A(major) price has changed. Has the price of everything else changed as a consequence?
In an action widely telegraphed by now, Standard and Poor’s (S&P) downgraded US debt by a notch to AA+. That’s the first time since the US was first rated AAA in 1917. The history buffs among you will recognize the quaint fact that it was the year of the Bolshevik Revolution.
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At once, it means everything and nothing. It means everything because the reference price for almost everything that is traded in the physical and financial marketplace is denominated in the US dollar. Oil, copper, information technology contracts, swaps, futures, among others, are priced and traded in dollars. Central banks with surplus foreign capital hold vault loads (figuratively) of US dollar bonds, led by the People’s Bank of China. In some senses it also means nothing because all it has done is suggest that the so-called riskless asset may have some (credit) risk. Unless people move off this asset as the riskless asset, it actually doesn’t change anything. The problem for the world is that no other set of assets has the institutional quality and experience of being the alternative “riskless” asset. Not the euro, not the renminbi, not the Swiss franc.
A commodity like gold could be an alternative. And it was, more than a hundred years ago, during the gold standard era. But the increasing sophistication of the world economic system and the lack of flexibility of the gold standard required the creation of so called “fiat” money. Fiat money is money that has value only because of government “fiat” or law. Since 1971 when the US finally banned conversion of the dollar into gold, all reserve currencies have been fiat currencies. Of course, it is the very flexibility of fiat currencies that is being questioned today. If the agent with the flexibility, in this case the US government, is not to be trusted, then the flexibility is better replaced with a lack of discretion, argue the gold bugs.
But gold is not a practical alternative, really. If we were to go back to the gold standard, every central bank would have to acquire gold in reasonable proportion to the money in circulation and the country’s gross domestic product. There is simply not enough gold to back today’s $65 trillion global economy. Even assuming it could be done; the price of gold would have to rise astronomically for it to be basically feasible.
All US government agencies were also downgraded by S&P. The large national home loan agencies Fannie Mae and Freddie Mac along with 10 of the 12 Federal home loan banks have been downgraded. S&P has not yet indicated what they are going to do with US state and local bodies’ bonds that have AAA ratings. The direct ramification of the S&P downgrade would have been forced sales by those bond investors who have covenants that restrict them to holding AAA-rated bonds as collateral. We’ve seen that the US Federal Reserve has already relieved the banks of this duty (banks hold US bonds as reserve). We will have to wait and see if other bondholders such as pension funds, insurance companies, and government agencies themselves make an exception in favour of continuing to hold US government bonds.
Bond markets in the US have been well behaved in the aftermath of the downgrade. Credit spreads have not blown out and money markets are largely functional (unlike in 2008). Equity investors though have taken it on the chin. For equity investors, the debt downgrade is only proximate cause. The real issue is whether the US is slipping back into recession. The recent decline in the price of oil and last week’s decline in long bond yields have lent some credibility to this fear. My own view is that given the dollar’s reserve currency status and the complete lack of an alternative, the US will muddle through without risk of default and with dull growth, but not a recession. This means that the only real price that will change, over time, is that of the dollar, particularly against the Chinese renminbi.
India has the relative luxury of watching this play out. A decline in oil and commodities, other things being equal, is positive for India. However, the usual smugness about our being “little affected” is out of place this time. S&P has noted that it makes credit decisions subjectively keeping the political climate, corruption and reform orientation in mind. It has hinted that India’s current debt rating (BBB-, which is the lowest investment grade) will likely be reviewed soon. Even a single notch reduction will reduce it to “junk bond” rating. While India does not have a large external base for funding its bonds, junk status could have devastating consequences for foreign direct investment and foreign institutional investment flows. Arise, awake.
PS: For equity investors it may well be time for Mark Twain’s words “to succeed in life, you need two things: ignorance and confidence”.
Narayan Ramachandran is an investor and entrepreneur based in Bangalore. He writes on the interaction between society, government and markets. Comments are welcome at firstname.lastname@example.org