My Work on Ift

S&P's Move

Standard & Poor's downgraded the long term debt of the United States in a rating action on August 5, 2011 setting off a month of political jawboning and intense volatility across global equity, debt and commodity markets.

Standard & Poor's is a credit rating agency. They rate the debt of various corporate and sovereign entities. Usually, the issuer of the debt pays S&P to rate the debt. Institutional investors across the world- mutual funds, pension funds, sovereign wealth funds, and hedge funds typically use these ratings, to make decisions on investing in the issuer's debt.

Most institutional investors require the issuer of debt to get a rating from one of the big 3 rating firms: Standard & Poor's, Moody's and Fitch ratings in order for them to invest. Many funds have investment philosophies that specify a minimum rating that a debt issue must have in order for the fund to invest in it. Hence the market as whole usually uses the rating in making investment decision about the credit quality of the issuer.

Although, the ratings are for debt- since they take into accounts the future income stream of the issuing entity- investors often use the debt rating of the issuer in valuing the equity of the issuer. In the case of the United States government, its AAA rating was a proxy for the prodigious $14 trillion GDP of the US economy as a whole.

An additional twist that US external debt has, is that, unlike India's external debt, it is denominated in US dollars; the currency that US government controls. That is, they can payback the debt by simply printing dollars. In other words, the can inflate the debt away. Although this form of payment would not technically constitute a default, it is in effect an underpayment to the US government's creditors.

So, in reality, nobody really doubts the ability of the US to service the debt. S&P's concerns stemmed from the way in which the debt was being financed - through deficits, and the concern that the two main political parties in the US don't seem to agreeing on how to control the deficits.

Impact of US Debt Crisis on India

As the wildly seesawing markets demonstrated that week, the implications for India and emerging economies are not clear.

On the face of it, one would imagine that the US debt downgrade and what it says about the US economy would imply that India by contrast, with it's around 8 % GDP growth rate would become a more attractive destination for global liquidity.

The ironic, short-term effect, though, of the US debt downgrade, was to actually make US treasuries more expensive. The reason is that a US debt downgrade implies a lowered ability for US to be borrower and purchaser of last resort that it had become during latter half of the 20th century. It in turn meant- the developing economies - especially Asian economies such as China, Japan and Korea- that depended on exports to the US would be disproportionately hurt.

In India, it meant that out bellwether