The Debt Trap !....

In a gruesome competitive and capitalist, world, along with top grades one also needs to be a consistent high performer. Apparently, the quest for higher grades, spectacular economic performance and higher credit ratings are also sought by all countries. No wonder when the grades and ratings falls, it creates furore, even panic and all of this was evident last week!

There is a famous aphorism “When the US sneezes the rest of the world catches a cold”. With Standard & Poor downgrading the United States government's credit rating from AAA to AA+, the aphorism has again got triggered sending shock-wave and creating panic across the globe. The decision is based on political situation and therefore the S & P downgrade may appear symbolic but the ratings do not belie severe financial implications to the US economy.

Let me try and list down how this credit rating impacts US and the global economy.

The U.S. debt over $14.3 trillion is the largest in the world and is the sum of all outstanding debt owed by the Federal Government. Nearly two-thirds is the public debt, which is owed to the people, businesses and foreign governments who bought Treasury bills, notes and bonds. The rest is owed by the government and held as Government Account securities. Most of this is owed to Social Security and other trust funds, which were running surpluses. For many decades, the US government had a great credit rating (AAA), making it easier to raise money from other countries at very low interest rates. The US borrowed blatantly that it finally hit the debt ceiling. The debt ceiling is a self imposed limit for US Government borrowing. The Government recently decided to increase the debt ceiling but that implied its credit worthiness and weakening of US economy. As soon as the debt ceiling was increased, the S&P downgraded the US long-term debt to AA+.

So what made this debt large?

Government debt is an accumulation of budget deficits. Year after year, the government continued to cut taxes and increase spending. There is still no consensus among Congress as the Republicans are not ready to increase tax cuts and Democrats are still harping on sponsoring welfare measures. One of the reasons for increase in debt is due to the Social Security Trust Fund. Instead of investing revenue from Social Security Trust Fund, which was collected through payroll taxes leveraged on Baby Boomers, the Fund was loaned to Government to finance the increasing deficit spending. This interest-free loan kept Treasury Bond interest rates low and allowed more debt financing.

The other reason for increase in debt is due to Treasury Bonds. The US and China are two sides of a same economy. US have outsourced its production and manufacturing to low cost China and later spends its dollars to buy the produced goods. So, foreign countries like China ($1.1 trillion) and Japan ($ 900 billion) kept on increasing their holdings of Treasury Bonds as a safe haven, at low interest rates and thereby managed to keep their currencies low relative to the dollar.

The debt also increased due to other factors. The two wars dipped heavily into Government surplus. To add to that, in 2008 the real estate bubble followed with subsequent sub-prime mortgage crisis brought down several large banking and financial organisations. In order to bail out the failing financial institutions from becoming bankrupt, the US Government had to dole out huge amount of money. Because of this people stopped spending and that led to economic recession and job losses. With rising unemployment, government found difficult to raise money from taxes and so they reduced tax cuts. It would have also been expensive for US to borrow trillions of dollars from other countries to offer as stimulus packages to failing companies and therefore US decided to print money.

In hindsight the doling of money, coupled with restrictions on immigration appears to have been a temporary respite since it failed to promote industrial growth, attract entrepreneurs, create more jobs and generate income for government. The government also ignored austerity measures to reduce government spending and all these led to widening of the fiscal deficit.

How U.S. Debt Affects the Economy

The US government debt is a benchmark for global financial markets. For the past few months, the US economy has been under severe stress and the GDP growth appears stunted. There is a slow down in industrial production, decline in employment rates and warning signs of so called double –dip recession. A credit rating downgrade will definitely impact the world. Investors will demand a higher return for holding US government debt. This would mean increase in interest rates, increase in asset prices which in turn would diminish demand for US Treasuries, putting downward pressure on the dollar and thus slowing the economy.

By the time Baby Boomers retire, the Social Security funds have to be repaid. Since this money has been already spent, resources have to be identified to repay this loan. That would mean higher taxes.

As an outcome of all these developments, the demand for gold which is seen as safe haven has increased manifold. Clearly the U.S. economy is caught in a debt-trap. Globally there will be clamour for an alternative global reserve currency, but the dollar will continue to hold sway for want of a real contender. Meanwhile U.S. will have to set in structural reforms, increase taxes and control fiscal deficit as a corrective measure. Recovery would be a long-drawn and painful process.

The downgrading is certainly not good for Indian exports with falling dollar. Even imports would be impacted. Companies with higher exposure to developed economies will be more vulnerable and Capex plans will be prolonged.

However as far the Indian economy is concerned, the downgrade would have only temporary impact on the nation's domestic consumption-based and service-led economy. The RBI has acknowledged ample liquidity and market hygiene in India. Baring gold and silver, a slower global economy could reduce commodity and oil prices which may bring down India’s inflation. There could be a possibility of higher inflows of foreign institutional investor (FII) funds which will lead to appreciation of the rupee, and in turn bring down the current account deficit.

But lets not get complacent since we are equally confounded with our own demons of corruption, terrorism, inflation, interest rates and falling industrial production. In weeks to come, the effects of the US crisis would be clearer until then we must aggressively implement reforms and practice good governance.