How it affects the world The market society-based economic-financial model of the US, touted as the most efficient and defined, drove the process of globalisation from the early 1990s. Its neo-financial theories had cast aside the classical ideas of a savings-investment based economy and opted for a credit-consumption driven model. The world began blindly following the US. But there is a sudden turn. The neo-economic-financial model of the US is now facing a serious challenge to its rationale, and survival, since the global meltdown in 2008. The meltdown is not only questioning whether the US market-society model is suitable for the rest of the world, but is also interrogating whether the US model is suitable for the US itself. The debate, led surprisingly by US allies France and Germany, is intense in the world, but feeble in India. This may be because, fortunately, India has been slow to adopt the US financial model. But the story of the rise and downgrading of the US financial model is an important lesson for India. “Standard & Poor’s (S&P) has downgraded America from AAA to AA+”. This news flash from the US on August 5 stunned the world, sent stocks crashing, and made governments and central banks sleepless. Before analysing the stated causes of the downgrading of the US economy by S&P and what its impact is on the US and the rest of the world, here is a brief for the uninitiated about some basics. Many may think S&P is a public or multilateral body. It is not like IMF or World Bank or WTO. It is a privately-owned entity. It has evolved over 150 years as a financial agency that rates the creditworthiness of companies and countries, even unsolicited (See boxes on Page 2 for what S&P is, and how it does its ratings and what ratings like “AAA” symbolise).
What ‘AA+’ means
Till August 5, the US rating was ‘AAA’, indicating “extremely strong capacity” to meet its obligations. After the downgrade, it is now ‘AA+’ with just “strong capacity” without the prefix “extremely”. The addition of ‘+’ indicated that the US is still better than countries with an ‘AA’ rating. What does the loss of prefix “extremely” signify? In S&P norms, the prefix indicates the high capacity of a country to withstand extreme levels of economic stress and still meet its obligations. The extreme levels of economic stress which S&P has cited as general illustrations are, ironically, the stresses the US economy has undergone in the past and still met its obligations, like the 26.5 per cent decline in GDP during 1929-33; unemployment topping 24.9 per cent in 1933 and remaining above 20 per cent during 1932-35; 85 per cent fall in stock prices during 1929-33; 47 per cent fall in industrial production during the same period; 80 per cent fall in home building. What S&P has now questioned is the future capacity of the US to withstand acute levels of stress and still pay its debts.
The cited cause
The causes cited by S&P for robbing the US of the AAA grade are stated in technical terms. Shorn of the technicalities, the S&P concern is about the balance sheet of the US government, how its expenses are uncontained, how its revenues are not rising, and therefore how its liabilities are disproportionately high and going up. Added to that is the perception that there is no political consensus in the US. In sum, the S&P focus is limited to government finances and politics. But the situation is graver than it has been perceived it to be. So what the S&P has not looked at is more important than what it has looked at. But that falls beyond the current economic paradigm, which S&P cannot recognise or handle. That’s the epilogue.
The US and 19 others
There are still 19 other countries with an ‘AAA’ rating which today stand above the downgraded US. But most of them are insignificant. The 19 do not add up to US in human or financial numbers. Three of them—Isle of Man, Liechtenstein, and Guernsey, tax havens handling world’s dirty money—have populations of less than one lakh each; the next 10—Singapore, Sweden, Switzerland, Hong Kong, Luxembourg, New Zealand, Norway, Austria, Denmark, and Finland—have less than 100 lakh; two of them—Australia and Netherlands—have less than 3 crore. The total population of all of them is less than America’s. The aggregate GDP of all 19 nations accounts for less than 80 per cent of the US GDP; the total GDP of the first 15 nations is some 27 per cent of the US GDP; the GDP of the big four, just 58.5 per cent of the US’. So, whether the first 15 nations have or lose the ‘AAA’ rating will matter little; even if the other four individually have or lose the AAA rating will equally mean nothing. Given the size of the US and its economy, any setback to the US economy impacts the world. But this is only the preface to the story. The US impact on the rest of the world economy can only be understood in terms of three critical elements: one, the penetration of the US dollar in the world economy; two, the huge forex holdings of other countries consisting of US dollars; three, the gargantuan trade deficits incurred by the US, which translated into both markets for other countries and also supply of US dollars for the world.
Dollar penetration
Take the first element, the US dollar penetration in the global economy. Two-thirds of US dollars printed during 1980-2005 are consistently held outside, as if by design! That the figure remains unchanged for 25 years is a miracle. According to Bloomberg Businessweek, US dollars in circulation were $829 billion in 2007 and now, in March 2011, the figure has crossed $1 trillion. Applying the same 2/3 ratio, the total amount of dollars held outside will top $660 billion now. According to Bank of International Settlements, the total daily forex business is $3.98 trillion, of which the US dollar accounts for 42.5 per cent, that is $1.69 trillion a day! The euro is at less than half, 19.5 per cent. The high share of the dollar is due to the huge dollar stocks held outside and transacted. QED: half the forex market is dollar-based.
Forex holdings
Take the next, the share of US dollars in global forex reserves. Of the total reported forex reserves of all countries, two-thirds are in dollars. This huge share is also due to the fact that two-thirds of US dollars printed or digitised are held and transacted outside the US. The US dollar held outside is not idle; it circulates. That explains why 42.5 per cent of world forex business, including trade, investment and also derivatives, is transacted in dollars. This in turn translates into forex stocks in others’ hands. Forex holdings in others’ hands mean investment in US securities by the holders. The total forex reserves of the world are $9.7 trillion. If two-thirds are in dollars, that will be $5.8 trillion, 8 per cent of the global GDP in cash!
US trade deficit
The third element, the most important, is US current account deficit. It is a long story that has built the US economic and financial model. The US dollar became globally accepted in the post World War II period, because under the original IMF model, the US had guaranteed that the dollar would be convertible into gold at 35 dollars per ounce of gold. A run on US gold stocks in 1971 forced US President Nixon to suspend convertibility. But, with the dollar and gold having the same status, by that time world nations had hugely invested in dollar-designated securities, and over 40 per cent of the dollars printed by the US Federal Reserve were held by others outside. So those who had invested in the dollar had but to hold on to it, very much like a honeybee that had fallen into the honey pot!
But with the rise and rise of the US, particularly after the fall of the Berlin Wall, gold became relatively less valuable than the dollar. This turned out to be the power of the US as well as its nemesis. With the dollar as its domestic currency as well as foreign exchange, the US evolved and instituted a financial capitalist model with the dollar as the no-alternative global currency. The US imported goods and services and just exported dollars to pay for them; the result, as The Economist wrote in early 1990s, dollar printing became a most profitable industry! The direct consequence of it was the increasing and huge current account deficit of the US from 1976. This was nothing but importing goods more than what the US exported and paying for the difference in dollars, which are just IOUs, or promissory notes. Between 1976 and 2009, the US incurred current account deficits of about $8.5 trillion, that is, it issued promissory notes for $8.5 trillion. That turned into forex reserves of different world nations. For instance, China, whose factories worked non-stop to satisfy the US consumers, got in return trillions of dollars which accounts for the largest part of its forex reserve of $2.6 trillion! Now understand why the US downgrade shook global markets?
US financial capitalism
The three elements constitute the cornerstone of what was touted since the 1990s as global capitalism, but it is actually US financial capitalism. With its penetration and domination, the dollar became the de facto global currency. The US Federal Reserve became the de facto global central bank. If the Fed raised the interest rates, the world followed. If the US Fed chief Alan Greenspan hinted, by his remark that the Japanese stocks are high because of “irrational exuberance”, the Japanese market fell by 2.5 per cent that very day! That power inevitably translated into financial and political arrogance. The US became even more profligate. Greenspan even theorised that there was no need for US households to save; there is a global “savings glut”, with Asians in particular oversaving. He almost asked what the stingy Asians would do with their savings if the US were not there to borrow and spend!
Globalisation drivers
It is a combination of the three elements—dollar penetration, the trillions of dollar assets held by others, and the US current account deficit—that drove globalisation since the 1990s. The US current account deficit deepened dollar penetration; the combined effect of this was the huge accumulation of dollar assets outside. This defined the very idea, process and institution of globalisation. There could have been no globalisation without a global currency. There could be no supply of that currency unless its issuer was willing to incur current account deficit by importing more than exporting. So, only the currency of the country that runs deficits can be the global medium of exchange. As the US ran continuous deficits, the dollar admirably filled the bill. The US Fed, which controlled dollar supply and interest rates, encouraged Americans to be profligate. But this was not a game that could continue for long. The fundamentals struck. The US household profligacy—spending more than earning—led to the subprime crisis.
Corporates enriched
The US Fed policies to make the people spend beyond their current income, virtually bankrupted the government and families, and enriched the corporates. Family savings gradually declined over three decades and collapsed from 80 per cent of both to negative savings of 20 per cent in 2005, and as a result, corporate savings rose to 120 per cent of both. The US government was broke as early as the 70s; US households had funded the government but their savings came down since 1990s, crashed in 2005 and, from 2006, went negative. The steep cut in the interest rates from over 20 per cent in the 1980s to 9 per cent in the early 1990s to just 1 per cent in 2001, was intended to force households to spend, not save. During this period, consumer credit rose from $808 billion in 1990 to $1.7 trillion in 2000 and to $2.4 trillion in 2006. And during 2000-05, US households borrowed $3 trillion against the appreciation of their home values—called “home equity” in US financial jargon—and splurged it. Promoting consumption at the cost of savings made the US economy grow high during 2001 to 2007. But it bankrupted families and enriched corporates, leading to the 2008 crisis. The overborrowed households, unable to pay back the home mortgages, generated the shocks that became the sub-prime tsunami. Greenspan declared in March 2008 that US corporates have “soaked away more than half a trillion in cash” and that would save the economy. But the corporates did not spend one dollar to save the economy.
S&P is still missing it
But S&P has looked at only the balance sheet of the US government. It has not seen the balance sheet of US households. It committed the same mistake prior to 2008 when it rated the consolidated home mortgage bonds (CDOs) of US households. It looked at only the balance sheets of consolidating intermediate debtor banks, not the balance sheets of the households, the underlying debtors. The households were known to be living beyond means, which Greenspan even considered a virtue of the US economic model! The debt-burdened households generated shocks and tremors, which caused the financial tsunami in 2008. The financial state of US households—declining savings, turning into negative, is obvious. Yet, before 2008, S&P did not look at the household economics before AAA rating the CDOs. It has not done so even now. And had S&P considered this unalterable truth on August 5, it might have re-thought about the AA+ rating. Logic is self-evident: a nation cannot be more prosperous than its people; it cannot be more solvent than its people; it cannot be more liquid than its people. People need to have cash, not debt in their hands.
Standard & Poor's - What is S&P?
Standard & Poor’s (S&P) is a financial services company based in the US. It belongs to The McGraw-Hill Group, which publishes financial research and analysis on stocks and bonds. S&P is well known for its stock-market indices, the US-based S&P 500, with similar indices for Australia, Canada, Italy and India (S&P CNX Nifty). S&P, which used to credit-rate only companies and their securities, started assigning rating to countries from 1941. It is one of the Big Three credit-rating agencies, the other two being Moody’s Investor Service and Fitch Ratings. Its revenue is $2.61 billion (2009) and it employs 10,000 people. This is what S&P claims in its website: About $1.1 trillion in investment assets is directly tied to S&P indexes; more than $3.5 trillion is benchmarked to the S&P 500—more than any other index in the world; S&P 1200 index covers about 70 per cent of the global market cap; outstanding debt rated by S&P globally is about $32 trillion, in 100 countries; in 2009 alone, Standard & Poor’s published more than 870,000 ratings, including new and revised ratings.
What is rating?
S&P rating is an expression of its opinion on the overall credit worthiness of countries and companies. S&P opinion is forward-looking and not based on historical facts. Rating is a relative ranking, namely that someone is more creditworthy than another or others. The likelihood of default is the centrepiece of creditworthiness, which encompasses both capacity and willingness to pay. S&P associates high rating with the capacity to withstand successive economic stresses. S&P rating is vital to the investment worthiness of a country or company. It divides ratings into Investment grade and Non-Investment grade (Junk). The grading of the capacity to meet financial commitments is indicated by the following normative symbols—Investment grade ‘AAA’: Extremely strong capacity, highest grade; ‘AA’: Very strong capacity; ‘A’: Strong capacity, but somewhat susceptible to adverse economic conditions; ‘BBB’: Adequate capacity to meet financial commitments, but more subject to adverse economic conditions; ‘BBB’: Considered lowest investment grade by market participants. Non-Investment grade ‘BB+’: Considered highest speculative grade by market participants; ‘BB’: Less vulnerable in the near-term but faces major ongoing uncertainties; ‘B’: More vulnerable to adverse conditions, but currently has the capacity to meet commitments; ‘CCC’: Currently vulnerable, dependent on favourable conditions to meet financial commitments; ‘CC’: Currently highly vulnerable; ‘C’: Currently highly vulnerable to obligations and other defined circumstances; ‘D’: Payment default on financial commitments. Sometimes, grading is suffixed by ‘+’ or ‘–’ to show that if a country with grade AA is better than other countries with the same grade, it is graded as ‘AA+’; if it were worse than others with the same grade, then it is graded as ‘AA-’. But the rating standards of all agencies including S&P were heavily criticised for helping to create the financial bubble that led to the financial meltdown in 2008. Time said, “Both agencies granted ‘AAA’ rating to Collateralised Debt Obligations (CDOs) that were chock-full-of crap mortgages, thereby helping to precipitate the 2008 financial collapse. The Washington Post wrote, “Standard Poor’s didn’t just miss the bubble. They helped cause it.” So the S&P reputation suffered heavily during the 2008 crisis.
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