troika chief's view jul2011

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[email protected], www.troika.ru

RUSSIA | ECONOMICS

JULY 29, 2011

Evgeny Gavrilenkov Chief Economist,Managing Director

[email protected]

Chief Economists ViewIf the US Gets Downgraded

So What?Amid continuous speculation about the debt problems in Europe and the US,

rating agencies have kept downgrading European peripheral countries, but have

done nothing to US ratings, apart from occasionally sending warnings of a

possible downgrade. Meanwhile, European governments eventually were able

to agree on a temporary solution for Greece based on a combination of a bailout

with public funds and the voluntary restructuring of Greek debt by private

bondholders, which many considered a model solution for other indebted

European countries. So far, the US has not come up with any solution, but its

rating remains at the highest level.

Early in the year, S&P downgraded Japans rating to AA on the grounds of the

absence of a coherent strategy to curb debt levels. The US administration lacks this

strategy as well, but still retains its top rating. Clearly, Japans debt/GDP ratio is

twice as high as that in the US, but the bulk of Japanese debt is held by locals, which

makes the country less vulnerable. In contrast, around a third of US Sovereign debt

is held by foreign investors (over $4.4 trln), such as other countries Sovereign funds

and central banks. Given that Japan is a country where inflation is not an issue and

deflation used to be quite regular, domestic investors holding lowyielding public

debt was not the worst option. At least they did not lose money.

Rating agencies normally cut ratings when they see a threat of investors losing

money, which in some sense occurred in the case of US debt held by foreigners,

as the dollar has weakened 1215% against many currencies. In the past twelve

months, for instance, the US currency depreciated around 12% against the

Japanese yen thus, Japanese investors, who hold around $0.9 trln in US debt,

lost about $0.1 trln. The Korean won, Singapore dollar and the euro also

appreciated 1112% against the dollar over the past year, while the Brazilian

real gained over 13% in the same period.

That said, in the case of the US, there is a combination of at least three factors that

have in the past encouraged rating agencies to downgrade other countries. These

include the lack of a coherent strategy of debt reduction, US politicians inabilityto come up with a mutually acceptable solution regarding the debt ceiling, and the

threat of continued loss of external money invested in US government paper,

which could eventually undermine the myth of US exclusiveness.


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Decision making in the US has proven to not always be as efficient as it was traditionally considered.

Economic and financial issues have become hostages of a political struggle between the two parties.

Indeed, the current debate on the debt ceiling centers not around debt reduction strategy (which ideally

should be coherent, as required by S&P, for instance), but whether the debt ceiling will be raised to a

level sufficient to finance expenditures throughout 2012 or if it will be a series of hikes (say, quarterly). In

the latter case, it will be much more difficult for Democrats and President Barack Obama personally to

compete with a Republican presidential candidate, as the current US administration will be held on a

short leash by Republicans. That said, despite the bombastic populist rhetoric from both sides, economic

issues are in fact of secondary importance. Politicians do not care that the uncertainty surrounding the

debt ceiling dispute is a less than ideal environment for investors. This is very similar to Russias

continuous uncertainty regarding whether the next presidential candidate will be Vladimir Putin or

Dmitri Medvedev. Both politicians are trying to keep it a secret so neither becomes a lame duck too early,

while the economy and investors interests are considered less important.

Taking the above observations into account, it looks as though the US deserves rating cuts, due to

remaining double deficits (current account and the budget balance), decelerating growth and a

rising debt/GDP ratio. The fact that the greenback has weakened over the past year illustrates that

markets, to some extent, have priced this in already. From this standpoint, it is already of secondary

importance (albeit, still an essential issue for the markets) whether or not rating agencies

downgrade the US and when, should the answer be yes. In our view, quantitative easing alone was

enough reason to downgrade US paper, and at minimum, one of the three rating agencies should

bring the US down at least one notch relatively soon, which is still a rather modest punishment for

longterm macroeconomic mismanagement. The problem is that the entire rating system is tied to a

single benchmark, namely the US paper, and if the benchmark is moved it is not completely clear

what to do with the rest, which is why markets have once again proven to be ahead of rating

agencies as the dollar has depreciated.

Given that the magnitude of economic imbalances in the US is of far larger scale than that in theEurozone, further weakening of the dollar will be the most likely outcome, despite the fact that the

prospects of eliminating those imbalances are quite unclear on both sides of the Atlantic. Partial

forced selling of US government paper (inevitable in the case of a rating downgrade) will inevitably

increase borrowing costs nationwide (at least a bit, which might encourage the Fed to resort to a

new series of quantitative easing). Higher borrowing costs will look normal. It seems much more

abnormal (and unsustainable, as a result) that a country with a weakening currency, sustainable

budget deficit of around 910% of GDP and debt/GDP ratio of around 100% pays only 0.4%

interest on a 2y note. Higher costs of borrowing will most likely accelerate inflation. This may help

increase tax collection and slightly soften the debt problem, but not provide a solution, as it will

eventually require quite unpleasant and seemingly unacceptable austerity measures aimed at

eliminating internal imbalances, such as overeager defense spending (the US share of global

defense expenditures is around 50%, while the country produces around 23% of global GDP).

Raising domestic fuel taxes is, in theory, another measure to reduce the budget deficit, though it is

highly unpopular and seemingly unacceptable at least for now.

We are not in the position to discuss in detail how the US administration should try to deal with the

budget deficit and debt problems, but some currently unacceptable steps might need to be taken

if appetite for US paper goes down amid potential rating downgrades (we do not consider US

default a serious option, as, being optimists, we trust that the countrys politicians will eventually

discover their longlost common sense).

Overall, it looks as though the dollar will remain crippled and could weaken even more, which iswhat makes the difference between the current situation and the 2008 crisis at that time,

investors rushed for safety and moved money to US Treasuries, which caused the dollar to


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appreciate and commodity prices to fall, while these days, such move would not seem logical.

Money stopped moving at end 2008 as a result. It looks likely that in the event that the US finds

itself in undesirable trouble (such as hypothetical technical default), money will still keep moving

at least away from the US dollar.

The greenbacks fundamental weakness will maintain commodity prices at a relatively high level a

rather comfortable environment for Russia. Moreover, Russias economy currently looks less

vulnerable than it did before the Lehman Brothers crash, as the economy is not as overheated as it

was three to four years ago. Russia looks to be in quite good shape versus many other economies,

demonstrating growth of around 45% we think that growth is actually closer to the higher

number, while official statistics, which are quite inconsistent, point to the former. Inflation has

declined to 0.20.4% mom since February, which could bring yoy inflation to around 6.5% (or

even lower) by year end (from 9.6% in January). In 1H11, Russia once again became a twin surplus

economy, while the foreign debt/GDP ratio remains below 30%. That said, we expect the Russian

market to rally once the dust settles.


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TROIKA DIALOG 2011

troika chief's view jul2011

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