In August 2011, the rating of US debt was downgraded by Standard and Poor's. The other major rating agencies, Moody's and Fitch, left the USA's top-notch AAA
rating untouched. This means that interest rates on future American borrowing are unlikely to rise: investors charge higher interest on sovereign debt only when a country's credit rating is downgraded by two agencies. Consequently, there will be very small effect on domestic US bank lending rates as well.
Paradoxically: the rating downgrade may increase the uncertainty and risk in international financial markets. When risk in these markets grows, investors put their money in "safe havens" such as the US dollar and American bonds. Thus, in the short term, both the US dollar and US Treasury bonds may actually benefit from the downgrade!
In the long-term, though, the picture is different. The downgrade is a major psychological blow to America's standing in the world. Heavy investors in US Treasury bonds, such as China, Russia, and Japan, have expressed their dissatisfaction with America's fiscal profligacy and political deadlock. These giant economies are likely to continue to diversify their foreign currency portfolios into other currencies and these currencies will rise against the US dollar (such as the yen, euro, Swiss franc, Australian and Canadian dollars.) Should another rating agency downgrade America's debt, the US will have to pay another 50-100 billion USD a year in increased interest rate costs on its future borrowing.
On January 12 and 13, 2011, Spain, Portugal, and Italy successfully sold 22 billion euros of new debt in the form of sovereign 5-year and 10-year bonds. The European Union (EU) spin-doctored the outcomes of these auctions as a great success. Actually, they came close to the brink of disaster: Spain had to pay an extra percentage point and Italy another half a percentage compared to identical obligations they had sold in November 2010. What a difference three months make! The rising yields demanded by investors indicate a perception of the growing risk of these two not-so-peripheral members of the EU.
All the auctions ended up being mildly oversubscribed (1.4-2 times the supply on offer). But, this is highly misleading: only 40% of the bonds were purchased by commercial investors. The rest were bought by the governments of China and Japan and by the ECB itself! Put bluntly: the auctions were rigged. China extracted an onerous price for its relatively moderate commitment in the form of technology transfer commitments and a further relaxation of EU trade protections.
Alarmed by the results, the beleaguered President of the ECB, Jean-Claude Trichet, lobbied even harder for a sizeable increase in Europe's rescue (read: bailout) fund and in the European Stabilization Mechanism. He was instantly rebuffed by the Germans, but realities being the way they are, the ECB is likely to prevail and, in the process, become the largest owner of sovereign bonds of illiquid and insolvent member states. This development is the most alarming: in the absence of a liquid, politically-independent and functional central bank, the euro project is all but doomed.
In a little noticed speech, given in January 2003 at an IMF conference in Washington, Glenn Hubbard, then Chairman of President Bush's Council of Economic Advisers, delineated a compromise between the United States and the International Monetary Fund regarding a much mooted proposal to allow countries to go bankrupt.
In a rehash of ideas put forth by John Taylor, then Treasury Undersecretary for International Affairs, Hubbard proposed to modify all sovereign debt contracts pertaining to all forms of debt to allow for majority decision making, the pro-rata sharing of disproportionate payments received by one creditor among all others and structured, compulsory discussions led by creditor committees. The substitution of old debt instruments by new ones, replete with "exit consents" (the removal of certain non-payment clauses) will render old debt unattractive and thus encourage restructuring.
In a sop to the IMF, he offered to establish a voluntary sovereign debt resolution forum. If it were to fail, the IMF articles can be amended to transform it into a statutory arbiter and enforcer of decisions of creditor committees. Borrowing countries will be given incentives to restructure their obligations rather than resort to an IMF-led bailout.
In conformity with the spirit of proposals put forth by the Bank of England and the Bank of Canada, Hubbard insisted that multilateral financing should be stringently conditioned on improvements in public sector governance and the legal and regulatory frameworks, especially the protection of investor and creditor rights. He rejected, though, suggestions to strictly limit official financing by international financing institutions.
Yet, these regurgitated schemes suffer from serious flaws.