Friday, January 14, 2011

Does it Matter if the U.S. is Not AAA?

The U.S. is currently rated AAA by the major ratings agencies. But reports are surfacing that those agencies are getting nervous. The markets don’t seem to care though. A recent U.S. bond sale went off without a hitch after these reports.

While, the U.S. is not perfect, it’s the safest place on the planet as far as investors are concerned. And with uncertainty about the Euro persisting, investors do not seem ready yet to swap out the U.S. for China as a the globe's financial safe-haven.

Moreover, the ratings agencies are famous for closing the barn door after the cow has left – witness how many sub-prime mortgage backed securities they downgraded from AAA years after they were nearly worthless. Does it matter if the U.S. is not AAA-rated? Sure, but what would be worse is if China’s Capital Receptivity Index (CRI) surpasses ours.

(As I posted on DailyFinance, the CRI rates countries on the basis of their Entrepreneurial Ecosystems -- consisting of their financial markets, corporate governance, human capital, and intellectual property protection. And by that measure, the U.S., at 82%, is far from perfect but it's much better than China's CRI of 46%.)

Why are ratings agencies thinking about downgrading the U.S.? According to the Wall Street Journal, S&P and Moody's are thinking about changing their ratings on U.S. debt from AAA with a stable outlook because they do not see an end to rising debt and deficits.

And looking over the last 11 years, they have evidence to back up their concerns. After all, in 2000, the U.S. national debt was around $5 trillion and it's spiked 180% to $14 trillion. And the U.S. federal budget has gone from a $230 billion surplus to a deficit of at least $1 trillion forecast for 2011.

But these are not the only factors that go into the ratings. The ratings agencies also take into account future pension and health-care costs both of which it sees as too high in the U.S..  And Moody's Aaa Sovereign Monitor report estimates that the U.S.'s debt to revenue and interest to revenue ratios are too high -- staying at 397% of GDP and doubling to 17.6%, respectively, until 2020.

Even though member of the Tea Party and eminence grise, Pete Peterson, are all huffed up about this, investors don't seem to mind. Thursday, an auction of $13 billion in 30-year Treasury debt after the ratings agencies announcements went off fairly well -- with the U.S. government being required to pay 4.515% on the bonds, slightly more than the pre-auction 4.492%. according to the Journal.

The reason for the world's willingness to fork over cheap money to the U.S. is based on investors' perception that its next best alternative, the Eurozone, is much much riskier. And this perception is helped along by the fear that the Eurozone could collapse. In the New York Times, Paul Krugman describes four scenarios of what could happen to the Eurozone in light of the fiscal problems in Greece, Spain, Ireland, Portugal, and Italy -- one of them is a dissolution of the Euro.

The interesting question is why investors are not flocking to China instead of the U.S. The answer is that while China is able to sell debt at lower yields than the U.S., the quantities are not overwhelming. For example, in Dec. 15, 2010, China sold its 40th batch of 30 year notes -- $4.2 billion worth at a yield of 4.23% -- bringing the total sold in 2010 to about $160 billion worth. 

So while global investors are making a big long-term bet on China, China is making a six times bigger bet on the U.S. -- holding $907 billion worth of U.S. government securities as of Oct. 2010. And for now it appears that China is getting more and more concerned about domestic inflation -- soaring at 10% -- through moves, such as increasing bank reserve requirements from 18.5% to 19%.

The ratings agencies seem to be late to the party here -- as they were to the subprime mortgage crash. But my hunch is that investors don't rely on the ratings agencies to decide where to park their money.

Perhaps they depend more on some form of the CRI. If China's CRI overtakes the U.S.'s, we will probably be in really bad shape. To prevent that, we need to keep a close eye on our relative CRIs to make sure we maintain our advantage.


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