Similarly, the way some American business leaders have reacted to the suggestion that the US government might not be able to service dollar debt lacks proper analysis and is based on misplaced hubris. Yes, the US can print dollar to repay debt.
But then, the value of the dollar as well as rating goes down further. If this is the strategy that the US is likely to follow, then it should state it clearly so that investors would take appropriate action before the US paper money becomes worthless. We may mention that such an attitude from a country with the world's reserve currency would be irresponsible.
The US is recovering from a crisis and not a recession; so, it is imperative that they understand that fixing consumer sentiments, over leveraged household balance sheets, high unemployment, asset bubbles and a high deficit takes time. This is reflected in the US banks requiring five years to fix their leverage, bad balance sheet quality and mismatched funding in terms of Basle III.
We must recognise that US accounts for 23% of the world's GDP in nominal terms and thus any slowdown there will affect global growth. With the US and euro in trouble, the world growth will slow down substantially and therefore, markets will be repriced lower.
The US downgrade should primarily impact the cost of US sovereign, corporate and retail borrowing and stocks. The impact on financial variables in other parts of the world will work largely through heightened global risk perception that will spread contagion. We will need to see how financial markets and governments react over the next few weeks and for a while irrational volatility will grip markets.
But there are reasons to believe that the panic this time around will not be like 2008. Comparisons with 2008 are incorrect because people were swimming in the dark in a crisis situation. Now, most people know what needs to be done. They may not find it palatable and may therefore take sub-optimal decisions but consequences are known.
While the downgrade by S&P is a wake up call on the state of its finances, the fall in US debt and equities will be cushioned because: A) the US has 43% weightage in MSCI index compelling fund managers to hold a significant fraction of their portfolio in US stocks. B) If two out of three agencies have AAA rating, then investors can treat as AAA - a pressure on other agencies not to downgrade. C) Tier-I investments need only A rating and most large institutional investors are mandated to hold tier-I bonds and not AAA bonds.
The near term prospects for the developing world
Let's face facts. In a risk-averse environment appetite for emerging market risks reduce. This will impact the cost and availability of international funding. Exchange rates will be volatile in the short run and will, instead of fundamentals, be driven by flows based on risk perception. Access to equity markets will also be an issue.
