S&P's downgrades US rating to AA+, impact on other economies

S&P's downgrades US rating to AA+, impact on other economies

As the credit rating agency Standard & Poor's downgrades the US government's 'AAA' sovereign credit rating, India would experience couple of pain points. The dollar losing its fundamental strength would mean a stronger rupee that can widen deficit, affect investor flows and so would draw the regulator to continue its rate hiking action in order to curb both inflation and asset bubble.

Every tsunami has an epicentre from where it emits destruction in circular waves. That was the role the United States of America - the epicentre of the global financial meltdown - played in 2008. Shaky 'too big to fail' banks, loose monetary policy and two rounds of quantitative easing followed the crisis, as did a near recession and rising unemployment. The US economy is likely to face a recession again.

Inflated government borrowings have taken the US' net public debt burden to 74 per cent of its GDP. The government recently arrived at an agreement to raise its debt ceiling. However, that wasn't even half the battle.

Now, Standard & Poor's (S&P) Ratings Services have lowered the long-term sovereign credit rating of the US to 'AA+' from 'AAA'. This is a major development in the financial history of the country, which has held the gold plated AAA rating since 1917. The August 2 passage of the Budget Control Act Amendment of 2011 has removed any perceived immediate threat of payment default posed by delays, so at least the S&P has taken the ratings off CreditWatch.

READ: S&P's press release

"The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics," said the S&P release.

"More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011."

US shocked after S&P downgrades rating from AAA to AA+

S&P also cautioned that the rating could be lowered further to 'AA' within the next two years if spending cuts don't pan out, interest rates rise, or new fiscal pressures during the period result in a higher general government debt trajectory than currently assumed in the base case.

Rajiv Bhuva
Interest rates are the most interesting point here - higher interest rates, at a time of higher borrowing, would likely mean higher expenditure in terms of debt servicing. So, it seems apt to assume that interest rates in the US are likely to remain low for a while.

Its revised downside scenario - which, other things being equal, S&P views as being consistent with a possible further downgrade to a 'AA' long-term rating - features less-favourable macroeconomic assumptions, as outlined below.  

That scenario also assumes that the second round of spending cuts (at least $1.2 trillion) that the act calls for don't occur, and that nominal interest rates on US treasuries rise somewhat.

"We still believe that the role of the US dollar as the key reserve currency confers a government funding advantage - one that could change only slowly over time - and that Fed policy might lean towards continued loose monetary policy at a time of fiscal tightening," said the S&P release.

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"Nonetheless, it is possible that interest rates could rise if investors re-price relative risks," S&P cautioned. As a result, S&P's alternate scenario factors in a 50 basis points (bps)-75 bps rise in 10-year bond yields, relative to the base and upside cases from 2013 onwards. "In this scenario, we project the net public debt burden would rise from 74 per cent of GDP in 2011 to 90 per cent in 2015 and to 101 per cent by 2021."

What does it mean for other economies, including India?

Regulators have turned to interest rate hikes to combat rising inflation, leaving the currency to swing as per markets' evaluation of the scenario. The emerging economies' currencies have been relatively strong, vis-a-vis the dollar, so far. The downgrade means a weaker dollar. China may choose to diversify its reserves, which would put further pressure on the dollar.

With rising riskiness, a possible third round of quantitative easing could mean an immediate rally in commodity prices. While the oil price rally is on a pause for now, gold prices have gone up.

This scenario spells trouble for India , where inflation has pushed the Reserve Bank of India to hike interest rates 11 times since March 2010. Not only that, investor flows will see major re-allocations owing to the ratings downgrade.

While there was political logjam around the US debt ceiling enhancement, investor flows remained uncertain. According to Emerging Portfolio Fund Research (EPFR) weekly data, as of August 3, while Emerging Markets' Equity funds had outflows of $1.18 billion, Developed Markets' Equity funds witnessed outflows of $ 9.6 billion. Of these, outflows from US Equity funds were $7.4 billion.

"Despite the changing global landscape, with US/EU growth slowing down and the EU debt crisis accelerating, we expect that flows to Emerging Markets local currency funds will continue," says Demetrios Efstathiou, Head of CEEMEA (Central Eastern Europe Middle East & Africa) Strategy.

"This is a bold statement to be made at this point, but we think that investors will continue to differentiate between the EU/US and the healthier EM economies," Efstathiou added in his report dated August 5.

So, for India, there are a couple of pain points.

The dollar losing its fundamental strength would mean a stronger rupee. At a time when GDP growth rate has exhibited a slowing trend and also when the Reserve Bank does not mind a growth-inflation trade-off, exports could take a hit.

On the import side, a stronger rupee along with higher commodity prices would widen the current account deficit. On the investor flows, while the numbers are muted, higher interest rate coupled with a strong rupee would mean higher inflows. And that would draw the regulator to continue its rate hiking action in order to curb both inflation and the asset bubble.

Someone's pain is not necessarily someone's gain. It is just that interesting times are getting both extended and more interesting.