Monday, August 1, 2011

US is no Japan if it loses triple-A rating

Aug 1, 2011

Those expecting debt downgrade to be non-event may be in for a rude shock

WHENEVER the possibility of the United States losing its triple-A debt rating is discussed, someone, somewhere, always manages to pull Japan into the conversation.

The usual refrain is that after more than 10 years of losing its triple-A credit rating, Japan is doing quite all right in the eyes of its creditors. Even now, the Japanese government can borrow money for a decade at about 1.09 per cent, a somewhat lower rate than in February 2001, when Standard & Poor's cut its AAA rating. Hence, the sky will not fall if the US is downgraded by rating companies.

Or so the argument goes.

Well, don't bet on it.

First, the Japanese government forces most of its sovereign debt down the throat of its domestic banking system; the US sells its Treasury securities to the central banks of China and Saudi Arabia. That is a big difference. Local buyers can be cajoled, hustled or arm-twisted; foreigners need to be lured, their confidence has to be earned and preserved.

A second and related reason is that Japan runs a current account surplus. In other words, the Japanese routinely sell more goods and services to the world than they buy from it. The surplus is the capital with which Japan goes shopping.

The public and private sectors in Japan together own 252 trillion yen (S$4 trillion) more of overseas assets than foreigners own of Japanese assets. The US, by contrast, is a debtor nation. Foreigners' claims over US assets exceed American claims over overseas assets by US$2.5 trillion (S$3 trillion). If the governments in Washington and Tokyo are treated differently in the bond market, no one should be surprised.

The third reason why a downgrade of US debt may matter more than it ever did for Japan is inflation. Japan has spent two decades battling deflation (falling prices) and disinflation (a slowing pace of price increases). The US does not have an inflation problem right now. In no month since the collapse of Lehman Brothers in September 2008 have consumer prices risen 4 per cent or more from a year earlier; the most recent reading for June was 3.6 per cent.

However, expectations are building up that once confidence in the economy improves, all the cash the US Federal Reserve has poured into the economy will leave the vaults and start chasing goods and services. That might lead to high inflation.

Naturally, bondholders who want to protect their wealth from being eroded by escalating price levels would demand higher yields in compensation - something they have had no reason to do in Japan.

Gross government debt in Japan was 220 per cent of gross domestic product last year, compared with about 92 per cent in the US. If the US wants to emulate Japan and force domestic investors to hold its debt, it might still be able to do that. But it would be similar to imposing a tax on its financial institutions. Such a levy would render them uncompetitive.

A downgrade of US sovereign debt looks more certain as each day passes without a sign of a credible plan to balance the budget according to the plan approved by the US Congress. This plan entails lowering the budget deficit over the next 10 years by about US$6 trillion.

The Democrats are reluctant to cut spending - especially on entitlements - beyond a US$2 trillion expenditure reduction offer President Barack Obama made in April; the Republicans are being squeamish about accepting tax increases. And there is no third way to bridge the gap.

True, a ratings downgrade is not the most immediate worry. A more threatening concern is the ceiling on US government debt. The world is still hopeful that good sense will prevail in Washington and the limit will be raised ahead of tomorrow's deadline.

If the Republicans continue to stonewall Democrats and the Obama administration, the effects will no doubt be calamitous. Social security payments are due on Wednesday, and coupon payments to bondholders have to be made on Aug 15.

Just to meet these two obligations in whole, the government will need to scale down health-care commitments - Medicare and Medicaid - by three-fifths, and other discretionary expenses by 85 per cent, according to a Credit Suisse analysis, which has also attempted to put a value on the knock-on effects this belt-tightening by the government will have on the rest of the economy.

In Credit Suisse analyst Andrew Garthwaite's assessment, if Americans were going to produce goods and services worth US$100 this year, then, in the absence of a debt deal, at least 50 cents of the output - and possibly more - would be lost this month alone. If the stalemate continues for three to six months, 'the risk of a US recession would be very significant', Mr Garthwaite concludes.

This, however, is a more benign outcome than the disastrous drama that might unfold were the US to miss out on any of its debt payments.

In such an event, credit markets globally would seize up; banks would stop lending to one another. Global trade would come to a standstill in the absence of financing. Emerging economies would suffer for no fault of theirs. It would be a repeat of the last quarter of 2008 - only, it would be much worse.

By comparison, getting booted off the lofty pedestal of triple-A sovereign rating - which the US does not anyway deserve - will undoubtedly be a less severe outcome for the domestic economy as well as for the investment community at large.

It may also prove to be a temporary problem. If politicians in the US do get around to addressing the long-term budget imperative after next year's elections, there may not be much of a lasting impact from the downgrade.

The biggest danger would be complacency and propagation of a mistaken belief that the US government can continue to be profligate and yet manage to borrow cheap, forever. Investor expectations have a tipping point whose location is unknown. But once it is crossed, things can get out of control very quickly.

Greece serves as a warning. In October 2009, the Athens government could borrow 10-year funds for as little as 4.4 per cent. Now, it is completely shut out of credit markets.

Those who are expecting a US debt downgrade to be a non-event, just like in Japan, may be in for a rude shock.

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