Tuesday, October 19, 2021
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The height of debt, US style

The recent stalemate in America over its debt crisis has been solved, but it is a temporary band-aid and the issue could one day impact global economy in a major way.

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By Sujit Bhar

The American economy has survived by the skin of its teeth, till December. Staring at a massive default, something that could have shaken the foundations of not only the American economy, but the world in general, the US Senate, its upper house, finally voted 50-48 to pass a bill that will increase the country’s debt limit by $480bn. That should cover expenses—debt servicing and other issues—till early December. All this happened just two weeks ahead of the abyss.

This is a typical American disease, if one might say so, but this time the country was also staring at a possible credit rating downgrade. Credit rating agencies had threatened to do so. When these things happen in countries such as Argentina and Greece, there are rarely any eyebrows raised. Instead, there are smiles and “I told you so” quotes from experts. This time it loomed large over the largest economy in the world. The payments are due by October 18, and with Congress initially not agreeing to further raise the country’s borrowing cap, the country’s treasury was left wondering where it would get the money to service its $28.43 trillion debt. Possibilities existed that the world might slide into a deep gloom, otherwise called a recession.

For the record, the entire US gross domestic product (GDP) was $20.93 trillion last year.

Why is a country’s sovereign credit rating so important? The definition is interesting: “A sovereign credit rating is an independent assessment of the credit worthiness of a country or sovereign entity. It can give investors insights into the level of risk associated with investing in the debt of a particular country, including any political risk.”

An AA+ rating—one that S&P still has on the US—indicates stable outlook. This means that investors look at it as a positive sign of raising funds, of investing, and banks and other financial institutions will love working in this atmosphere, with a stable government and economy. The monies keep circulating and bonds are sold. Sovereign ratings start at AAA and end in D.

For India, for example, as per S&P Global Ratings, the country’s sovereign rating “will remain unchanged at the current level of BBB- for the next two years.” This means that India’s credit rating is still investment grade, but there is a certain degree of risk associated with investments into this market. Therefore, when India wants to raise funds from the international market, this rating will force India to pay a higher interest rate than, say, the US will have to pay for the same level and kind of loan. Also, India bonds will generate less interest in world markets, whatever the promised return. Such ratings also have a great impact on how, when and where the FDI flows.

S&P gives a BBB- or higher rating to countries it considers investment grade, and grades of BB+ or lower are deemed to be speculative or “junk” grade. Moody’s considers a Baa3 or higher rating to be of investment grade, and a rating of Ba1 and below is speculative.

Currently there are 11 countries with the top AAA credit rating from S&P in 2021. They are: Germany, Australia, Canada, Switzerland, Denmark, Liechtenstein, Luxembourg, The Netherlands, Norway, Sweden and Singapore. According to Fitch, China has an A+ rating, which is “Outlook Stable”.

So what was happening in the US? Politics, of course. To put it simply, the US spends more than it earns. Way more, actually. And since the greenback is still the world’s reserve currency, the country’s bonds are in demand across boundaries and this is what funds its huge spending budgets. However, each dollar thus earned, comes with an IOU attached. And that exponentially growing debt has to be serviced every year. So the US, technically, takes another loan to pay an earlier loan. For smaller financial dealings—from households to even large companies—this is a sure recipe for disaster. But the US has been doing this for a while now, and arguments rage as to how long this can continue.

When the current administration wanted more loans to be raised, the Democrats had said no to a simple majority passing such a resolution. It got stuck there, because in the absence of a resolution no further debt could be added. This also meant that there would have been no money to pay the interest on the humongous amount of loans that the government had already taken.

Had the government failed to pay its dues, the rating agencies would have had to statutorily downgrade the country’s sovereign credit rating. That would have started a domino effect in the financial markets, which could have grown so large that 2008 would have returned in nightmares.

HOW DID IT GET TO THIS POINT?

Truth be told, this is nothing new to the US. It has done this over and over again—this artificial debt ceiling was created to impose fiscal discipline on lawmakers. Some other countries have very high debt ceilings, others, such as Japan, do not have any. But that ceiling has changed (upped) by Congress 98 times since the end of World War II and 17 times since 2001.

As of now, both the Republicans and the Democrats have been responsible for this imbroglio. For example, as per Moody’s analytics quoted in the media, early in the Trump administration, about $1.8 trillion was added to the nation’s debt as huge tax cuts were passed by a Republican-controlled Congress. Then, last year, both parties agreed to pass about $3 trillion in spending for the Covid-19 pandemic. As if that was not enough, Biden has pushed through another round of Coronavirus relief worth about $1.9 trillion.

These were political imperatives and it was quite evident then—and this correspondent, too, had written about that, as well as about a $1.2 trillion infra push to boot—that funding all these will be a problem. To fund these, sovereign bonds will have to be sold on the market, in the US and abroad. In the case of a downgrade in credit rating, buyers would have shied away from such bonds that will carry difficult ticket rates. Unsold sovereign bonds are like a shop in a fire sale failing to push out stock. That’s a complete fiasco.

Such political imbroglios had resulted in the first ever downgrade of the sovereign rating of the US in 2011. The economy had handled its matters well thereafter, coming back from the brink several times, as Congress agreed to raise the debt level. This time the issue had gotten stuck in a deeper hole.

Moreover, the projection about the domestic economy wasn’t healthy. According to a Moody’s Analytics report (a warning, really) a 4% decline in economic activity is seen, combined with the loss of almost 6 million jobs, an unemployment rate of close to 9%. As of October 4, 2021, India’s overall unemployment rate was 6.75%, with an 8.38% urban and 6% rural unemployment rate. And we all know what the economic situation of India is at the moment.

If such things happen in the US, there will ensue a panic sale of stocks (quick profit booking before exit) that could potentially wipe out $15 trillion in household wealth. This will result in a spike in interest rates on mortgages, consumer loans and business debts.

The overall doom will affect all, Democrats and Republicans. That was one reason why this imbroglio did not last, but what is the end game of this? Democratic Senate leader Chuck Schumer had warned that the country was “flirting with a disastrous downgrade in its credit rating” and President Joe Biden had told reporters there was a “real possibility” of changing the rules in Congress to circumvent Republicans.

THE INDIA PICTURE

India’s debt situation isn’t good either. But, then, the Coronavirus pandemic has pushed most economies to the wall. The IMF’s January 2021 Fiscal Monitor Update showed that global public debt has risen to 98 per cent of GDP (higher by 14 percentage points from the same report, October 2019). This was primarily due to additional spending, forgone revenue and liquidity support. These, as we can understand, were all emergency measures to pull economies out of the pandemic-induced slump. The debt situation was varied. Between advanced, emerging and middle income and low income developing countries, they were 123%, 63.3 % and 48.5% of their GDPs, respectively. Pre-pandemic levels, respectively, were 105.2 per cent, 54.2 per cent and 43 per cent.

In India the public debt ratio rose to 89% from the pre-pandemic level of 72%. There is worldwide scepticism about India’s ability to service this debt. As of end-March 2021, the Reserve Bank of India concedes, India’s external debt was pegged at $570 billion. It was an increase of $11.5 billion over its level at end-March 2020. However, against this, India now has a healthy set of foreign currency assets (FCA). India’s FCAs accounted for the bulk of growth (in foreign currency reserves) during late March, rising $8.213 billion to $579.813 billion.

HOW DOES JAPAN SURVIVE?

Japan is a strange case in point. The figures, even compared to the US, are mind-boggling. As of this fiscal, Japan’s public debt is estimated to be approximately $13.11 trillion (1.4 quadrillion yen), or 266% of Japan’s GDP. This is the highest of any developed nation.

However, the case of Japan is qualitatively different from that of the US or any other country for that matter. The first thing that strikes observers is that almost all of this debt is denominated in Japan’s own currency, the yen. And the more quizzical issue is that about half of all this debt is owned (as assets) by the central bank, the Bank of Japan (BOJ). While the BOJ is essentially an autonomous body, being a central banker, it is actually part of the same government that is issuing the debt.

This year itself—and the Olympics has had no little effect on that—Japan added nearly $2 trillion to its debt mountain. The main debt was to service huge spending by the government for stimulus packages to cushion the impact of the pandemic.

So how does this system function? First, the Japan bonds have extremely low yields. That helps avoid default, because servicing them when payment is due is easier. But, then, isn’t it also an issue that very low yield bonds will generate very low interest among buyers? That is where the BOJ comes in.

Before trying to untie that knot, let us know the exact volume of Japan’s bubbling debt. According to the BOJ, by the end of 2019, Japan’s debt stood at 1,328,000,000,000,000 yen, which is equivalent to around $12.2 trillion. This may be less than half the US debt in absolute terms, but if you put this in the backdrop of the Japanese economy, yen to yen it is by far the biggest debt pile in the world. It reached to about 240 percent of the total GDP of the country. That amount is said to have increased to around 266% of the GDP.

How did Japan get into this? It was in the 1990s, with the dot com bubble or the first internet bubble—on the shoulders of false and sky high valuations of new dot com companies in an underprepared technical environment—burst, leading to a financial collapse, allied with a real estate bubble bursting in the face of the economy. The stimulus needed huge funding and debt was seen as the only way out.

Japan, though, had a bigger problem. Its population was ageing for a while, and healthcare and social security costs were only rising. By the end of the 1990s, the 100% of GDP mark was breached. In two decades, it had crossed the 200% mark, as per IMF data. Then came the Olympic Games (a year’s delay in that also raised cost) and the pandemic which pushed the government to initiate anti-Coronavirus measures worth 117 trillion yen. The 250% mark was breached.

How does Japan manage this scary situation? In its effort to manage the debt, the country issues bonds known as JGBs. These are the bonds with ultra low yields. And the BOJ eats these up in very large quantities. The bank had been pushed to remove its own self-imposed ceiling on buying JGBs. It now holds more than half of all JGBs.

Understandably, this legal round-tripping holds the price of the JGBs steady on the open market. Technically, the government is now being funded by the bank with ultra low or even negative interest rates.

What happens to the other half of the JGBs? This, risk-free bond, is taken up by private and institutional investors who at least know that their principal is secure, even if does not pay. Then there are those old people who, unknowingly, assume this is safe haven for the future and delve into government bonds.

Also, with almost 90 percent of the bonds being sold in the domestic market, there is little chance of international exposure and allied risks to filter through.

Japan also has a buffer. Japan’s foreign currency reserves are at $1.4 trillion now, plus Japanese overseas assets held by private parties have reached some 10 trillion yen ($95.20 billion), according to the National Tax Agency.

Such accounting complexities and low (or even negative) growth may not be appreciated by the US, but even with the greenback backing its efforts, experts feel there has to be a limit to the borrowing. Deficit budgeting may prop growth and hence higher fiscal velocity, but to really address this, there has to be huge belt tightening, a prospect neither the Democrats nor the Republicans will like.

Till then, each American will be liable to pay more than his/her due in blood and tears for the country. That is nationalism at its best, perhaps.

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