Top Credit No Longer, Will the US Damage Asia?

by Cesar Bacani, 07 August 2011

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topics:
Management Risk Management

tags:
AA+ Credit Rating double dip recession economic slowdown risk-free rate triple-A US Treasuries

Let’s cut to the chase. What does the downgrade of US debt from the top triple-A rating to AA+ mean for Asian business?

Nothing much, it seems, at this time – but perhaps everything else in the longer term.

The decision by Standard & Poor’s on August 5, which diverges from the earlier action of rival credit rating agencies Moody’s and Fitch to keep the US at triple-A, technically lowers the creditworthiness of the US only slightly. At AA+, the world’s largest economy is still a better credit than the next biggest economies, China and Japan (both AA-).

Indeed, as Bank of America Merrill Lynch points out, “according to Basel II rules, risk weights change only when the rating of the issuer goes below AA-, but even at that point it is still at the discretion of the banks.”

This means that Asia’s financial institutions, which typically hold US Treasury notes, bills and bonds as part of their assets, can still assign a zero risk weighting to them, and thus do not need to set aside additional bank capital (that could otherwise be used to extend corporate loans, for example) to cover credit risk. US Treasuries can still be plausibly regarded as the risk-free rate.

And because it is only a one-notch downgrade (arguably less than one notch, in fact, because of the ‘+’ designation), S&P’s decision should not cause regulators to order Treasury haircuts, an action that could trigger margin calls and forced deleveraging. Japan’s stock markets did not require haircuts on the valuation of JGBs (Japanese Government Bonds) when S&P downgraded that country’s sovereign rating from triple-A to AA+ in 2000.

Money market funds will not be forced to sell their US Treasuries, either. The US Securities and Exchange Commission amended 2a-7 rules last year to classify US government securities as first-tier securities regardless of their rating. The SEC requires money market funds to invest only in the highest rated short-term debt. S&P has not downgraded the credit rating of US short-term debt, affirming its top A-1+ grade.

Blackrock Investment Management, which has US$3.66 trillion in assets under management, has said it "has no need to execute any forced selling of securities in response to the S&P action." In a press release, the global asset manager said: "We don’t believe that investors should change their behavior based solely on the downgrade. However, in combination with continued economic weakness and regulatory uncertainty, this may provide a signal to some investors to reassess their risk appetite."

Psychological impact

That’s where the longer term danger lies. In the longer term, there is no saying whether spooked holders of money market funds, including corporate treasurers in Asia and elsewhere, will redeem their holdings, thus forcing asset managers to sell Treasuries to honour their obligations – possibly causing a fall in Treasury prices and a market rout.

This is the very first time that US sovereign credit has been downgraded – American debt has been the gold standard since 1941, when sovereign credit ratings were first made – and so no one really knows what the psychological impact will be.

The S&P downgrade was announced after the markets closed on August 5, although rumours swirled about the move. Last week, confidence in US debt remained strong, particularly because stock prices had imploded – the Dow Jones fell 512 points on August 4 over renewed worries about a double dip recession. Investors dumped equities and took refuge in the safety of risk-free, albeit low-yield, US debt.

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