Sovereign downgrades typically have two major consequences: first, interest rates increase as investors require additional returns to justify increased risk; second, banks have to raise capital as Tier-1 capital ratios are weakened, slowing lending and the economy. With the United States remaining as the world’s safe haven for capital during crises, these consequences are unlikely to materialize in this case.
Interest rates are unlikely to spike because there is no other low-risk alternative for capital preservation. With Europe’s own sovereign debt crisis turning it into a ‘hot-zone’, and the US economy teetering on the brink of a double-dip recession, capital has nowhere to turn except US government bonds. Equities are clearly not an option as benchmark indices have plummeted despite cheap valuations. European government debt may not be denominated in Euros by the time it matures. The best performing asset class during the past few weeks has been US Treasuries. The ten-year opened Tuesday at 2.38%, near all-time lows, despite warnings of a downgrade.
US banks, unlike other banks during sovereign debt crises, are not at risk. US banking laws treat US government debt as the safest holding regardless of credit rating so there is no need for banks to raise money to strengthen their capital base. The most imminent risk to US banks is the opaque derivatives trades banks have entered into to speculate on European government debt.
It is also important to acknowledge the political nature of downgrades. S&P’s decision is an effective commentary on Congress’s mismanagement of spending and broken processes. However, S&P also has an axe to grind as Congress embarrassed the ratings agencies by implicating their behavior as one of the root causes of the global economic downturn.
This downgrade is driven more by the fraught relationship between the US government and S&P, than challenging current economic realities. Real sovereign risk lies in Europe where each round of draconian spending cuts lowers the probability of recovery increasing the risk of a Eurozone default.
Emerging Markets Impact
For emerging markets, after a period of short-term volatility, it will be business as usual. China will complain loudly as the downgrade bolsters its case for more stringent debt management in the United States. These complaints will lack teeth, as China will need to maintain and add to its US Treasury portfolio to protect the asset from painful devaluation. A large sale of US government debt by China would be far more impactful to markets than the revised credit rating from S&P.
Other emerging markets stand to gain from this decision. They will lobby the ratings agencies for higher credit ratings based on improved debt management processes and lower debt ratios. The ratings agencies will have to react in favor of the emerging markets issuers, or risk losing their own credibility. In the years to come, the decision to downgrade the US (and possibly France, Germany, UK, Australia and other debt-laden markets) will benefit emerging markets as higher ratings will result in lower interest rates and more liquidity for them. Having access to capital markets on these terms will be one of the most important steps in graduating emerging markets to emerged markets.
