The Standard and Poor’s Down-Grading of U.S. Sovereign Debt
The recent down grading of U.S. sovereign debt has apparently upset financial markets worldwide. But before we get carried away by a wave of “irrational panic,” as opposed to “irrational exuberance,” we should pause to reflect on the true meaning of the down-grading.
First of all, it definitely does not mean that the U.S. is more likely to default on its sovereign debt after the down-grading compared to before. In fact, the probability of a U.S. default was higher before the U.S. Congress raised the debt limit than afterwards and before the down-grading. If the U.S. sovereign debt deserves to be down-graded, it ought to have been done before and not after the debt limit has been raised. The down-grade therefore has little new information content—it conveys nothing new that we do not know already but it creates unnecessary and irrational panic. I have never taken credit ratings too seriously anyway—I have often argued that if the credit rating agencies are really good at discriminating among the creditworthiness of debt securities, they should be out there managing large investment portfolios and earning large fees rather than rating. We should not be overly concerned by a marginal down-grade issued by a credit-rating agency with a questionable track record of both over-rating (for example, sub-prime mortgage-loan backed securities and Icelandic banks) and under-rating (Chinese sovereign debt) in the recent past.
Thus, I do not believe the S&P downgrade in itself will have a significant impact–the damage to the U.S. credit standing has already been done by the bickering and inordinate delay in the U.S. Congress with respect to raising the debt ceiling. I believe the probability of a U.S. default of its sovereign debt remains close to nil, notwithstanding the credit rating down-grade. Thus, there is no need to panic and rush out to sell U.S. Government debt securities. Investors worldwide should remain calm, and not let hedge funds, which thrive on volatility, take unfair advantage during this period. This is not the end of the World as we know it. However, this down-grading may serve a domestic political purpose, a warning to the politicians to stop playing with the future of the U.S. economy only to advance their individual private agenda. It may also have been part of the political maneuvering on the part of S&P to forestall possible federal government regulation of the credit rating agencies. Thus, it may do some good ultimately. But the downgrade itself should have little effect on the real economy.
Second, in the short-term, with or without the downgrade, the U.S. Federal Reserve Board will do its best to keep the short-term interest rate low in the U.S. However, in the medium and long term, it is probably inevitable that the rate of interest will rise in the U.S., and that the foreign holdings of U.S. sovereign debt will begin to decline, albeit gradually. This may, however, be coupled with an increased domestic U.S. holdings of U.S. debt, as the result of a flight to safety (from equities). But the fact remains that there are very few alternatives to U.S. sovereign debt at the moment and that a massive sell-off of U.S. sovereign debt by foreign central banks is definitely not in their own interests so that it is most unlikely to occur. The U.S. is “too big to fail.” One win-win strategy for the U.S. Treasury and the foreign central banks is for the U.S. Treasury to issue long-term, say thirty-year, U.S. inflation-indexed bonds (Treasury Inflation-Protected Securities (TIPS)) to the foreign central banks so that the U.S. Treasury does not need to roll over as much of its debt as frequently and the foreign central banks feel comfortable holding U.S. debt securities long-term despite the possible expected devaluation of the U.S. Dollar vis-à-vis other currencies. It also enables the U.S. Government to send a strong and credible signal to the market of its determination to control inflation. It may even wind up saving interest costs for the U.S. Treasury in the long run.
Third, the real threat to the U.S. economy is the possibility of stagflation. It is for this reason that I believe it may be a mistake for the U.S. Government to focus solely on the reduction of the U.S. Government deficit, important that it is. The primary goal of the U.S. Government should be to restore economic growth and reduce unemployment as soon as possible. If the economic pie can be made bigger, deficit reduction will be made that much easier. What the U.S. Government needs to do is to try to change the expectations of U.S. households and firms about the future of the U.S. economy, and this it can do only through an unanticipated exogenous increase in real aggregate demand, with monetary policy having exhausted its effectiveness. But additional fiscal stimulus at the Federal level at this time appears unlikely, giving the inclinations of the U.S. Congress. What the Federal Reserve Board may wish to consider doing, instead of buying U.S. Treasury securities, is to buy long-term (possibly zero-coupon) state bonds, for example, in proportion to each state’s population, with the requirement that the proceeds must be used for new infrastructural projects within each of the states. This will increase both real aggregate demand (and hence real GDP) and employment rather quickly and help to change expectations about the future in a positive direction.
Fourth, the downgrade may actually have the unintended but, in my opinion, beneficial effect of cooling down the speculative fervour in the World financial markets today. The less bubbly the World is, the better it is for the real economy. Softening of commodity prices, including the price of oil, should be regarded as a positive development for the World economy.
But precisely because the downgrade itself will have little effect on the real U.S. economy, it will have little effect on the real Chinese economy as well, including Chinese exports to the U.S. The Chinese economy will continue to grow, based mostly on domestic demand, even as the U.S. and European economies continue to be plagued by various problems. However, we should expect that the residential housing prices in China will begin to decline in the near future–the Chinese Government is unlikely to loosen its monetary and credit policies until it sees some concrete signs of an easing in the prices of residential housing, which will in turn ease the domestic inflationary pressures in China. And if the Chinese economy continues to do reasonably well, the Hong Kong economy will also do reasonably well.
Foreign demand for the Renminbi for transactions purposes and as a store of value will continue to rise over time, as it has been doing over the past couple of years. I believe the Renminbi-U.S. Dollar exchange rate will continue its steady but gradual rise. The same will apply to some of the other East Asian currencies. However, it is unlikely for the linked Hong Kong Dollar-U.S. Dollar exchange rate system to be changed in the near future. This entire issue deserves a full article. Here, I only wish to point out the obvious: that a devaluation of the Hong Kong Dollar resulting from a devaluation of the U.S. Dollar against the major currencies actually increases the relative competitiveness of the Hong Kong economy and can lead to an increase in employment in Hong Kong. Conversely, any attempt to revalue the Hong Kong Dollar relative to the U.S. Dollar can only reduce Hong Kong’s relative competitiveness, decrease the exports of good and services from Hong Kong and raise the unemployment rate in Hong Kong.
Anyway, stay calm, China and Hong Kong will survive the downgrading of U.S. sovereign debt. The sky is not falling!
Lawrence J. Lau is a Hong Kong economist and the former Vice-Chancellor of The Chinese University of Hong Kong. He is also the non-official member of the Executive Council of Hong Kong from 2009.