Monday, August 15, 2011

The real meaning of US ratings downgrade

Since the dust has settled down on the decision by the Standard & Poor's to downgrade the rating on long-term US debt, it may be appropriate to dwell into its real meaning. Far from the dreaded scare scenarios, the impact appears to have been more benign.

If the bond markets are any indication, and they are arguably the best barometer of market perceptions, then the US ratings downgrade appears to either have had no impact or, perversely enough, made the US debt more attractive. Subsequent to the announcement, investors have been piling into US debt, not out of it, driving down yields on 10 year Tresuries to its lowest in two years.

This flight to US Treasuries in the aftermath of the market uncertainty created by ratings downgrade and the Eurozone debt-crisis, is to be expected given the natural investor reaction of fleeing to "safe havens". For all talk of Euro-assets and gold, US Treasuries and other highly rated American corporate securities remain the assets of choice for global investors seeking a "safe haven", and will continue to remain so for the foreseeable future. No other asset categories posses the level of "institutional strength, depth and liquidity of the market", besides lower risk.

This market response is also an accurate reflection of the reality underlying America's current debt "crisis". A simple arithmetic calculation of the US debt situation reveals that the relative magnitude of the short and medium-term US debt servicing burden is more easily manageable than imagined, especially at the prevailing interest rates. Paul Krugman calculates that an additional trillion dollars in debt with 30 year bonds (at a real interest rate of 1.25%) translates to $12.5 bn in additional real interest payments or 0.07% of GDP in future debt-service costs. In any case, in this time of deep debt over-hang, there are several countries with much higher debt-to-GDP ratios who continue to enjoy the triple-AAA rating.

Felix Salmon has an excellent post which adds a much needed sense of perspective to the S&P decision. The S&P, he writes, measures only the "probability of default", not the details of the default - the recovery value for investors (amount that will be left after default), time the issuer will remain in default, or the expected way in which the default will be resolved. In other words, the S&P rating decision does not convey any signal about what happens after the decision to default, on the ultimate losses that investors are likely to suffer.

This also brings us to the distinction between the S&P and other rating agencies. In keeping with the information failure that abounds in financial markets, the important fact that different rating agencies actually rate different things is not as widely known. The ratings of different agencies are most often used interchangably, atleast certainly in policy making circles. Unlike S&P's focus on default probability, Moody's is interested in expected losses.

A sovereign credit rating of the kind signalled by S&P's "is therefore primarily a function of a country’s willingness to pay, rather than its ability to pay". S&P's ratings are not investment-advice, but a rating of how likely a creditor will default. In contrast, Moody's rates specific instruments and the expected value of their losses if the issuers default. It assumes that people will use its ratings in the context of deciding which bonds to buy and which bonds to sell. In investment speak, a S&P downgrade is not a "sell" rating as is the case with a Moody's downgrade!

In the context of the US, this difference means a lot. It is politically possible that the US Government, driven by the Conservative push, could formally default. But nobody doubts that any such "legal default" will be only temporary, before sense kicks-in and bond holders are paid out in full. The expected losses being virtually nothing (except for the market determined losses), it is no surprise that Moody's retained its triple-A rating for the US debt. In other words, the S&P downgrade means that the political possibility of a US sovereign default has increased, though it tells little about whether investors should exit US Treasuries.

In simple terms, the S&P ratings downgrade is more a reflection of the market's perceptions of the crisis in American polity than problems with its short to medium-term fiscal balance. And academics and commentators would do well to confine themselves to this interpretation, as investors already appear to be following.

And for all those still sceptical, there is the example of Japan.

Japan lost its triple-A rating in 2002, and early this year S&P took a second shot, with another downgrade to double A minus. Japanese bond yields have continued to fall, with yields on 10 year bonds dipping below 1% briefly last week. The FT describes this as "the lowest level of interest rates anywhere since Babylonian times"!

1 comment:

Anil Nilugonda said...

As Once stanley Kubrick said "The great nations have always acted like gangsters, and the small nations like prostitutes". so it is !!!