Chaos was the law of nature; order was the dream of man?. Henry Adams captures the current state of economic affairs simmering since the start of the financial crisis in late 2007. The latest event is the announcement by Standard and Poor?s, timed as a bit of a surprise, of a credit rating downgrade of the US long-term rating to AA+, a notch below the AAA ratings the US Treasury has reportedly commanded since 1941.
It wasn?t as if the concerns underlying the downgrade were a revelation; concerns about the US federal liabilities, already large to begin with, had been progressively intensifying with each successive attempt, using either fiscal or monetary tools, to stimulate the moribund US economy. Including its contingent liabilities (its social security, Medicare, etc), the US fiscal burden has been pointed out as being worse than Greece?s. Threats of downgrades had been voiced as far back as late 2010, and then periodically reiterated by all the three major credit rating agencies. Even after the debt deal, S&P had expressed its doubts about the credibility of the projected reductions in the fiscal deficit, which is still a work in progress, with a committee to submit the final proposals in late November. The questions being raised post the financial crisis on the role of the ratings agencies would probably have upped the ante on the agencies to act proactively on significant stress points, of which the US had become one.
Initial market reactions to the changed reality of the US being stripped of its implicit gold standard status seem to have been quite muted, but some volatility is likely to persist for a while as the markets digest the implications, with some unintended and unanticipated ripple effects. There will be increased uncertainty, and risk capital hates this. It appears that foreign exposures to US debt?sovereign, corporate and personal?are limited, but still uncomfortably large in absolute terms. But a flight to safety away from US Treasuries? What are the alternatives? FDIC insured US bank accounts, German Bunds, Swiss Francs, oil, gold, emerging markets? There?s just not enough to go around in all of these.
In the shorter term, the effects on Europe might have more serious implications. The situation there was quite dire even before the downgrade event, and had been progressively and cumulatively worsening every day. Things are likely to deteriorate progressively from here on. First, bond spreads of many European sovereigns over German Bunds have already spiked much above normal levels. Costs of servicing the very high debt levels will increase, increasing the vulnerability of an already fragile ecosystem. Central banks have been scrambling even before the downgrade, with the European Central Bank recently resuming bond purchases that had been discontinued for the past 18 months. Even more fearsome is the prospect that the ratings agencies will follow up the US ratings downgrade with that of a large European AAA sovereign, some of whose have prospects, if not actual debt, worse than the US.
What are the implications for India? First, global risk aversion is likely to increase, and the hit on stock markets is immediately apparent. This volatility will eventually dissipate, and the longer term effects will then be factored in. There?s likely to be a slowdown in global growth, which will hit exports. The increasing recourse to external commercial borrowings will likely need to be scaled back, with higher interest costs. But the core effect will be on industrial commodities, specifically oil. While it is almost certain that commodities prices will fall, the effect on crude will need to be observed in the days ahead. As expected, crude has fallen yesterday, but the question is, what might reverse this? If a serious global slowdown threat emerges, leading to a resumption of quantitative easing, bond buying and (less probable) fiscal stimulative measures, there is a chance that crude will again start inching up, being one of the few risk-reward remunerative instruments left to investors. On the whole, though, this is unlikely, given the magnitude of the envisaged adverse impact on a global slowdown, particularly if China?s exports slow down.
Over time, the more serious concerns are the wider systemic impacts, with a weakening of confidence in the global financial public goods that the US produces: the dollar as a reserve currency, US Treasuries, and its financial system in general. These have served as anchors, however imperfectly of late, of global financial stability. In the final analysis, the core of efficiently functioning financial markets, as we have discovered, is confidence. This has been severely shaken, and the downgrade event might serve as a wake-up call to make a coordinated effort to fix some of the broken and dysfunctional components.
In particular, this is an extraordinary opportunity for India. The global financial architecture will almost certainly become more multi-polar, as investors seek to diversify out of the concentration risk. Without delay, reforms, not just financial, should be initiated, designed, among other things, to enhance investor confidence in viewing India as a preferred investor destination during the brief window of opportunity that the S&P rating action will have provided.
The author is Senior Vice-President, Business and Economic Research, Axis Bank. Views are personal