|The Downgrade: What It Really Means To China
by Patrick Chovanec on Aug 6, 2011, 8:50 PM
In my last post, on the Chinese rating agency Dagong’s credit downgrade of U.S. debt, I jumped the gun when I said, by way of introduction, that all three major rating agencies — S&P, Moody’s, and Fitch — had all decided to keep their rating for the U.S. at triple-A. Today, S&P announced that it has downgraded the U.S. from AAA to AA+, with a continuing negative outlook. So what does this mean, and how does it affect my comment about Dagong being “hypersensitive” to U.S. risk?
S&P’s downgrade does not come as a surprise, although I prematurely assumed that no news meant good news. As I noted in several interviews this week, the $2.1-2.4 trillion in savings that Congress’ debt ceiling deal with the President provides for falls short of the $3-4 trillion the credit agencies wanted to see to prevent a downgrade, so the possibility was always out there. In fact, Moody’s and Fitch were probably being a bit generous by maintaining a “wait and see” stance, perhaps to reward what they saw as a modest step in the right direction.
More importantly, S&P’s move doesn’t really tell market participants anything they don’t already know and have been thinking about for months. I’m not dismissing the significance of the event — which is historic, by any measure — but the actual market impact remains to be seen. Sovereign debt acts as a benchmark for many other types of credit. Most analysts believe the downgrade is unlikely to immediately trigger any debt covenants, but many worry there may be a ripple-effect across the U.S. credit landscape that will raise interest costs for all American borrowers. Regulatory and benchmark effects aside, however, this downgrade doesn’t tell us anything about U.S. risk we don’t (or at least shouldn’t) already know and have priced into our behavior.
The S&P downgrade doesn’t change my view of the Dagong rating. S&P dropped the U.S. from AAA to AA+, on par with New Zealand and South Korea; neither rating has ever seen a sovereign or municipal default in recorded history. Dagong dropped the U.S. from A+ to A, on par with Estonia, Malta, and Trinidad and Tobago, and — as I mentioned in my previous post — at least two steps below its ratings for some very worrisome-looking Chinese infrastructure project bonds that I wouldn’t touch with a 10-foot pole. True, both agencies downgraded, but they started and ended up in very different places.
The reasons S&P gave for its downgrade reflect long-standing, widely-shared concerns over the trajectory of the U.S. debt. The debt ceiling debate, and the compromise that emerged from it, reflect an awareness of those concerns and an effort to face up to them, although there are huge differences over what the solution should be. Dagong, on the other hand, appears almost eager to conclude that the U.S. economy and the U.S. political system are doomed. Its chairman has stated that he believes the U.S. is already in default, using (as he puts it) new bonds to pay off old ones in a kind of Ponzi scheme. (Of course, virtually every country, not to mention virtually every Chinese company — which are often funded by short-term loans rolled over on an annual basis — does exactly the same thing, as long as they’re not liquidating their debt). The point is, Dagong is still an outlier, its reading of the U.S. economy far more pessimistic (and, in many ways, more conspiracy-oriented) than S&P’s.
I just got back from taking my little boy to the doctor’s for a check-up, so let me try this medical analogy: Say the U.S. has been experiencing fiscal chest pains, maybe even had a fainting spell this past week, and went to a team of doctors for their opinion. Dr. Moody and Dr. Fitch both say there’s nothing wrong with the patient’s heart, but he should come in for another check-up soon just to make sure. Dr. Standard-Poor says he’s worried the patient’s heart isn’t as strong as it should be, and unless he stops smoking, watches his cholesterol, and starts exercising regularly, he could develop a heart problem. Dr. Dagong, a practitioner of traditional Chinese medicine, says that the patient’s heart is diseased and will probably give out. As he leaves the examination room, Dr. Dagong is overheard muttering that maybe that wouldn’t be such a bad thing, given the patient’s crude manners and dissolute lifestyle.
That sure sounds a lot like China’s official response to the S&P downgrade, which you can read about here. As I’ve said many times, though, this is a lot of sound and fury signifying nothing. The only plausible, long-term solution to China’s frustrations over holding U.S. debt is to cease accumulating official reserves (which it does by choice, in order to keep its currency low) and allow the dollars that it does earn to be used to buy U.S. goods and services and invest abroad, rather than financing U.S. fiscal deficits. Ironically, that’s precisely the kind of rebalancing the U.S. has been encouraging China to undertake for years.
Along these lines, this week’s must-read for China watchers is an op-ed that appeared in Thursday’s Financial Times, by Chinese economist Yu Yongding. It addresses precisely this issue in clear and compelling terms, and will hopefully prove more persuasive to Chinese leaders than the unwelcome ranting of foreigners like me.
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