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21 October 2013

Dagong Downgrade - Sometimes Little Ripples Become Big Waves



Amongst all the debate, analysis and comment surrounding the tortured attempts of US executive and legislators to agree how to reconcile their differences and work out how to keep the flow of the nation’s finances going last week, one small item of news may have slipped under the radar of many observers. Well, small, but with possibly quite significant implications. The Dagong Credit Rating Agency, one of the four principal Chinese agencies, downgraded the United States from A to A-. Now, for those who like to indulge in a little schadenfreude, that puts the US below, for example, the UK, Belgium and, yes, mighty Botswana. Before dismissing this with a wave of traditional western feelings of superiority, it is worth taking a look at the well-argued reasoning behind their decision.

Difficult to Contest the Arguments

First, they point out that the shut-down of the Government spending which lasted for  - roughly – the first two weeks of October, is a reflection of a shortage of liquidity caused by the retirement of old debt without a concomitant increase in new debt. Between 2008 and 2012, the ratio of the government’s stock of debt to its fiscal income moved from 4.0 to 6.6. That clearly imposes a strain on the US government’s ability to pay its normal expenses, and reflects a genuine decrease in its actual solvency. In other words, if you've run you borrowings up to the limit and you don’t generate enough income to pay your expenses, something has to give – hence the shut-down.

Secondly, since the financial crisis of 2008 erupted, the gap between the stock of debt and the country’s wealth creation has grown markedly. Between 2008 and 2012 the stock of debt increased by 60.7% while at the same time nominal GDP increased by 8.5% and fiscal income (effectively, tax take) actually decreased by 2.9%. You don’t have to be an economic genius to work out that that’s not good; if the relationship between the increase in your debt, the growth rate of your economy and your tax receipts is like that, then the only conclusion one can draw is that the debt cliff will be a threat for a very long time. In other words, things don’t appear to be getting any better.

Thirdly, the contentious policy of quantitative easing has caused liquidity to be injected continuously over the period into the economy. The dominant position of the US Dollar as a reserve currency has enabled the US, effectively, to an extent to monetize its debt at the expense of the international holders of that debt. In other words, if you devalue your debt through QE, that looks good for you, but at the same time you devalue what your creditors are holding – and there will come a point where they will no longer sit back and watch that happen. The debt will become more difficult to sell, as international holders look for a safer asset. The estimate of the effective ‘cost’ to the holders of US debt between 2008 and 2012 is US$628.5bn. The caveat I must make here is that I have no way of judging the accuracy of that figure, but it doesn’t appear to be disputed.

Fourthly, the US Government, broadly, has no alternative to try and squeeze out of the hole it is in but to continually raise the debt ceiling, which is precisely what they have been doing. Unfortunately, that simply exacerbates the problem, because adding more debt when already the growth of income does not match the growth of debt is almost bound to lead to the problem getting worse and worse. The posited solution is in fact no solution at all.

Fifthly, the US politicians seem incapable of co-operating for long enough to begin to make some steps towards a rational solution, which frankly calls into question the solvency of the US Government.

That’s a summary of the logic Dagong have applied to their assessment of the current state of the US and the rationale behind their downgrade. I can’t pick too many holes in it.

Others may Follow?

Dagong are not the only ones, of course. Fitch are strongly rumoured to be looking at a downgrade (after putting the US on negative watch a while back), and the implications of this are potentially quite significant. The biggest holder of US debt these days is China, and downgrades, particularly coming from a Chinese agency, will cause waves. If Fitch follow, it will make more than waves; if the security level of US debt drops below that preferred by international buyers – and think particularly central banks here - then our picture of the world will change dramatically. The best guess is probably to expect more buyers chasing gold, since it’s difficult to make too much of a case for the sovereign debt of other states – a weakening of US creditworthiness will mean a relative strengthening for Euro, Sterling, Yen et al debt, but surely the ultimate triple-A asset of gold would see the greatest reweighting of asset allocation?

Politicians miss the Target

Now, there will be those who point out that the Chinese (and all the rest of us) have a vested interest in the security of the US, and there is of course a great deal of truth in that. I’m not for a moment suggesting imminent collapse and ruination; what I am saying is that the US problem is not eased by the actions taken by its politicians, and indeed the very short-termism that they are indulging in (all seeking electoral advantage) is making the problem worse and strengthening the logic behind Dagong’s assessment. Small ripples can spread a very long way and ultimately become frighteningly big waves.

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