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.