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[Editorial] U.S. rating downgrade

Aug. 7, 2011 - 19:14 By
In a surprise move, Standard & Poor’s has lowered the credit rating of the United States by one notch from the highest “AAA” level to “AA+.” The unprecedented rating downgrade is expected to have far-reaching effects on Korea and the global economy as it could hinder the U.S. economic recovery and accelerate the decline of the dollar.

S&P said in a statement issued on Friday that, “The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.”

On Aug. 2, President Barak Obama signed legislation aimed at reducing the fiscal deficit by $2.1 trillion over 10 years in return for raising the federal government’s debt ceiling by $2.4 trillion from the current $14.3 trillion. To S&P, this deficit reduction scheme was nowhere near large enough to stabilize the government’s debt burden. Specifically, it called for a $4 trillion cut as a good “down payment” on fixing America’s finances.

As if the downgrade was not enough, the rating company put a “negative” outlook on the new U.S. credit rating, indicating another rating adjustment to “AA” was possible within the next two years if the U.S. economic conditions get worse than it currently assumes.

S&P’s action is likely to make it more difficult for the U.S. government to put the economy back on track. According to a pessimistic scenario, the rating downgrade will, in the first place, cause a rise in Treasury yields, increasing the U.S. government’s funding costs. The hike in government bond yields will also increase interest rates associated with mortgages and credit card use, as well as student and car loans.

Furthermore, the downgrade will have knock-on effects on other borrowers, both corporate and public. For instance, rating agencies warned that a downgrade in U.S. government bonds will automatically lead to a cut in many municipal bond ratings, increasing their borrowing costs.

Under this scenario, the lowered rating will thus make a dent in corporate investment and private consumption spending by increasing the interest burden on companies and consumers. This will put a drag on economic growth and job creation, ultimately pushing the economy into a double-dip recession.

Last week, fears that the U.S. economy might slide back into recession, coupled with concerns about the worsening debt crisis in Europe, rattled stock markets around the world. The Seoul bourse, which is especially vulnerable to changes in the global economy, saw the main board index shed 10.5 percent during the four days from Aug. 2.

The S&P’s rating decision could amplify recession fears in Korea. Hence the first task facing Seoul policymakers is to soothe market jitters and calm public disquiet over the economy. In allaying fears, they can cite U.S. job growth in July, which beat expectations as private employers stepped up hiring. The July job data indicate that the fundamentals of the U.S. economy are still strong, which implies that recession fears could have been overblown.

Seoul officials will also have to step up monitoring on the dollar as the rating cut will inevitably affect the value of the Korean won. A more serious concern for Korea would be the likelihood of the dollar moving more wildly than before, increasing instability in domestic financial markets. Officials need to watch out for sudden changes in capital flows in the stock and foreign exchange markets.

For Korean exporters, wild fluctuations in the won-dollar exchange rates are worse than the won’s appreciation. Therefore, they will have to make extra efforts to prepare for increased volatility in currency movements. At the same time, they also need to heed the possibility of the world’s largest economy being dragged into recession as this would weaken demand for their products.