In the evening of August 5, 2011, the Standard & Poor’s downgraded the US credit rating from AAA to AA+, and set its outlook as negative. This seemed to be a bold decision unprecedented the US history. In actuality, however, it was a product coming from the compromise between the Republicans and the Democrats to raise the US debt ceiling and the global stock sell-off triggered by market frustration at the inability of the US government to boost economy and rein in fiscal deficits. It was also a decision made in a hurry. Later, the rating agency bowed to the finger pointing by the US Treasury Department at its error in calculation because, indeed, it had miscalculated the US debt in the next 10 years by as much as $2 trillion. In the end, the agency had to take out this key parameter supporting its downgrade from its rating report.
We have no way to determine, of course, whether S&P had won private ‘agreement’ from the US government before making the decision. So far as the timing is concerned, however, its decision is nothing more than an action after the event. Instead of offering investors any positive help, it rushed to show itself as a ‘responsible’ agency, dreaming to gild the infamous role it played in the hideous financial tsunami originated in the United States in 2008.
Whatever the case, we must come to see that, in essence, the US credit rating downgrade is totally different from the debt issue in Europe, especially in Greece and Italy. In the latter case, debt has been raised for welfare purposes instead of promotion of economic growth. The United States also borrows from the world to buy and consume top-quality products. But that is not all. More importantly, it borrows money to increase its military power and strengthen its position in science, technology, education and other fields. We may hope to challenge the dominance of the current international monetary system by the US dollar. But can we readily find any currency for its substitution? With the deterioration of the European debt crisis, the defects of the euro have become all the more obvious. Backed by an economy long in slump, neither can the Japanese yen play such a great role. To shield off the excessive demand for the Japanese yen from venture capital, the Japanese government recently even intervened at the market through a massive sell-off to offset the negative impact on its economy from the continuous appreciation of its currency, even without taking the actual effect of such intervention into consideration. In this sense, it must be admitted that the harm from a default by the economically powerful United States will be much smaller than that from lending to countries that are economically weak, although these countries may turn a ready ear to your suggestion about improvement of their current situation.
Seen from a short perspective, the impact direct from the US credit rating downgrade will be an enormous increase in China’s cost from reduction of its large amount of long-term US Treasury bonds due to their price drop and poorer flowability. The basic principle governing any move by China, the largest holder of US Treasury bonds, to control such risks in the present-day climate is to ‘meet changes with constancy.’ Otherwise China will incur the biggest costs if it tries to sell its holdings at a time of market panic. The US government, now unable to offer any financial bailout and deep in the hot water with no room for any interest rate cut, will most likely renew its monetary policy of quantitative easing, a move that is most harmful to its creditors and extremely unpredictable in effect. Since the US market has now become fairly poor at self-rehabilitation and the European debt crisis keeps worsening, the global stock market seems to have lost its bottom. This is in reality a show of the doubt of the stock markets in various countries about the future recovery of the world economy.
Seen from a medium and long point of view, the impact direct from the downgrade will be fairly uncertain. Still, the key here lies in whether a new point of growth will be spotted in the US economy within the shortest time possible and whether its role and vitality as a world economic leader is best revived to firm the trust and confidence of global financial capital in the US government. Meanwhile, China may try to make up its losses at the bond market by seizing new opportunities to invest in other dollar assets. Whether or not the US dollar will give way to another currency, say, the Renminbi yuan or the supranational currency the euro, will hinge on the change in the US strength: whether or not its strength will go noticeably downhill due to fund shortage. On the other hand, whether China and other countries will seize this opportunity to build up their strength through system perfection and maximum exploitation of innovative talent will count. One major reason why South Korea has surpassed Japan to arrive at the farthest end of the international chain in some hi-tech fields is because fund shortage has cut deeply into Japan’s R&D ability. In other words, unless China keeps improving itself, its foreign assets will remain at the mercy of the rise or fall of the US economy.
As for the indirect impact, we will see a rapid and drastic drop in the bulk commodity prices due to the bearish look of the global financial market at the US economy, the continuous deterioration of the European debt crisis, and China’s continuation of a tight monetary policy, thus easing off some of the cost-driven inflation pressure accumulated so far. If no substantial improvement is expectable in the fundamentals of the global economy in the medium or far future, however, the prices of gold and bulk commodities will hover at a high level as people hoard them to hedge against risks. This will cut deeply into the investment capacity badly needed by emerging markets for development of their real economies. Also, without any other outlet, the liquidity flooding the world may most likely surge into the Asian market for its most bullish economy, posing an unprecedented challenge to the sustainable development and macro-regulation endeavors of Asian countries.
Any way, quite a number of countries in the world, including most of the commodity, oil and resource exporters in Asia and Latin America as well as Russia, are now US creditors. What is of top importance for us right now is, therefore, to put up an investment stage for onshore competition with the United States as soon as possible. Specifically speaking, in China’s case, Shanghai as an international financial center should first of all be turned into Asia’s market for onshore US dollar deals so as to bypass the bottleneck from the non-marketization of the exchange and interest rates of the Renminbi yuan and overcome its sharp shortage of qualified international financial talents and absence of risk control mechanisms, thus keeping its creditor’s rights in close hand and securing a rare time and space for constant completion of conditions for the internationalization of the Renminbi yuan. In this connection, we may bring China’s voice about reform of the dollar-dominated international monetary system to the summits of the G20, the BRICK and other international bodies in the practical and progressive way illustrated above and through the personal influence of Zhu Min, vice-president of the IMF who enjoys solid support from the Chinese government, thus joining forces with more countries of common interests to safeguard the due rights of China as the biggest US creditor.
Sun Lijian is an Associate Professor of finance in the China Center for Economic Study at Fudan University