It has been one week since S&P downgraded US credit and stock markets around the world has gone through one of their most volatile weeks ever. I’ve stayed close to the markets during this exciting week and in this note I’ll reveal some from my observations.
Let’s stop here for a while to explain about all of this mess: credit rating agency, credit rating, and its implications.
There are three credit rating agencies: S&P, Moody’s, and Fitch are widely recognized. Financially, a corporation or governmental organization needs a credit rating to issue debt securities (i.e. borrowing money). Why? Because credit rating reveals the default risk that lender will bear when buying these debt instruments (i.e. lending money), from that – discover the interest rate and price of the debt securities. For example, think about Unknown Corporation, it is a new and unfamiliar player has just joined the market and wanted to borrow money to expand its business. Who will trust this company to lend money to them? and how much is the coupon rate fair? at which price? Therefore, credit rating plays a central role on price discovering in debt markets. And do you how large are the debt markets? It’s not-many-known breathtaking number of US$82.2 trillion (2009), 42% higher than the world total stock markets capitalization of US$58 trillion (2011).
The credit rating assesses the default risk, hence, helps revealing the interest rate of the bond – this is the direct cost of borrowing from the borrower’s stand point. Take Vietnam for example, its VND nominated 10 Years Bond is now 12.65% yield annualized with S&P sovereign credit rating at BB-. If tomorrow S&P decides to downgrade Vietnam credit rating to B+. There will immediately increase the cost of borrowing from Vietnam government by either two ways: Vietnam government has to increase the interest rate of next issuance the same price of a bond or decrease the price of a bond with the same coupon rate to compensate for higher default risk. An increase in interest rate from international debt would immediately increase the government’s financial cost and potentially domestic interest rates. For this reason, since the last 30-40 years when the global economy started to converge, killing power of S&P, Moody’s, and Fitch has raised tremendously because they hold the key to the international debt markets and the cost of borrowing.
Why did S&P downgrade US credit rating? – (1) the political outlook are no-longer certain and predictable. The brinkmanship risen from Washington during its last debt ceiling debates made the markets quite disappointed. Under the 2012 election influence, two parties tried to gain advantages and delayed the agreement to the very last minutes. I’ve also got the chance to follow this issue, and from the agreement, I can say that most of the terms were favored to republican party. (2) S&P required the US to cut more and increase tax, that the last debt ceiling agreement failed to achieve. On August 5th, S&P lowered US credit rating one notch with the “negative” outlook. There is the very real risk for the US to continue be lowered one more notch by S&P as well as Fitch and Moody’s.
Here is the country sovereign ratings from Reuters in July 28th, 2011. US is now off AAA club:
What has happened since the US downgrade last week?
1/ The global stock markets has gone through one of the craziest weeks in their history. On Monday, the Dow decreased 600+ points (-5%), reversed 400+ points (+4%) by Tuesday. Wednesday and Thursday followed by a wobble of plunging 500+ points (-5%) and then turning around with 400+ points (+4%) recovery. Friday ended the week by adding 100+ more points (+1%) – closing only 1.5% lower from last week.
Globally, the same wildness observed from EU and Asia markets. Volatile market is a dream market for day traders. Few of my friends made a fortune on the first trading day after the downgrade by shorting. I don’t know their fate afterward (I hope they are doing well). But most investors were not quite comfortable with this fluctuated and unsecured market. Over the week, investors withdrawn US$14 billion from stock funds and effectively put US$48 billion into money market funds and US$1.6 billion into gold (think of those US$48 billion to flow to gold!!!).
2/ So are there any deep change on the US economy from the S&P downgrade? – No, actually the downgrade brought nothing new to the market, except the news itself. Dow had been decreasing from the week before the S&P’s opinion. The announcement was like a trigger on psychological nerve that spread the fear across the board and pushed up the worldwide volatility. Everybody knows that the US has a very serious long-term fiscal outlook. Most fundamentally, there is no runaway from US T-Bill toward other sovereign bonds like other Triple-A countries nor any increase in US T-Bill yield made by a selling off wave as some expected.
3/ Longer term: if not US T-Bill, where will the governmental reserves come to? Foreign debtors are holding around 46% of total US debt. China penetrates 9.5% and Japan holds 6.3% of total US debt, the rest of the world own only 30.2%. Japan announced early that US is the best place they could place their reserve and did not attempt to sell off US debt. China, even blames US fiercely, has no other choice but to continue directing its huge dollar earned from exporting to US back to US T-Bill. This is not an investment decision but a trade policies decision (I have a deeper analysis about US-China relationship regarding to this issue in the 1st comment of the note Is US a mega Ponzi scheme?). Economically, China will diverse its reserve, build up a strong domestic currency with the ambition of replacing USD someday, extensively invest into Latin America and Africa, fiercely invest into oil and other commodities like copper, and reduce its reliance on exporting to US by building up domestic consumption power and diversifying its exporting destinations.
Now in case those 30.2% want to run away and find a better place, there is not many options for them. The reason lays in the market system, not the governmental system or credit rating. There is no other markets that is large enough to absorb that whole bunch of money which flows from US money market.
Euro zone is too unstable with all of the monetary and debt troubles for these years. Ireland, Portugal, Greek, Italy, and Spain are in national debt trouble. England and France are in the risk of credit rating downgrade. German is too conservative and their market is not large enough. Other countries are simply just too small.
Asia. Buying China bond is an option. However, the China debt market is small and infant. Plus, a fix rate currency exchange and too much government control seem not supportive to the idea. Finally, there is problems regarding to legal framework and investment climate that constrain the monetary free flow. China needs time to develop it debt market and open itself toward international monetary flow. Japan is not so appealing regarding to its stagnant economy (even their bond market is large) and old demographic. India is too infant. Middle East is too political unstable.
Are you thinking about Latin America and Africa?
So basically, there is no place to go. US hedged all of this downgrade effect because its unique position that has been built for a hundred years of the world super power nation. There will be a little bit diversifying outside US T-Bill (China is the leader), but that’s it.
– Portland, OR – August 13th, 2011 –