Meanwhile, the US government
continues to borrow around 40 cents for every dollar it spends, while
the economy is hardly growing and unable to generate the needed revenues
to sustain its fiscal path.S&P cited two reasons for the
downgrade: 1) the fiscal consolidation plan agreed to be around $2
trillion in deficit reduction over the next 10 years falls short from
containing the debt growth over the medium-term. 2) the extended
political debate regarding raising the debt ceiling underscored the gap
between the political parties. These indicate that measures needed to
restrain the growth of public debt, such as raising taxes and
entitlement reforms were less likely to be adopted than S&P had
initially envisioned.The S&P's decision was not a total
surprise, but the surprise in the accelerated timing since the July 14th
announcement when S&P put the US on CreditWatch negative, hinting
that a downgrade was imminent over the next few months. Apparently, the
announcement shortened the time period in which S&P wanted the
political parties to agree on deficit reduction, with an ambitious $4
trillion debt reduction target. As the deficit reduction plan, which was
passed last week, was significantly less at $2.4 trillion, a downgrade
seemed unavoidable.The Saudi economyThe impact of the
S&P's downgrade of US's credit on Saudi Arabia economy will come
through three channels. The first is through its impact on crude oil
demand and prices. Triggered by worries of a new economic decline or a
double-dip recession in the US, the world's largest oil consumer, this
would greatly undermine global energy demand. In addition, recent
concerns that Europe's debt crisis could spread to Italy, the euro
zone's third-largest economy, accentuated fears of a vicious new global
economic downturn. Oil prices sank more than $10 a barrel last week,
highlighting just how quickly commodity markets can swing in the peak of
a crisis, and continued to sag below $80 a barrel.Apparently, the
NCB report said drop in prices reflects the market's revision to
expected demand growth. On Monday, Light sweet crude for September
delivery, fell $2.08, or 2.56 percent, to the level of $79.23 a barrel.
Meanwhile, Brent North Sea crude for September delivery dropped $1.21 or
1.17 percent to $102.53. More volatility in oil prices can be expected
in the near-term as financial investors reduce their long positions on
the back of risk aversion and the uncertain global economic outlook.
However, the NCB believes, that the fall in oil prices may be nearing
an end. This would be especially true if the Fed steps up its purchases
of US government bonds. However, even if oil prices fall below the $80 a
barrel level, Saudi Arabia will not have a great impact as the Kingdom
enjoys a large reserve to meet its planned spending.The second
channel of impact on the Saudi economy is through the US dollar. The US
dollar response against most currencies will likely follow broader
market developments. As equity and commodity markets keep falling
globally, investors are likely to cut long positions in equities, and
commodities. These are mainly funded by short US dollar, so whether or
not the safe-haven status of the US dollar is impaired over the
long-term, a downward shock to markets is likely to be US dollar
positive in the near term. There are contradictory forces at work with
the pull down from the credit rating and the push up from an equity
market disturbance, for as stocks are sold and dollars are bought.
Although this is positive for the US dollar in the short-term, once
things settle down, as noted earlier, the downgrade would have a
negative impact on the US dollar. Meanwhile, there may be other concerns
in FX markets that the euro AAAs are not strong, given the economic
issues facing the euro zone. While investors instinctively may want to
sell US dollar and buy euro, the euro sovereign issues do not look
better because the US' looks worse. With the impact of S&P's
downgrade being positive on the US dollar in the short-term, it is
unlikely to raise the level of imported inflation in the kingdom,
especially that commodity prices are falling. However, weaker US dollar
in the long term, due to the S&P's downgrade, may eventually
contribute to higher imported inflation, the report said.The third
channel of impact is through the official holdings of US treasuries,
which is believed to constitute the majority of the Kingdom's net
foreign assets, currently amounting to $492 billion. The downgrade is
actually more of a referendum on the dollar rather than US treasuries,
due to the fact that US's ability to pay its debt obligations remains a
fundamental certainty because the dollar remains the world's reserve
currency and the US government can continue to print money to fund its
obligations. Therefore, holders of US treasuries like Saudi Arabia
should not be concerned that they may not receive interest payments on
US bonds. However, the value of those payments will essentially decline,
given the fact that with more dollars in circulation due to the
printing presses, the value of each dollar by definition declines. Given
that the Kingdom is keeping much more than enough to maintain the peg
of the Saudi riyal to the US dollar, it is advisable that the Kingdom
should opt for diversifying future excess revenues away from US
Treasuries into other real assets across different currencies and
regions, the NCB report said.US Treasury marketDespite the
S&P downgrade, treasuries trading strengthened, with the prices of
long-term treasuries soaring to high levels and accordingly yields
falling further. In fact, the yield on the 10-year Treasury benchmark
fell to a record low of 2.034 percent on Aug. 9. Demand for treasuries
is going strong till date, with investors submitting $2.99 in bids for
every dollar of the $1.26 trillion sold this year, exceeding the $2.26
in bids for every dollar of debt sold during the budget surplus years
between 1998 and 2001. This is also partly due to speculation that the
Fed might buy longer duration treasuries. One cannot rule out that that
the US Treasuries have been driven by the changing perceptions about
monetary policy, and also fears of a new euro zone sovereign debt
crisis. Nonetheless, the flattening yield curve is the opposite of what
one would expect if the markets concurred with S&P's downgrade. The
US Treasuries remain the flight to quality asset class of choice, and we
do not believe that recent S&P's decision will change that in the
near to medium term, the report added.It has been for some time
believed that based on fiscal stance alone, the US was no longer a
triple A rated sovereign. But the credit rating of a country is not a
function of its fiscal stance only, let alone for a country like the US.
In the case of US, two factors are of remarkable importance, which
include the political weight and the reserve currency status. It is true
that political system in recent months has demonstrated gridlock,
diminishing its political will, but the status of the US dollar as the
global reserve currency will continue to provide the US with a
significant advantage no other economy enjoys.In addition, the lack
of immediate credible alternatives will keep the rest of the world
highly de- pendent on the US treasury market. The two biggest bond
markets after the US are the Japanese and Italian bond markets. Japanese
yields have been low and are now far lower than the US's and in
addition Japan's fiscal position is significantly worse than that of the
US. In Italy, the fiscal stance has been worsening, with its debt/GDP
ratio far exceeding that of the US debt/GDP ratio. Notably, despite its
fiscal challenges, the US economy is more positioned to recover than
either of these two economies. Emerging markets, on the other hand, do
not offer trustworthy alternatives as their bond markets beside being
small, their currencies are in general not fully convertible, and their
political and legal institutions are non predictable.The financial industryThe
near-term impacts of S&P's downgrade expected, as noted above, to
be minimal for the US bond markets. “We do not anticipate forced selling
of US treasuries from any major investor base. Foreign central banks
maintain a large share of their FX reserves in US treasuries because it
is the deepest and most liquid bond market. But, international funds
that limit their investments to “AAA” rated bonds may dump the US
holdings, causing the US dollar to depreciate. Yet, mutual fund
investment guidelines do retain some flexibility regarding the handling
of such matters,” the NCB said in its report,In the US banking
system, where US treasuries are benchmarks for lending and collaterals,
the impact could be more disruptive. That is especially true in the
interbank "repo" market, where banks swap bonds for cash to balance
their books in the short-term. To mitigate the impact on banks, the US
Treasury quickly issued a ruling on Friday stating that the risk weight
of US debt in their reserves would not change despite the downgrade,
thus banks should not be forced to sell. Moreover, given that major US
banks are several notches below AAA, a single- notch downgrade should
not lead to downgrades in the credit ratings of banks. Assuming that
this occurred, additional collateral requirements believed to be
manageable, the NCB report said.Similarly, insurance companies are
also unlikely to be forced to sell as the National Association of
Insurance Commissioners (NAIC) has already de-emphasized credit ratings
for regulatory capital requirements. Meanwhile, the impact may be seen
on institutions, which rely on the US government guarantee for their
bonds, like heavily indebted home lenders Freddie Mac and Fannie Mae.
Their borrowing costs may rise, and that would spill over into higher
mortgage costs and possibly bank lending rates for the consumers.The US dollarThe
size of the US economy and its treasury market and the dollar's status
as a reserve currency make it impossible to find a historical parallel
for the current situation. However, being the world's reserve currency,
the US dollar now appears inconsistent with an AA+ rating. The
longer-term effects are driven primarily by whether international
markets will eventually also downgrade the US. Consequently, the biggest
impact should be through the effect on the US dollar as a reserve
currency. Theoretically, the downgrade should raise the borrowing cost
of the government, to rates higher than other AAA countries like
Germany. This, in turn, should push down the dollar's value relative to
other currencies of strong economies.With China alone holding more
than $1.2 trillion worth of US debt and Japan, $900 billion any
questioning of US's ability to pay its debts should unnerve the global
financial system. Foreign investors have supplied nearly 40 percent of
non-financial credit creation in the US over the past few years.
Ultimately, the downgrade could increase diversification away from the
US assets. Therefore, an increase in the pace of diversification should
have a negative impact on the dollar and also would be an economic drag
on the US, as domestic savings would have to rise to pick up the slack,
the NCB report said.
