Impact of U.S. debt downgrade

August 8, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

Standard & Poor’s has cut the U.S. triple-A rating down to AA+ which if one is to go by the technical meaning, says the U.S. is no longer as reliable as it was last week when it comes to repaying its debts.

U.S. debt is now hovering around 100 pct of its GDP ($14-15 trillion).

However, what’s more worrying is the manner in which U.S. politicians driven by short-sighted electoral objectives pushed the country to its reputational edge, making them look very similar to some of the much maligned emerging market leadership which lacks political will to take hard and nonpartisan decisions.

The game was not very different with the Republicans sheltering the rich with lower taxes and wanting to prevent the Democrats playing to their gallery by spending on welfare.

As a lender would put it, the quality of management and ability to deliver the growth agenda while keeping its accounts balanced is in doubt.

This has not gone unnoticed by S&P and has contributed to the downgrade decision which it also says is based on projected growth leading to the debt reaching $21 trillion in ten years.

China is really the U.S. production shop set up to keep production input costs as low as possible in an attempt to stem inflation and migration. Seen in a different way, the U.S. and China are really two parts of one economy separated by sovereign borders and resulting political considerations.

The dollar surpluses get invested back into U.S. Treasuries. The dollar’s exchange value will depreciate causing heart burn for countries like China and Japan which hold more than $1.2 trillion and $900 billion in U.S. debt. China also faces a possible depletion in its already meagre export margins. The U.S. slowdown therefore, means slower growth in China and its riled response questioning Washington’s ability to pay its debts and enforce fiscal discipline is quite understandable.

The U.S. debt at $14.5 trillion is like 100 pct of Italy’s GDP. However, that’s where the similarity ends.

The situation is more like Japan whose debt is over 220 pct of GDP which it continues to service through low cost debt, a scenario which may well get replicated in the U.S.

In the immediate term, the U.S. interest rates may see a marginal increase considering it will be rated lower than rates quoted on other AAA rated countries like Germany.

With the challenges facing the euro, there seems no easy alternative to the U.S. dollar and U.S. Treasuries especially when gold is already in bubble zone.

Unlike China which has about 40 pct of GDP from external trade, India’s is only about 15 pct of which the U.S. may be about 9 pct. This may well be time the Federal Reserve may do a QE3 to stimulate the economic momentum.

India is largely a domestic economy which is what pulled us through the post nuclear test U.S. sanctions and even if we are more integrated into the global economy today; I would believe the fundamentals supporting the India economy remain valid.

Therefore, the impact on India in sheer economic terms is really nowhere as material as the challenges posed by our internal challenges particularly stubborn inflation and deficits.

The RBI has acknowledged ample liquidity and market hygiene in India. The Prime Minister’s economic adviser has assured us that growth will remain unaffected.

A slower global economy could cool commodity and oil prices which may help in bringing down India’s stubborn inflation thereby giving the government time to put its languishing reforms agenda through and RBI the time to test the transmission of its monetary policy measures and slow down its interest hikes.

All said, I would believe that S&P’s downgrading should have been discounted by all markets much earlier and the Friday fire sale was triggered more because of the ‘in the face’ nature of its declaration.

Even if India GDP grows by 7 pct, it would easily be 3 times of global growth. Therefore, in the medium term, India which has now corrected itself to a FY12 PE 14-15 and FY13 PE 12 multiple, is possibly the best alternative for FIIs.

Indian equity markets could possibly see a rise in Q3 and Q4 of FY 2011.

That a country whose currency makes up 61 pct of global reserves should be subjected to a downgrade is bound to unnerve the global financial system because it reflects poorly on the future outlook for the global economy. It would be naïve to assume any country would go unaffected.

However, the truth really is that this is an unprecedented occurrence, the impact of which will get revealed only with the passage of time.

Irrespective, it’s another indication of the centre of economic epicentre’s gradual shift to emerging markets and Asia in particular.

Retail investors should only invest through mutual funds, stay on with their SIPs. It’s a good time to invest in emerging markets and more so in India.

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