Wednesday, August 24, 2011

The US debt crisis: Lower US credit rating and its discontent


The Jakarta Post (original link)

Berly Martawardaya, Jakarta | Wed, 08/24/2011 8:30 PM

For the first time in 70 years, the US Treasury bond (T-Bill) is no longer rated AAA by all rating agencies. On Aug. 5, it was downgraded one notch by Standard & Poor’s (S&P) to AA+.

For decades, the interest rate on the T-Bill has been known as the “risk-free rate”, because a US default was as close to impossible as anyone in financial markets could imagine, and all other bonds were priced relative to the US.

The US is likely to face higher interest rates on borrowing. The score given, from highest AAA to lowest D usually corresponds to the interest rate that the issuer needs to pay when borrowing money.

According to The New York Times, the average bond yield of a country debt with an AAA rating is about 3 percent.

The average yield of the bonds of the countries in the next three categories, which is where the US will be, is 4.15 percent. Thus, a debt-ridden America will have to pay more to borrow, which could lead to the country becoming trapped in a tangled web of deficit and recession.

However, it’s not all doom and gloom for the US. The other two major rating agencies, Moody’s and Fitch, maintain AAA ratings of the US Treasury’s debt. There will also be periodic reassessments by S&P of its downgrade.

Furthermore, major financial institutions still express confidence in US debt. “The US Treasury remains the benchmark for global yields and is also a key source of funding and collateral in money markets.

“The treasury market also remains the deepest and most liquid fixed income market in the world,” said Bob Lynch, global head of G10 currency strategy at HSBC in New York.

Global collaboration and show of support surely can’t hurt. Financial officials from the Group of 20 major economies reportedly held an emergency conference call on Aug. 7 to discuss the debt crises in the US and Europe following several days of market panic and a downgrade of the US credit rating.

What are the impacts of the US credit downgrade for Indonesia?

First, there is a potential influx of short-term capital to Indonesia. There’s likely to be fewer buyers of T-Bills due to risk perceptions.

Even worse, as most pension funds and money market funds, (current holdings are 338 billion), need to hold a certain proportion of AAA rated bonds, there will be massive selling in the near future.

Both events mean less capital entering the US economy, with investors looking for other sites for their money. Some will enter Indonesian stocks and bonds market, which, if left unattended and unguarded, could fuel an economic bubble and/or a shortage of capital if investments are suddenly moved to another country.

The Bank of Indonesia will need to tighten the rules for a foreign short-term capital influx to avoid the aforementioned problems.

Second, there will likely be an increase of Indonesia’s exchange rate to the dollar. The same short-term capital influx will result in the sale of the dollar and purchase of rupiah. If there is no volume increase in the opposite direction, selling rupiah and buying dollars, then the rupiah’s relative value to the dollar will appreciate.

Third, Indonesian exports will weaken. A weak US economy will consume less. US consumption has been the driving force of Asian economic exports including Indonesia. A higher exchange rate for rupiah will increase the prices of our exports and lower our competitiveness.

The Trade Ministry needs to actively look for further diversification of our exports to other countries and reduce our export reliance on the US market.

More importantly, Indonesia needs to diversify the means of exchange other than the dollar when conducting international trade.

Fourth, our reserves should be realigned. The dollar comprises a 60.7 percent share of global reserves. Being the currency of global transactions enables the US to print debt and sell it abroad while avoiding the risk of currency fluctuations.

The downgrade will lead central banks to reevaluate the safety of their reserve policies and reduce dollars while increasing their stocks of other currencies.

Over the last month, the dollar plummeted 6 percent against the Swiss franc and about 4 percent against the yen. China’s renminbi is getting stronger and the Chinese government is actively promoting its currency.

Bank Indonesia needs to realign the combination of currencies it holds in its reserves to reflect current international conditions and reduce risk.

Fifth, there could be a shift in economic dominance to East Asia, especially China. This could be a tipping point for the shift of global dominance from the US to its great rival China, where its central bank holds an estimated $1.1 trillion in US debt.

The Chinese state-run Xinhua News Agency recently declared: “China, the largest creditor of the world’s sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China’s dollar assets.

“To cure its addiction to debts, the United States has to reestablish the common sense principle that one should live within its means.

“It should also stop its old practice of letting its domestic electoral politics hold the global economy hostage and rely on the deep pockets of major surplus countries to make up for its perennial deficits.”

Indonesia enjoys good relations within East Asia in groupings such as the East Asian Economic Caucus, ASEAN+3 and CAFTA (China-ASEAN Free Trade Agreement). We should make the most of this opportunity to increase exports and use non-dollar currencies in trading with other regional states.

One of the most astute observers of the US said, “American infrastructure used to be the best, but the lead has slipped.

“South Korean homes now have greater Internet access than we do. Countries in Europe and Russia invest more in their roads and railways than we do. China is building faster trains and newer airports. Meanwhile, when our own engineers graded our nation’s infrastructure, they gave us a ‘D’.”

His name is Barack Obama and the quote is from his 2011 State of the Union address to the American people.

If America does not move fast to improve its economic, financial and political infrastructure, the D grade might be coming soon.

Indonesia needs to carefully adjust our economic policies to avoid being dragged down.

The writer is a lecturer at the School of Economics, University of Indonesia, and senior economist at the Institute for Development of Economics and Finance (INDEF).