The US Debt Crisis and Downgraded Credit Rating has Global Implications
In August 2011, credit rating agency Standard & Poor’s (S&P) downgraded the USA’s long term federal debt from AAA to AA+ for the first time since 1917 suggesting that US treasuries are no longer risk free assets. As the world’s largest economy, biggest importer of goods and the US dollar being the world’s reserve currency, the downgrade has far reaching implications for the global economy.
The US downgrade by S&P came despite the announcement in early August 2011, to raise the US debt ceiling (the legal limit on total amount of debts the US government can run in order to pay its bills) by US$2.1 trillion, from its existing limit of US$14.3 trillion eliminating the need for further increases until 2013. The government also outlined further plans of spending cuts worth US$2.5 trillion over a 10 year period.
According to S&P, the trigger for the reclassification was the failure of the US government to present a viable plan to manage its government finances, as opposed to any doubt over the ability of the USA to reduce its deficit. The government’s budget deficit has increased from US$403 billion (3.2% of GDP) in 2005 to US$1.6 trillion (10.6% of GDP) in 2010. As a result, public debt rose sharply from 61.7% of GDP in 2005 to 91.5% in 2010.
USA’s Government Public Debt and Budget Deficit: 2005-2010
- The most immediate impact of the US debt crisis has been a loss of investor confidence and liquidity of global financial markets. Global stock market indices plummeted following the downgrade; the Dow Jones Industrial Average fell by 11.7% by 8th August 2011 from its closing value in July 2011. The loss of liquidity could mean slower growth in countries such as India, which rely heavily on the USA for financing. Many investors were already trying to diversify away from the USA and the ratings change is likely to hasten this diversification;
- Although the US dollar still holds world currency status, the downgrade is likely to weaken the currency in the medium term. Like gold and the Swiss franc, the US dollar was previously regarded in the eyes of many investors as an ultra-safe investment. The flood of investment into the Swiss Franc, Japanese yen and gold after the announcement of the US downgrade is indicative of the fact that the perception of the US dollar has been tarnished. By mid-August, gold prices almost reached US$1,800 per troy ounce from US$1,614 per troy ounce at the end of July 2011;
- Other emerging market currencies such as Indonesia, Brazil and South Africa were already appreciating against the dollar before the downgrade due to high interest rate differentials that attracted foreign investments. For example, the Brazilian real has appreciated by 11.7% annually in July 2011. This is likely to impact the export competitiveness of many these countries and might warrant further protectionist measures in order to safeguard domestic economies;
- Due to its world reserve currency status, US treasury bonds are owned by governments of many countries. According to the US Department of the Treasury, by June 2011 China was the biggest foreign holder of US treasury bonds at US$1.2 trillion followed by Japan (US$911 billion). The UK was the third largest foreign owner of US treasury bonds, at US$350 billion by the end of the same month, less than half of the value owned by Japan;
- As the world’s largest consumer of crude oil in 2010, the US downgrade had an immediate impact on crude oil prices. The debt crisis in the USA has renewed fears of slowing economy with crude oil prices (WTI Cushing) declining to US$79.32 per barrel by 8th August 2011, after reaching US$97.30 per barrel in July 2011. This is likely to reduce inflationary pressures in the near term impacting both businesses and consumers. For businesses, the fall in crude oil prices could lead to reduced distribution, production and input costs, which will help to increase profit margins;
- The US downgrade came at a time when the US economy was slowing and consumer confidence continues to be below pre-crisis levels of 2007. As a result, consumer expenditure in the biggest consumer market in the world, is set to remain stagnant until the end of 2011 at US$10.1 trillion, unchanged from 2010;
- The US downgrade is likely to worsen the EU debt situation. This is because the USA was previously seen by many as infallible, and the downgrade highlights the delicate state of the heavily indebted economies in the EU, especially France and the PIIGS countries (Portugal, Ireland, Italy Greece and Spain) in a worse light for investors. In a bid to contain the debt crisis in the EU, the European Central Bank (ECB) bought Italian and Spanish bonds for the first time in mid-August 2011. In addition, other AAA rated countries that have high levels of public debt, like France (84.8% of GDP in 2010) could also have their credit ratings reduced;
- As the world’s biggest importer of goods in 2010, many emerging markets are likely to try to diversify their exports going to USA. Asia in particular, which accounted for 34.0% of total imports into the USA in 2010, has attempted to increase regional trade since the global economic crisis of 2008-2009. China and Mexico, accounting for 19.5% and 11.8% of US imports in 2010, will be affected the most as a result of reduced US demand for imported goods.
USA’s Imports by Region: 2005-2010
- There have been fears that the US economy is at the risk of a double-dip recession. Real GDP is forecast to grow by 2.5% in real terms in 2011 but there is a possibility of a downward revision if the slowdown continues. On the positive, unemployment rates fell marginally in July 2011 to 9.1%, down from 9.2% in June 2011;
- A sell-off of US treasury bonds is highly unlikely and many major economies will continue to hold high levels of US treasuries. The US bond market is far bigger and more liquid than advanced countries in the eurozone or any emerging market economy, making its treasuries desirable investments. In mid-August, another major credit rating agency – Fitch ratings – has affirmed its AAA rating for USA’s long term federal debt;
- The ability of the USA to rectify its budget deficit looks promising if the government can overcome infighting to implement the planned austerity measures. The IMF forecasts a budget deficit of 10.8% of GDP in 2011 after which it is expected to decline consistently to 5.2% of GDP by 2014. However, public debt levels are projected to rise from 99.5% of GDP in 2011 to 108% of GDP by 2014;
- The domestic impact of the US downgrade could be offset to some degree by the announcement the Federal Reserve aims to keep the federal funds rate at near-zero levels until mid-2013 in order to support the economy. This move could help the market to stabilise, encourage growth in the property market, and have a positive impact on consumer spending levels in the mid-term. On the other hand, low interest rates in the USA also increase the risk of overheating in many emerging market economies.