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Did S&P overreact in downgrading the US?

Business Standard  |  New Delhi 

The move made sense since the chances of a in the future have increased, but the rating agency’s track record suggests that its analyses have been flawed and is unsound in this case too.

Ajit RanadeAjit Ranade
Chief Economist, Aditya Birla Group

Continuing with an would have been difficult to defend. And a post facto downgrade is also hugely embarrassing to explain

Standard & Poor’s (S&P) review of the AAA status had started more than two weeks before the August 2 deadline. This was the deadline before which politicians had to agree to a deal on raising the sovereign debt ceiling. In ordinary times such increases in debt ceilings would have been routine, just like raising the overdraft limit. As US GDP grows, it is but natural to keep revising overdraft limits upwards. The limit was raised seven times during the previous presidency, without too much fuss. But this time there was political brinkmanship, with Congress refusing to cooperate with the president. If the debt ceiling had not been raised before the deadline, the US would have crossed a new Lakshman Rekha of having committed a technical sovereign default. In that case, continuing with an would have been difficult to defend. And a post facto downgrade is also hugely embarrassing to explain.

Rating agencies have repeatedly faced flak for having been slow to wake up to risks, as in Lehman, or AIG, which enjoyed high ratings till the end. Two decades ago, in one of the biggest municipal bankruptcy in the US, that of Orange County, many county bonds enjoyed stellar ratings just weeks before going bust. There are numerous examples of ratings having misled investors, often ending up as protracted litigations. Even in the case of India, the S&P sovereign rating in May 1991 was actually higher than in 2001, a curious anomaly hard to explain. Were they slow in 1991, or were they too harsh in 2001?

Hence S&P chose to sound hawkish during the countdown to the deadline, and warned that a downgrade was imminent if a substantial and credible debt reduction plan was not put in place. The other two major rating agencies chose not to downgrade, but all agreed to a negative outlook. S&P’s actions were guided by the credibility of a future plan. Future debt reduction will require at least one of two things: (a) tax revenue increases; (b) reduced spending. Tax growth will need GDP to grow, which is unlikely due to structural impediments. These are high unemployment and negative net worth of one-third of mortgage holders. Growth will be tepid for the foreseeable future. Sharply increasing taxes on the rich or on corporations is also impossible due to the influence of the “Tea Party” folk.

As for prospects for reducing spending, these too are slim, since a large part is committed to entitlements like Social Security and Medicare. Reducing those benefits sharply would be political hara-kiri unless there is bipartisan support. But the bitter squabble leading to the debt deal brink convinced S&P that bipartisanship was dead, and substantial spending reduction was going to be difficult.

Of course there is a third option, which is reducing the debt through inflation. If the US were to run a consistent inflation rate of five to seven per cent a year for a decade, the resulting debt reduction would be like cutting spending in half. Inflation is a hidden tax that would transfer income from savers (i.e. taxpayers) to borrowers (i.e. the US treasury). But this too is unlikely to happen given the mandate of the US Fed. It is not the Fed’s job to inflate away government debt. So the chances of a in the future have increased, which is why S&P’s downgrade makes sense. The ensuing mayhem in stock markets, and the strange bounce back of treasury bonds is hardly a reason S&P should have held back. Maybe future policy-makers may actually thank S&P for the timely, though rude wake up call. Didn’t we curse them for not warning us about and The reaction of the US government to the downgrade was not unlike a developing country, which bristles at every downgrade. But better to be jolted by a rating than by an actual sovereign default. And better to hasten into a new world, wherein dozens of US corporations enjoy rating higher than their sovereign.

Gurumurthy KalyanaramGurumurthy Kalyanaram
Dean, Amrita School of Business

China has hardly moved any of its holdings out of the US. So, which is the most valued and trusted economy? Clearly, it is the United States’

Here are five reasons that the downgrade of US sovereign debt from AAA to AA+ by Standard & Poor’s (S&P) was wrong and flawed.

First, S&P’s record in the recent past has been deeply discouraging. There is nothing inspiring in the record. Here are some recent decisions by S&P. S&P, for good part, missed the monumental subprime mortgage crisis in the US in 2007-2009. The US Department of Justice is investigating the role of S&P in the mortgage crisis. As reported, the Justice Department has been asking about instances in which the company’s analysts wanted to award lower ratings on mortgage bonds but were overruled by other S&P business managers.

Let us look at how S&P fared with other economies. Ireland, which is in deep jeopardy, was awarded with its top-of-the-line in 2006, and S&P did not downgrade Ireland until March 30, 2009, long after its financial problems had become obvious, and the price to buy insurance on its debt had increased almost tenfold from a year earlier.

Spain, whose economy is teetering, maintained an AAA rating till January 2009 and, now, is still rated AA — only a notch lower than the US debt rating. Iceland, the tiny country that depends excessively on the banking sector, and which has come perilously close to national bankruptcy was rated in 2006 AA+, the same rating the US now has.

Greece, which now appears more likely than not to endure at least a technical default, had debt rated A, lower than most European countries but a reasonably good grade by world standards. It, too, was not downgraded until January 2009, and its bonds were still rated as investment-grade until March 2010.

Second, even in the current analysis of US debt and budget situation, S&P made a grievous and evident error in overestimating the debt by over a trillion dollars (double counting). So, S&P’s analysis is apparently not that sound — technically, too. The current investigation of S&P began before the decision to downgrade the credit rating. However, since the downgrade policy-makers have questioned the agency’s secretive process, its credibility and the competence of its analysts even more vociferously.

Third, here are commonsensical litmus tests and questions: Where would any country put its money? Not in India or Brazil because they are relatively small economies. Not in China because 40 per cent of that economy depends on export-import, which means China’s economy depends on the vibrancy of the US economy. Not in Europe with the near-bankruptcies and the Euro-crisis. Where else except the US? In fact, China, which holds over $1 trillion of US treasuries, has hardly moved any of its holdings out of the US. So, which is the most valued and trusted economy? Clearly, it is the United States’ economy.

Fourth, the US economy is the largest (over $15 trillion in GDP) and the most varied. The economy has grown consistently and robustly over the last 60 years.

Fifth, US securities account for 40 per cent of total market capitalisation. At eight and seven per cent, Japan and Britain are distant second and third. What about Germany, China and India? They account for about three, two and one per cent respectively of the global capitalisation or investment. So, which is a stable and attractive marketplace? Evidently, it is the United States.

As a footnote, it must be noted that as of August 15, the US equities markets had returned to pre-downgrade level, which was announced on August 5. On Monday, August 15, the was 11,482.90 and at 2,555.20 — the levels prior to the announcement of downgrade of US sovereign debt by S&P.

First Published: Wed, August 31 2011. 00:34 IST