By Ichiro Suzuki On August 5, 2011, Standard & Poors downgraded its credit rating on U.S. Treasury securities to AA+ with a negative watch, stripping the U.S. of the treasured AAA rating. Prior to the action S&P had been mulling downgrading for several months because of growing amount of debt outstanding in relation to the size of the economy and an increased risk of default. The latter was questioning not the ability of the U.S. to repay debt in full but its political will to do so. The Republican-led Senate was threatening not to raise the proposed debt ceiling that would enable the Treasury Dept to pay back the debt. The outstanding amount of debt had been growing for years since the beginning of the 21st century and especially sharply after large economic stimulus packages amid the deepest recession since the 1930s as a result of the global financial crisis in 2008-09. The downgrade did not cause a panic in the financial markets as was feared, since the move was already well expected. The price of T-notes even rose (sending its yields lower.) On the other hand, the equity markets showed some concerns, going through an unstable few weeks before fully digesting the event. In a much longer-term, the downgrading proved to be no event. In the U.S.’s battle against the coronavirus, the outstanding amount of debt is ballooning to a what was once considered as a scandalous level that exceeds the size of the economy. S&P has not done anything to U.S. ratings since then, despite a negative watch, and in the face of surging debt levels. In retrospect, that volatility offered the last chance to get into U.S. equity markets before they began a historic ascent in 2013. The downgrading did not affect the status and the function of U.S. Treasury securities. It doesn’t matter if it’s rated AAA or AA+, and even the U.S. now owes almost 50% more than it did at the time of the downgrading. The debt security issued by the largest economy with a reserve currency is widely, or grudgingly sometimes, accepted by trading partners. The vast majority of global trade continues to be quoted in the U.S. dollar. Exporters that earn the greenback by selling goods and services almost certainly choose U.S. Treasury securities to park their cash. Japan currently holds the largest amount of U.S. Treasury securities at $1.26 trillion, with China as a runner-up at $1.08 trillion. For much of the last decade, China was No.1 holder of T notes and bonds. China’s current account surplus had peaked out in relation to the size of the economy in 2007, at about 10% of GDP, and it has almost diminished to a largely balanced account. Being an export juggernaut China continues to run trade surplus. However, China’s current account surplus fell in the last decade, driven by Chinese tourists’ robust spending overseas. In addition, capital flows out of China in the form of remittances of dividends by multi-national corporations that have invested in China since the country opened up the economy to foreign capital. The renminbi has been facing headwinds created by these factors since the middle of the last decade. The People’s Bank of China (PBOC), the central bank, has been intervening in the foreign exchange market to support the RMB, reportedly having spent as much as a trillion dollars of its foreign exchange reserves. The PBOC intervention reduced China’s holding of Treasury securities from nine years ago. In contrast, Japan’s trade account is almost balanced, and sometimes registers deficit depending on prices of crude oil, the single largest import item. On the other hand, investment income in the form of interest and dividends keep the current account amply in surplus at about 3% of GDP. This persistent surplus keeps the Japanese yen under an upward pressure. Aside from its effect on export competitiveness, an upward pressure on the yen has intensified deflationary pressure for two decades till the early 2010s. An ability to import at lower prices always works to reduce inflation in the domestic economy. While this is an envy for countries with an inflation problem, it has exacerbated a problem for the Japanese economy that had been afflicted with a downward price pressure as a result of debt overhang. Anyway, Japan keeps adding on to its foreign exchange reserves, especially the last few years, and the bulk of It Is parked in U.S. Treasury securities. For large holders of U.S. Treasury securities like China and Japan, their position cannot be weaponized. They cannot threaten the U.S. to dump them, however unreasonably the United States might behave, often amid trade tensions. There is no other liquid assets of comparable size that can host a trillion dollars, and still pay reasonable interest (by today’s standard). Such a gigantic sum cannot be converted into their own currency, without driving up the value of their own. The U.S. real estate market can host the money, but the asset class lacks liquidity. The U.S. equity market can easily absorb it, but it adds volatility, even if stocks deliver higher returns than bonds over a very long time. So no one is able to threaten the U.S. to sell their bond holdings without backlashes and drawbacks. They are trapped in what they have, as a price of their own success. Since the downgrading, the U.S. dollar delivered strong performances, rising by 25% against the Japanese yen and over 15% against the euro. Both of these currencies proved to be overvalued in the early years of the 2010s. China’s renminbi has been firmer than other developed countries‘ currencies but still fell 5% against the greenback. The Chinese currency at one point looked like rising indefinitely. As it turned out, as China’s current account began to be hit by factors stated earlier, it changed its direction. For a while the RMB kept rising to 6 against the USD, and then moved lower. After all, the downgrading had zero effect on U.S. assets. About the author: Mr. Suzuki is a retired banking executive based in Tokyo, Japan.
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