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Curtain falls on US debt ceiling drama only to roil global markets

Published: Wednesday, Aug 10, 2011

Economic Analysis

August 10, 2011
Curtain falls on US debt ceiling drama only to roil global markets

Zaidi Sattar

The long protracted bickering barely over, the US Congress passed into law a compromise bill to raise the debt ceiling by some $2.3 trillion dollars

on August 02, 2011 thus averting the possibility of an imponderable default by the most trusted repository of global sovereign holdings – US Treasury debt. For those who followed the squabbling between Republicans and Democrats in the US Congress must be well aware that the Budget Control Act of 2011 was a compromise deal that neither side liked. It was hardly the bipartisan pursuit of rapprochement that characterized many compromises worked out in Congress throughout history. This time it was all too apparent that neither side got what they wanted. It felt like the parting of ways rather than a meeting of minds. What is now clear, the markets as well as the rating agencies did not like what they saw.

Hypothetically, if the debt ceiling were not raised by August 02, the US government would have had to cut spending immediately by 40% which would mean defaulting on many of its obligations, including debt. For one, that would have been the most vexing development for the Chinese – holders of the largest amount of US Treasury Bills, to the tune of some $1.5 trillion. For another, that would have led to the downgrade of US debt, creating a firestorm in financial markets across the globe. In the end, the two groups in Congress thought it better than to let the US economy fall off the precipice.

But perhaps the damage was already done. The way the two sides kept tossing their dogmatic positions at each other until the final hour would make the Awami League (AL)-Bangladesh Nationalist Party (BNP) confrontation in Dhaka look like a friendly football match. Republican members of Congress (House and Senate) found themselves boxed in on their inflexible stand for spending cuts and no tax (revenue) increases which left little room for compromise with their Democratic colleagues – led by President Obama -- who argued for a balanced approach to debt and deficit reduction comprising a combination of spending cuts and revenue increases. As subsequent polls and market developments show, neither side won, but the nation lost.

What was merely a threat did come to pass as S&P, one of the three leading global ratings agencies, went ahead with the downgrade of long-term US debt as of August 05, 2011. S&P reduced the triple-A rating held by US debt to AA+ -- the first such downgrade of US Treasury debt since 1917--, pointing fingers at the budget deal recently brokered in Washington which they said didn't do enough to address the gloomy outlook for America's finances.

Though Moody’s and Fitch did not mimic the S&P position, they stayed with their previous rating but warned that US debt was under review in the near term (Table 1).

Table 1: US Sovereign Debt Rating Before and After Raising of US Debt Cap

Rating Agencies

Rating

Outlook

Before

After

Standard & Poor’s

AAA

AA+

Negative

MOODY’s Investors Service

Aaa

Aaa

Under Review

Fitch Rating

AAA

AAA

Under Review

What comes as an embarrassment to those at the helm of US affairs is the fact that this downgrade occurs while the triple-A rating remains for dozens of other sovereign debt across Europe (Table 2).

 

Table 2. Public Debt and Ratings among Selected Countries,2010

Country

Public Debt to GDP (%)

Sovereign Debt Rating

Risk Grade

       

France

84.3

AAA

Premium

Germany

79.9

AAA

Premium

United Kingdom

77.2

AAA

Premium

       

USA

91.6

AA+

Investment

India

68.2

BBB-

Investment

       

Bangladesh

40.0

BB-

Speculative

Sri Lanka

81.9

B+

Speculative

Pakistan

56.8

B-

Speculative

Vietnam

52.8

BB-

Speculative

Source: World Economic Outlook Database, IMFaftern

 


Coming as it does in the wake of a Eurozone debt crisis that is still far from resolved, the markets could hardly bear the shock of a double whammy. So stock markets from Hong Kong to London, Tokyo to Paris, have been gyrating on their way down, with New York’s Dow Jones Index being the latest to take the hit, plunging 630 points this Monday to wipe out all the gains since last October.

But that is not the end of the story. There is a serious crisis of confidence in the way lawmakers in Washington appear to be addressing their nationaldebt problem. There is clear evidence that the gridlock in Washington is anything but constructive. Even the formation of the bipartisan fiscal commission has failed to raise the confidence of markets in Washington’s ability to resolve the problem over the long haul through a balanced approach that is warranted. All this could lead other rating agencies to convert negative outlook on US debt to eventual downgrade.

Then there could be trouble ahead for the real economy. The first hit will be on a wide range of interest rates, from home mortgage to car loans to credit cards. Most of these rates in the USA will go up a few notches having the effect of an across-the-board tax hike, raising costs for businesses and individuals alike. The US government might have to pay a higher rate on its trillions of dollars of debt.

A key concern will be whether the appetite for U.S. debt might change amongforeign investors, in particular China, the world's largest foreign holder of U.S. Treasurys. In 1945, foreigners owned just 1.0% of U.S. Treasurys; today they own a record high 46%. China has already been sounding like an aggrieved creditor sending word to Washington to live within its means.

Some analysts however don’t believe there is yet an alternative to parking the world’s surpluses except in US Treasuries, despite the downgrade. All this has not shaken the confidence of Warren Buffet who would give US debt a quadruple-A rating if there was one and President Obama reiterated that US will always be a AAA country, regardless of rating agencies might think.

The biggest fear which weighs heavily on minds of policymakers on both sides of the Atlantic is the impact this downgrade will have on prospects of US economic recovery and hence on the global economy. The prospects of a double-dip recession in the USA appear very real. And this time, with deficit reduction on the immediate agenda, one cannot expect to see any stimulus money. On top of it, there is little maneuverability left with policy makers in monetary or fiscal policy instruments to lift the economy out of a recession.

What does all this mean for the Bangladesh economy? Once again, as in the last financial crisis, our financial sector is not integrated enough with global financial markets to be directly affected by the turmoil in global markets. One would be hard pressed to attribute gyrations in our stock market to global developments. Our borrowings from or lending to international capital markets are practically nil. Our foreign exchange reserves, mostly parked in US Treasuries, may earn a bit more interest but those gains would be wiped out by a fall in the value of the dollar that is likely to follow from the US downgrade.

But the real economy is much more integrated through trade in goods and services – exports, imports, and remittances – and very modest flows offoreign direct investment (FDI). A double-dip US recession can not only halt the global recovery but potentially push the global economy back into recession. That would effectively undermine Bangladesh’s exportperformance, and cause remittances to dry up as well.

With trade and remittance volumes approaching 50% of Bangladesh’s GDP, the adverse impact on growth, employment and poverty, is all but certain. On the brighter side, one would expect petroleum and industrial commodityprices to dip with a global recession, giving Bangladesh a modest terms of trade boost. That would be little consolation in an otherwise gloomy outlook overall. Lets hope this does not happen. (Dr. Sattar is Chairman, Policy Research Institute of Bangladesh. E-mail:   zaidisattar@gmail.com)

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