Thursday, April 28, 2011

Markets Don't care about US Debt and S&P; warning ! Why?

As per the last report by Standard & Poor's that it has raised a concern it cuts America's AAA debt rating if the United States will not agree on how to address medium and long term budgetary challenges, but the health of the economy is stronger than last economic crisis. S&P might be wrong about US debt?

As per the statements by S&P “We believe there is a material risk that United States. policymakers might not reach an agreement on how to address medium and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation is not begun by then this would, in our view, render the U.S. fiscal profile meaningfully weaker than that of peer AAA sovereigns.” 

The chances of credit rating downgrade is 33 percent over next 2 years, highest probability in history.

Controversy is neither markets nor investors care about it, as indices keep touching new highs. It is because facts are quite different. Below is the comparison of the last government Savings and Loans Crisis in 1988 and now.

If we see, government debt has keep increasing since last crisis almost 23 years ago, but important factor is interest rates, which are very low, so the cost of carrying of current debt load means continuing to pay interest on debt is fraction of what it once was. For example in 1988 the average cost of a dollar of US treasury was 9 percent, while today it is around 2 percent

Current GDP of country is triple than what was in Savings and Loan crisis in 1988.

If we look in to the treasury portfolio, it has more diversified assets. Besides traditional bonds, Treasury now issues Treasury Inflation Protected Securities ( TIPS) to balance the interest rate risk of United States because interest rates on TIPS moves inversely to traditional debt securities. This will help treasury to diversify and manage risks.

According to the data from Treasury Department, interest expense as a percent of GDP in 1988 crisis was 4.23% and now it stands close to 2.8% declining steadily.
This means today the ability of US to serve its debt is 60 percent higher than it was in 1988.

Calculated in 2005 dollars, the GDP in 1988 was $4.95 trillion and interest expense was $321.4 billion. Today, interest expense has increased by about $50 billion to $375 billion, but GDP has swelled to more than $13.2 trillion. This clearly demonstrates that the U.S. has a much better ability to pay its liabilities than it did in the past.

Meanwhile, demand for U.S. debt continues to be strong. Sovereign purchases of our debt have never been greater in both the raw dollar amount and by the percentage of assets held in other countries. And US currency remains the world’s currency of choice, despite its recent decline.

S&P criticizes the weakness of the U.S. balance sheet compared to other AAA-rated countries, but it fails to name which ones. Perhaps this is because it doesn't exist. The Euro, for example, has been strong, yet five of its members have debt ratings barely above junk status. Italy, Spain, Greece, Ireland and Portugal are all heavily dependent upon bailouts.

The Chinese situation is also questionable. They are imposing wage and price controls to fight inflation, despite the failure of that policy in the U.S. during the Nixon administration. History tells us that once that policy ends, the Chinese economy will swoon along with the currency. Not only that, but the Chinese manipulate their interest rates, capping consumer savings rates at 2.75 percent while charging as high as 11% for consumer debt. That is not, so called stable balance sheet and currency.

S&P missed the mark then and is now trying to redeem itself by warning against another potential crisis. While this might be well-meaning, it is also irresponsible. To pronounce the U.S. insolvent is a very serious action that can damage the currency and scare away borrowers.

( Source: CNBC )


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