US- Debt deal, ratings, economy and the Dollar

We have been hearing a lot about the public debt crisis in the Euro zone, their rising borrowing cost, continuous rating cut by sovereign rating agencies, bailout etc. Recently, there have been concerns regarding the health of US public debt and market fears that US would default. In such a situation the global economic recovery will stall and another global economic turmoil may happen.

The recession that hit the global economy during 2008 has lead continuous rise in government spending in terms of fiscal stimulus. This has lead to further rise in government debt level.

As per old Keynesian theories which most of the developed economies are following after the recession, says there is tolerance for fairly high levels of public debt to pay for public investment in lean times, which, if boom times follow, can then be paid back from rising tax revenues.

This theory gained global popularity in the 1930s- the Great Depression times. Many nations took the help of public debt to bring in bring back the economic activity towards the trend level. As per the theory, this could start a virtuous cycle and a rising business confidence since there would be more workers with money to spend. The former British Prime Minister Gordon Brown, former President of the United States George W. Bush, President Barack Obama, and other world leaders have been using Keynesian economics through government stimulus programs to attempt to assist the economic state of their countries.

Despite sharp rise in spending by government authorities in the developed market, the economic recovery has not been very strong after the 2008 recession due to structural problems. As per recent GDP data, US growth has slowed to 0.4% in Q1 2011 while UK and Euro zone is still below 1% level. High debt level and slow pace of growth along with rating cut by the rating agencies has been a major concern for these economies. A cut in rating leads to rise in borrowing cost for government and debt financing difficult.

Recently, the debt fear mounted in the US as the federal government reached their debt ceiling of 14.29 trillion dollars on May 16^th 2011. The Treasury would have been run out of cash to pay its bills unless Congress failed to raise the limit by Aug. 2 and leading default on its payments.

On 31^st July, 2011, some relief came after the US President Barack Obama's announced that he and Senate leaders had agreed on a framework debt deal to cut spending and raise the debt ceiling. Wars in Afghanistan and Iraq, the former administration's tax cuts, anti-recession stimulus packages under Obama, and ballooning Medicare expenses in an aging society all contributed in a major way to the spiking U.S. national debt. While the deal comes before the date, uncertainties remain over whether it will be enough for country to maintain its top-notch credit rating.

The proposed deal would allow Obama to raise the debt ceiling by at least $2.1 trillion in three steps. It involves spending cuts of at least $2.4trillion over 10 years, which Congress would approve in two steps, an initial $917 billion when the deal passes Congress and another $1.5 trillion by the end of the year.

The deficit reduction plan in the form of austerity may harm the economic recovery as growth remains painfully slow. With unemployment heading further, slowing down of manufacturing, services growth and final GDP, federal spending cuts or tax increases could hinder what little progress is being made from the recession of 2008.  A former Labor Department economist in Washington said “by reducing spending even by very modest amounts in the short run, we're probably doing the exact opposite of what we ought to be doing if we want to lift the ranks of the employed."

As per latest GDP data release, growth slowed to a 1.3% in the second quarter of 2011, lower than expectation of 1.8% by forecasters. The 1^st quarter GDP is revised down to 0.4% from 1.9% earlier. The pace of personal consumption expenditures slowed markedly, +0.1% in the second quarter compared to +2.1% in the first. The segment of GDP contributes almost 70%. As unemployment rising and no turnaround is happening in the corporate sector, personal consumption expenditure is likely to remain depressed as of now.

Another blow came from manufacturing sector as it slowed more than expected. The Institute for Supply Management reported that activity in the manufacturing sector barely increased at all in July. The manufacturing PMI index logged just 50.9 %, falling short of expectations and of the previous month's reading. New orders shrank for the first time since June 2009 with a reading below 50. A reading above 50 means expansion otherwise expansion.

Let us have a look at the major economic data release in the US from past few months. All shows economic indicators are slowing downward trend with rising prices.

Indicator	Jan-11	Feb-11	Mar-11	Apr-11	May-11	Jun-11	Jul-11	Trend
Consumer Price Index (yoy %)	1.6	2.1	2.7	3.2	3.6	3.6		Up
Unemployment Rate (%)	9	8.9	8.8	9	9.1	9.2		Up
Industrial Production (mom %)	0.2	-0.3	0.7	-0.1	-0.1	0.2		Down
ISM Composite Index	60.8	61.4	61.2	60.4	53.5	55.3	50.9	Down
ISM Non-Manufacturing Index	59.4	59.7	57.3	52.8	54.6	53.3		Down
NAHB Housing Market Index (sa)	16	16	17	16	16	13	15	Mixed
Retail Sales (mom %, sa)	0.8	1.3	0.8	0.2	-0.1	0.1		Down
Consumer Confidence Index	74.2	77.5	67.5	69.8	74.3	71.5	63.7	Down
Total Net TIC Flows (USD bln)	40.1	92.4	113.9	66.6	-67.5			Down

Poor's has threatened to dock the AAA credit rating of the U.S. government if the legislation to raise the debt ceiling doesn't come with a "realistic and credible" plan to reduce the long-term deficit. A Chinese credit rating agency downgraded U.S. debt, saying the deal does nothing to address the underlying problem.

If the United States' credit rating is cut from the AAA status by major rating agencies, the world's largest economy would join a group of nations such as Ireland, Japan and Spain, that lost the popular status.

Ireland:  S&P cut Ireland to AA-plus on March 30, 2009; Fitch cut it to AA-plus on April 8, 2009 and Moody's cut to Aa1 on July 2, 2009  

Japan: Fitch cut Japan to AA-plus on Sept. 21, 1998, Moody's cut it to Aa1 on Nov. 16, 1998 and S&P cut AA+ on Feb. 22, 2001

Spain: S&P cut Spain to AA-plus on Jan. 19, 2009; Fitch cut it to AA-plus on May 28, 2010 and Moody's cut to Aa1 on Sept. 30, 2010

On Fitch's current list of AAA rated sovereigns, none are in this category of nation's that held, lost and then regained the coveted status.

A downgrade could increase the cost of borrowing to US treasury’s as it will be perceived as riskier asset while still better positioned than the EU and UK or Japan. However, a reduction in the Treasury's rating could increase the government's cost of borrowing by $100 billion a year. The rise in borrowing rates may push up the other market interest rate such as home loan, car loan, student loan etc and slow down the pace of growth of consumer spending. As already mentioned that consumer spending almost 70% of GDP, the overall growth will be reduced.

After a rating cut, pressure on the dollar as the world's reserve currency will mount. In the short-term, the US dollar is standing safe, because no other country is able to take its place. Europe's own deep crisis with indebted nations such as Greece, Ireland and Portugal means that the euro is not quite the stable bet it once seemed to be, and China has no clear alternative to buying U.S. bonds to prevent its huge trade surplus from driving up the value of its tightly managed yuan. But China's economy is rapidly shifting, and its need for reserves of Treasury debt will shrink. Beijing's latest five-year economic plan focuses on building up domestic consumption, and China could even post a current account deficit by 2015.

If the dollar lost its status as the world's reserve currency it would do more that the US will lose its status as earlier regarded as world economic power.