The economic uncertainties facing the US, particularly in the aftermath of the downgrade of its credit rating, have brought back fears of a downturn in the global economy. While no one doubts the difficult times ahead, few would like to hazard a guess on the extent of adjustment costs that this most recent crisis emanating from the world’s largest economy would bring. However, even if the precise dimensions of the problems cannot be anticipated, there are tell-tale signs that unless the US economy undergoes a structural change, its troubles and, therefore, those of the global economy, are not going to disappear in a hurry. In short, the time for quick fixes is passé.
It would seem that for the US “bad news comes in threes”. Alongside the news about the downgrade came the strongest evidence that the US has indeed gone into what John Maynard Keynes called the “liquidity trap”. This is a situation where monetary policy does not work, in other words, the rates of interest are so low that potential investors prefer to hold on to cash in the absence of a viable option. Last week, the Bank of New York Mellon provided the evidence of the “liquidity trap” in the US economy through its decision to charge corporate depositors a fee for putting money on deposit instead of paying them interest.
What are the possible ways out of this impasse? The most widely professed view is that the solution lies in the classical Keynesian prescription of the government to borrow. This solution is not available to the US administration now that Congress has linked the raising of the debt limit to a cut in federal spending. The administration seems no longer in a position to spend its way out of a squeeze.
But it is the downgrading of its credit rating, the first time this has happened since the US emerged as the world’s biggest economy, which could considerably affect its standing in the world. While Standard and Poor’s (S&P) has faced the flak for the downgrade, the more significant development was the move a few days prior to the S&P announcement by the Chinese credit rating agency Dagong to downgrade the local and foreign currency credit rating of the US from A+ to A with a negative outlook. For a number of weeks, expectations were rife that the US’ credit rating would be lowered, but quite clearly none of the leading rating agencies had dared to do so until Dagong pulled the plug. Whether the Dagong-S&P moves set off herd behaviour among the rating agencies would be seen with interest.
While the precise ramifications of this downgrade—coming particularly from a credit agency from the US’ largest creditor country— may be felt in the weeks and months ahead, there are indications that the Chinese are signalling diversification of their assets away from dollar holdings. Currently, China holds around $1.5 trillion in US treasury bonds, but advisers to the Chinese government have already started commenting that the dollar holdings may hurt the country in the medium term. Suggestions are also being made to limit the holding of treasury bonds to $1 trillion.
Most of these suggestions are unlikely to be implemented in the immediate future for two reasons: One, China can ill-afford risking a huge depreciation in value of these assets that would result from a sudden loss in confidence in the dollar, and two, it has rather limited options to park its $3 trillion plus reserves. The US treasury bonds remain the largest and most liquid investment product in the world despite the recent upheaval. Further, China can do little to limit its dollar holdings as long as it maintains the extraordinary trade surplus that it has enjoyed with the US. The size of the US market is such that even the best efforts the Chinese may make towards diversifying their exports, are likely to pay dividends only over the medium term. It must be mentioned here that China has been taking several steps to deepen its trade relations with some of the major emerging economies by promoting the use of bilateral swaps and even promoting the use of yuan. These moves will not only help China to reduce its dollar overhang, it will also pose a serious challenge to the dollar as the primordial international currency.
Another development worth noting is that China has upped the rhetoric through its severe comments on the economic governance of the US. For instance, the downgrading of the credit rating was ascribed to the defects in the US’ political structure that were exposed during the bipartisan struggle in Congress, as a result of which the US government faced great difficulty in defusing the sovereign debt crisis. In the view of the Chinese authorities, the interest and safety of the US creditors lack guarantees needed from political and economic risks. While the global economy will adjust to the emerging reality of the growing weakness of the US economy, the shift in the economic power balance, which is an inevitable consequence of the events unfolded in the past few weeks, will be watched with interest.
Illustration by Jayachandran/Mint
Biswajit Dhar is director general at Research and Information System for Developing Countries, New Delhi
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