downgrade and its impacts

In Money on June 7, 2011 at 7:52 am

This is an interesting picture. While it appears that S&P gave a black eye to the dollar, the real blow was delivered to the politics and politicians involved in the great debate to reign in the ballooning national debt.  The credit ratings is an interesting thing though. India has declared it’s ‘grave concern’ over the downgrade. What is all this fuss about?  To be sure, let’s first understand the bond market.

I came across a great counter-point to all the gloominess surrounding the drop in credit ratings the US suffered in the hands of S&P last week.  I am not an original thinker here, just summarizing from their own blog:

1. The vast majority of U.S. debt is held by big institutions like pension funds and central banks. Those institutions do their own research on sovereign debt, and don’t tend to be heavily influenced by rating agencies

2. Ratings are a factor in financial-industry regulations and in internal policies at financial institutions. But almost all of these regulations and policies treat a AAA rating the same as a AA rating.

3. When other countries were downgraded from AAA to AA, the effect was minimal in most cases, according to this this report from AllianceBernstein.

* Why a downgrade might be a big deal: There’s ultimately no telling what investors would do in case of a downgrade

S.&P. said that the recent deal to raise the United States’ debt ceiling failed to address the country’s mounting obligations.  Here’s the key takeaway from the agency’s statement:


In our view, the difficulty in framing a consensus on fiscal policy weakens the government’s ability to manage public finances and diverts attention from the debate over how to achieve more balanced and dynamic economic growth in an era of fiscal stringency and private-sector deleveraging (ibid). A new political consensus might (or might not) emerge after the 2012 elections, but we believe that by then, the government debt burden will likely be higher, the needed medium-term fiscal adjustment potentially greater, and the inflection point on the U.S. population’s demographics and other age-related spending drivers closer at hand.

The last sovereign that received an upgrade was after nine years of being downgraded!  In outlining what could lead to a further cut, to AA, S.&P. had this to say:

We could lower the long-term rating to ‘AA’ within the next two years if we see that less reduction in spending than agreed to, higher interest rates or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case.

Deven Sharma, President of S&P has a lot in his hands for downgrading a soverign that has held it’s turf for a very long time.

China has nearly $3.2 trillion of foreign-exchange reserves, and some estimate that as much as 70% are in dollar-denominated assets.  Little wonder that they expressed anguish at the downgrade.  As it becomes tougher for the United States to borrow, the interest rates on these T-Bonds go up.  This makes for an increased demand in the market.  So is this good for the consumer and bad for the government?  At least in the short term, this appears to be the case.  Here is the rating system that denied a superlative grade:

S&P lists 5 pillars in its Sovereign Rating Framework as:

  • Institutional effectiveness and political risks, reflected in the political score
  • Economic structure and growth prospects, reflected in the economic score
  • External liquidity and international investment position, reflected in the external score
  • Fiscal performance and flexibility, as well as debt burden, reflected in the fiscal score
  • Monetary flexibility, reflected in the monetary score(Source: Standard & Poor’s Sovereign Rating Framework)

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