.

The US economy is staring down the barrel of, at worst, another recession and, at best, a lost decade of sluggish growth and high unemployment.

In this context, events such as Friday’s downgrade can quickly become a lightning rod for justifiably negative market sentiment towards the prospects for American and world growth.

What does that mean for Australia? There are three potential channels through which the Australian economy could be affected. First, a new credit squeeze could feed through into higher funding costs for Australian banks, hurting profitability and leading to higher interest rates for home borrowers and an unwillingness to lend.

Second, lower commodity prices, as investors anticipate lower global demand, could hurt Australian export earnings. Yet bulk commodity prices for coal and iron ore have held up thanks to growth from China.

The third, and perhaps biggest immediate risk to the Australian economy, is that market jitters spread to the “real” economy by prompting consumers to tighten belts further or businesses to delay investment and employment. In which case, the RBA is well placed to cut interest rates and the federal government to delay its return to surplus.

Much will depend, however, on politicians accepting a “hair of the dog” prescription: that the answer to the world debt crisis is more government debt and spending to stimulate economies out of recession.

The prospects of such a political consensus have been severely downgraded of late.

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9 Responses to US credit rating downgrade explained

  1. Magpie says:

    Totally agree with this piece! Very thoughtful and balanced, too.

    The bond yields behaviour has been documented here:
    http://www.stonestreetadvisors.com/2011/07/27/chart-of-the-evening/

    In fact, I’d go a little farther: no one can possibly believe what the S&P crooks (or those from Moody’s and Fitch) say.. Ever.

    Have a look at this:

    “Former Moody’s President, John Bohn Jr. had in 1995 claimed that: ‘We’re in the integrity business: People pay us to be objective, to be independent and to forcefully tell it like it is.’ (Reference: Ratings Trouble, Institutional Investor, October 1995: 245).

    “Later the agencies were forced to admit to the US Congress (at the height of the recent crisis) that they took money from firms in return for their AAA corporate rating. Many of the products the agencies gave top ratings to collapsed as worthless assets in the crisis. The agencies are one of the greatest cons around and can never be considered independent.”
    http://bilbo.economicoutlook.net/blog/?p=15580

    And their announcement at noon that Asia was not off the hook smacks of a deliberate attempt to manipulate the market.

    I just wonder who is paying S&P to make these pronouncements in such a timely fashion.

  2. Jim says:

    Yes, this is truly economics without the boring stuff, if by boring stuff you mean actual, hard, credible analysis.

  3. Jim says:

    If you accept things at face value then I guess for the most part your analysis is reasonable enough – but then we come to your conclusion that the best solution to a global debt crisis is for governments to add to their debt. Not sure that Japanese policy makers would unambiguously agree with that conclusion almost 25 years into their sustained recession. Yes, I know we’re not Japan. We’re worse. I guess at the end of the day you either agree with the notion that the current global economic framework must be sustained at all costs (with the primary policy objective the avoidance of pain – default, bankruptcy, depression, crash in asset prices, etc) or you don’t. Now, I know I haven’t lived through a depression (though I have lived through bankruptcy and loss of personal wealth) and can’t begin to imagine what the alternative solution would actually be like writ large, but one can’t help but feel that we are just kicking the can down the road on this one. The bill will be have to be settled for all of this eventually. Twas ever thus. End of diatribe. I thank you.

    • econogirl says:

      Hi Jim,
      I agree we need to pay down the debt. But in the short term, I think the bigger focus has to be on securing economic growth. Growth is how we generate the tax revenue to repay the debt. Cutting government spending now detracts from growth, and feeds the downturn.
      Sounds like you’re writing from the US?
      Cheers
      jessica

  4. Magpie says:

    Current unemployment in Japan: 4.60%
    Current unemployment in Germany: 9.10%
    Current unemployment in Australia: 4.90%

    My God! Godzilla’s about to kick all the cardboard Japanese buildings.

    Grab your katana and run for the hills, Mitsuo

  5. Magpie says:

    Oh! By the way, have a look at this BBC report (early morning, Sydney):

    Stock markets fall again as bank shares tumble
    http://www.bbc.co.uk/news/business-14472079

    Have a look at the “Countries most exposed to Greek debt” chart. The dark orange is Greek debt in the hands of banks. So, where is the risk coming from? Public or private sector?

    • JIm says:

      Not sure what your point is. Didn’t GFC Mark 1 just teach us there is no such thing as private debt ? BTW – if you have ever spent time in Japan you will appreciate that employment figures are distorted by the massive degree of underemployment there underwritten by government. Unemployment in Australia is statistically rigged and is set to increase anyway. Once again, not sure what point you are trying to make.

  6. harry mahoney says:

    your analysis cool almost as cool as me

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