Straight from the Specialists
U.S. drops from AAA to AA+
(The views expressed in this column are the author’s own and do not represent those of Reuters)
It was S&P that took the lead and downgraded the U.S. with a ‘negative outlook’. The other rating agencies are not comfortable either with the current debt and fiscal status of the U.S. government and may only confirm later what S&P has already done now.
The reason for the downgrade is that the U.S. deficit reduction plan did not go far enough to stabilise the country’s debt situation. Presently, the U.S. fiscal deficit is over 9 percent of GDP, well beyond the generally accepted 3 percent limit which was a pre-condition for European countries to join the EU.
The increase in deficit and consequently debt was not so much the outcome of fiscal policies to counter the 2008 recession as the excessive defence expenditure by President George W. Bush. The latter pushed up debt by $6.1 trillion to $12 trillion. Obviously, increasing the debt limit is not a permanent solution. It is the increase in revenue or reduction in expenditure that can stabilise debt. The first option was ruled out; the second did not go far enough. The expected downgrading became inevitable.
That will have serious fallout not only on the U.S. but the rest of the world as well. First, the U.S. fiscal deficit is not wholly funded by U.S. public — it’s also funded by central banks of other countries. Foreign money in U.S. debt is about 28 percent of total debt. With a lower rating, there will be hesitation on the part of foreign central banks to buy U.S. treasuries which had been looked upon as the safest investment.
If the U.S. deficit is not reduced, the funding will have to come from internal sources, principally the Federal Reserve. That will expand money supply and generate inflation.
Second, to compensate for a lower rating, the U.S. will have to raise the interest rate on U.S. treasuries with consequent reduction in capital value. As the largest investor, China will suffer a huge loss on its $1.2 trillion investment in U.S. treasuries. The increase in rate will not stop with the treasuries but will extend to all other securities, including securities issued by private agencies. There can be an increase in interest rates all over the world and a fall in share prices.
The cuts in expenditure and the rise in interest rate will discourage investment and together slice off the rate of growth in the U.S. — there are apprehensions of double dip though the fall may not be as deep as it was in 2008.
Countries that are more integrated with the U.S. economy like China or Mexico may be hit a little harder than other countries. Exports to the U.S. will shrink because U.S. growth may stagnate and the dollar may weaken. Emerging market economies like India will find exports to U.S. decline, FIIs to repatriate some of their investments which will knock out stock markets, and FDI to slow down. A fall in growth will be inevitable.