Impact of the US Credit Rating downgrade by S&P

On August 4, Thursday, US stocks suffered the worst one-day sell-off in two years, with the Dow Jones Industrial Average (DJIA) falling 4.31% and the Nasdaq Composite Index losing 5.08% of its value.

A few hours after US stock markets closed, Philippine stocks followed suit and the benchmark Philippine Stock Exchange Index (PSEi) tumbled 1.4% on Friday, August 5.

My friends and I, together with other investors around the world, were surprised to see such panic and sell-off. A fall is generally expected, given the lingering uncertainty in the US economy partly brought about by the eleventh-hour sealing of the deal regarding the US debt ceiling crisis. But a steep 4%+ decline in the US is unprecedented, considering there were no other major financial news spreading in the market.

Apparently, we were wrong. It looked like several investors already got the leak that credit rating agency Standard & Poor’s (S&P) was about to downgrade the United States’ credit rating.

Indeed, one day after the bloodbath on August 4, S&P announced it is cutting the long-term US credit rating by one notch — from the prized AAA rating the US has enjoyed since 1917 to a “still-good” AA+ level. In addition, S&P gave the US a “negative” outlook which means another downgrade might be possible within 1-2 years. (See What the Credit Ratings mean)

Although the AA+ rating means the US is still within investment grade, the credit rating downgrade — the very first for the United States — could cause further anxiety in financial markets still reeling from the effects of a continuing recession, rising unemployment, and declining home prices.

With its AA+ rating, the US has been booted from the top-tier AAA club with only fifteen countries, including Australia, France, Germany, Singapore and the United Kingdom, enjoying such prestige.

According to S&P, the downgrade was mainly a result of problematic policy-making in Washington: “The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed,” S&P explains.

How would the credit rating downgrade impact the financial market and, ultimately, individuals? The downgrade has several effects, as postulated by analysts.

1. Higher cost of borrowing for the United States. With the downgrade, the United States is deemed “riskier” compared to before. Higher risk means it has to raise interest rates on the debt papers it issues in order to attract lenders. It was estimated that the downgrade could add up to 0.7 of a percentage point to the yields of Treasuries over time, costing the US an additional $100 billion in borrowing costs. To cover for these, the US might resort to more borrowings that could sink the country further to a deeper debt quagmire. In addition, with more money being spent for debt servicing, less money could be allocated to social services and infrastructure which could lead to lower GDP growth.

2. Depreciation of the US Dollar. The downgrade could make foreign investors rethink their investment holdings in the United States. China, for instance, owns billions of dollars worth of Treasury holdings and any major action by China to reduce its investment would dump more dollars into the financial system leading to a weaker US dollar. Other investors might also start unloading their US portfolios as they look for alternative investments in foreign markets. More dollars in the system means the US dollar could depreciate in value compared to other currencies.

3. Higher import prices but better export prices. A weakened dollar would be good for US exporters since they can be more  price-competitive due to the exchange rate. But Americans wishing to import or buy foreign products would find that prices have become more expensive because of the depreciated value of the dollar versus the other foreign currency.

4. Higher loan interest rates. Since Treasury yields have to rise to compensate for higher risk, other interest rates tied to the benchmark rates such as the federal funds rate would also have to increase. This means banks and other financial institutions would have to raise the interest rates they charge customers. Affected products would be credit cards, mortgages, student loans, personal loans and the like. An increase in the interest rate becomes an additional burden to consumers who would have to pay more charges on their loans.

5. Flight of capital to emerging markets. Analysts are split on the issue with some believing that the increased risk in the US would cause foreign investors to look for other investments in other markets. Some, however, believe that capital flight is possible but only in the short-term, with foreign investors returning to the US since US Treasuries remain to be one of the safest and most liquid in the world despite the downgrade.