As the US loses AAA, where is a safe harbour?
- 6 August 2011
- From the section Business
The loss of America's AAA credit rating shouts loudly that there is risk in lending to America - which at a time of great stress in financial markets could be very destabilising.
Almost everything in the world - loans, goods, services - is priced in or priced off the dollar.
It is the measuring stick of the world financial system and the global economy.
The dollar has a status in the financial system once occupied by gold.
Also, whenever investors believe that the world is becoming a riskier place, their instinct is to buy US Treasury Bonds, to lend to the US government.
So when the price of US government debt rises and the yield on that debt falls, that typically means investors believe prospects for the global economy have deteriorated.
That event happened last week, when global share prices fell on the back of concerns that the eurozone isn't gripping the problem of investors declining confidence in the ability of Spain and Italy to repay their debts.
Or to put it another way, the risk of the US not repaying all its debts is supposed to be infinitesimally small.
That is why the US losing its AAA rating matters. It is a very loud statement that there has been an appreciable increase in the risk - which might still be tiny, but it exists - that the US might one day struggle to pay back all it owes. Another important certainty in the world of finance has gone.
Of course many will argue - and already have - that the record of ratings agencies such as Standard & Poor's of getting these things right in recent years has been lamentably poor. Think of all the subprime CDO products rated AAA by S&P that turned out to be garbage.
But S&P, Moody's and Fitch (and particularly the first two) still have a privileged official position in the world of finance: they determine what collateral can be taken by central banks from commercial banks, when those central banks lend to commercial banks.
Or to put it another way, it is tricky for governments to dismiss out of hand what the likes of S&P say, because S&P's authority is hardwired into rules set by regulators and state bodies for the functioning of the financial system.
What's more, much of the basis of S&P's downgrading of US credit is not easy for the US government to dispute.
S&P says that "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".
The fiscal and economic challenges are conspicuous: a substantial and intractable gap between public spending and tax revenues in the US at a time of anaemic economic growth.
And as for a weakening of the stability and predictability in American policymaking? Well, the recent protracted and messy negotiations between the White House and Congress, between Republicans and Democrats, on how to reduce the deficit, as a prerequisite of sanctioning more US borrowing, was seen by most investors (and others) as a model of rancour, mistrust and lousy compromise.
So what's going to be the damage from the loss of the cherished AAA?
That's very difficult to assess.
The US still has its AAA from Fitch and Moody's (though in the case of Moody's, there's a negative outlook). And the US Federal Reserve and bank regulators said that the downgrade won't affect the risk-weighting attached to US sovereign debt for banks - which means that US banks should not be deterred from lending to their government to any great extent.
More important, perhaps, is the attitude of China, America's single largest creditor, which holds at least $1.3 trillion of US government debt and probably rather more, based on official figures.
If today's remarks from the official Chinese news agency Xinhua are any kind of a guide, the Chinese government is rather anxious to protect the value of its apparently wasting dollar assets.
Xinhua said: "China, the largest creditor of the world's sole superpower, has every right now to demand the United States address its structural debt problems and ensure the safety of China's dollar assets...
"International supervision over the issue of US dollars should be introduced and a new, stable and secured global reserve currency may also be an option to avert a catastrophe caused by any single country."
In theory there will be a financial cost for the US government and US citizens, whose debt is priced off the interest rate paid by the government. Perhaps an additional half of a percentage point on interest rates, over time, according to some analysts? Perhaps an additional $100bn of interest costs for the US economy, according to the US bank JP Morgan?
These estimates feel a bit like a wet finger held up in a gale swirling in different directions - more hunch than exact science.
Probably the only thing to be said with any confidence is that the downgrade could hardly have come at a worse time, in that conditions in global markets are febrile.
With the integrity of the eurozone, one of the three great economic areas, in some doubt, it is seriously discombobulating for banks, sovereign wealth funds, pension funds, insurers and central banks that the safe harbour of US Treasury Bonds, US government debt, no longer looks quite the comforting refuge in a storm that it once was.