From USAAA to USAA+

ON 5 AUGUST 2011, the United States-based credit rating agency Standard & Poor’s (S&P) downgraded the long-term debt issued by the US Treasury from a AAA rating to AA+. The financial services industry in the US and the credit rating agency have long shared a symbiotic relationship, and this was the first time that any estrangement crept to the surface. Predictably, like all relationships gone sour, a sense of betrayal, recrimination and defensiveness lingers in the air.

What does the credit rating agency’s downgrade of the US mean for India? Not much—in the short run. A global mistrust of S&P ratings is part of an enduring sense that the three major ratings agencies betrayed just about everyone. In the end, however, India is left with few options.

There are four principal critiques of S&P that buttress this sense of betrayal.

First, with the banks complicit, the ratings agencies had, prior to 2008, given AAA ratings to risky securities that were later implicated in the credit crisis. But when the crisis hit, many of these top-rated securities, like those of the government-sponsored enterprises Fannie Mae and Freddie Mac, suddenly turned out to be worthless. Billions of dollars were written off and assets were sold at highly discounted prices, even as many more investments continue to languish on the off-balance sheets of the investment agencies, often without a credible price. It was as if the ratings agencies had, metaphorically speaking, told partygoers (perhaps, unknowingly) that the drinks being served were non-alcoholic when, in fact, they were spiked. This dissembling forms the crux of the moral outrage many lawgivers have expressed. Notwithstanding the defensive grandstanding by politicians, this critique of the ratings agencies is publicly damaging.

Second, if the market has a decidedly different perception of the likelihood of the US defaulting on its debt, then what use is the S&P rating? Generally, when a country’s debt is downgraded, the interest on its bonds rises to compensate for its lowered credit quality. But, in the US’s case, particularly for the 10-year and 30-year bonds—a debt obligation issued by the US Treasury for a period of 10 and 30 years, respectively—the yields of those bonds have declined. (The yield of a bond is the rate of return earned on the bond. The more precarious the repayment, the higher the interest charged.) Following the downgrade, the 10-year bond yields have decreased from 2.08 percent to 1.97 percent. Instead of rising, the credit premium has declined. Capital flight, efficient-market hypothesis and the Eurozone crisis are among the reasons offered for this rise. But, whatever it may be, S&P’s downgrade has had the added misfortune of occurring at the wrong place at the wrong time. America may be floundering, but Europe is at a standstill.

There are, however, deeper and more fundamental reasons to distrust the S&P ratings. Most prominently, its ratings have a distinct bias against non-European bond issuers.  European countries are systematically rated higher (and thus enjoy a reduced cost of borrowing), even after accounting for political instability. Bond analysts who study debt-to-GDP ratio and political instability indices have puzzled over this. Yet at no time has this discrepancy been revealed so dramatically than over the past few months, as peripheral European countries totter towards default. India, for example, has a BBB- rating while Italy holds onto its A+. If this is an indication of the probability of default, then something seems rotten in the whole process. Nate Silver, from the polling aggregation and statistics website FiveThirtyEight, argues that S&P ratings are correlated with Transparency International’s Corruption Perceptions Index, which ranks countries according to “the degree to which corruption is perceived to exist among public officials and politicians”. This index has been criticised for its use of the cultural preconceptions of “experts” at international agencies to define how corruption is measured. In essence, S&P’s assessment of the ability and willingness to repay debt relies on both subjective and cultural measures.

The last and most damning critique is that S&P ratings can rarely account for real-world dynamics. The default probability of an asset is a function of credit quality and liquidity in the market. What the ratings claim to do, and are expected to do, is provide an assessment of both. Yet, what they are able to do, at best, is rate the quality of credit conditional on markets being liquid. But it is precisely a liquidity crunch that brought the financial world to a standstill in 2008. To wit, this is like saying that as long as there are no rains, the raincoat will keep you dry.

None of this, however, changes the seed of doubt that S&P has sown. Is the debt issued by the US a safe asset? Should India invest in the US debt markets? The answer is an unequivocal Yes. And the reality is that India, like many other sovereign countries, has no other option. The US Treasury market is the world’s deepest and most solvent market. In actual terms, this means we are most likely to find sellers and buyers at the earliest and pay the minimum premium for liquidity. The downside to this ease-of-trading is that the US Treasury market is extraordinarily sensitive to market fluctuations. For example, ever since the downgrade of US debt, the yield curve has steepened and the reasons are, as of yet, uncertain. Investing in US Treasury securities is fraught with the risk of capital erosion. Special care is needed, independent of the credit rating.

Based on publicly available data—from 30 September 2010—the Reserve Bank of India (RBI) is holding nearly $265.2 billion. Of what is known, $146.4 billion was invested in securities while $113.6 billion was held by other Central banks. In May 2011, India held $41 billion in US Treasury assets, up from $29.3 billion in May 2010. From this we can extrapolate that roughly 13-18 percent of India’s reserves are held in US Treasuries. The question of where to invest is rendered even more urgent when one recognises that the future of the Euro, as Margaret Thatcher had correctly anticipated 21 years ago, is in peril. Others, like Professor Ricardo Caballero at the Massachusetts Institute of Technology, have pointed out that the world suffers from one singular shortage: good quality collateral that we can invest in. Lest one rejoice that there still remain other AAA-rated securities, more pessimistic readings might force us to rethink. Willem Buiter of Citigroup argues that within 10 years all the members of the G7 will likely lose their AAA ratings, and only countries like Norway and Switzerland will retain theirs. The sovereign’s inability to tax effectively in the face of offshore tax havens, labyrinthine accounting standards and rising debt from mandated spending in social security are all used to explain this prophecy. In short, global capital will slosh around only to park itself in havens of safety.

None of this is reassuring from the perspective of India’s foreign reserves management.  For now, the US Treasury remains the natural choice. But, prudence demands that we think and formulate policies to manage our reserves not just outside the realm of dollars but also that of debt instruments. The scars of the balance of payments crisis of the 1990s will no doubt encourage us to emphasise liquidity, but the key lesson learnt from the S&P downgrade is that the days of a risk-free treasury and passive financial investments are over. Irrespective of what one may think of the S&P, it may have done India an unwitting favour by downgrading the US. Successive Indian governments will now have to explain our reserves management policies in greater detail. Merely stating, as we do today, that US Treasury instruments were purchased won’t do. Why did they invest as they did? What particular economic projection led them to invest in asset A over asset B? The byproduct of such scrutiny will be greater public debate on whether we need new agencies, far removed from the overburdened RBI, to run our reserves, and what kind of alternative asset strategies are possible. The opposition and the media will also have to ensure that the government and the RBI purchase treasury instruments or other sovereign bonds not out of some misplaced sense of diplomatic quid pro quo but only after careful assessment of the risks and rewards involved. In essence, our collective engagement with the world will be more nuanced and more in sync with the growing sophistication of the economy.

The S&P downgrade is a wake-up call that reminds us not too subtly of that old Yogi Berra quip: The future is not what it used to be. It is what we make of it.