Global Trends by Martin Khor

Monday 8 August 2011

Global turmoil as US economy faces downgrading

The US credit downgrade – coming after a weak solution to its debt ceiling crisis and signs of a new recession – is signaling greater turmoil ahead in the global economy.

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Last week was a tumultuous time for the global economy, as stock markets plummeted on a series of bad news in the United States and Europe. But this may be only the start.  This week is likely to usher in even more turmoil as the prospects for recovery have suddenly turned negative.

After several other dramatic events, last week ended with the United States’ credit rating losing its AAA status to AA+.   It was only one notch down, this downgrade was by only one (Standard and Poor’s) out of three rating agencies, and it had been half expected.

Nevertheless it was a historical landmark for the end of an era.  It was the first time since 1917 that the US does not fully enjoy AAA rating.  It has long been assumed the US dollar and its Treasury bills are the safest of havens.

There may be some practical effects of the downgrade, as some funds which prefer or are allowed to only invest in AAA investments may have to find alternatives.  The US dollar is also expected to depreciate further, thus freshly raising questions about the role of the dollar in global trade and as the world’s reserve currency.

Manufacturers and traders are asking whether they should trade their goods in currencies other than the US dollar, to avoid making losses, as shown in yesterday’s Sunday Star* report on the reactions of Malaysian businessmen to the news of the downgrade.

The Federation of Malaysian Manufacturers’ president Tan Sri Mustafa Mansur urged Malaysians to consider trading in Chinese renminbi (since China is poised to be the world’s largest economy and a lot of Malaysia’s trade is with China) and in other currencies to avoid losses in export earnings from the continuing use of US dollars.

Besides the use of the dollar as the main medium of exchange (the currency for global trade), it is by far also the world’s most important reserve currency, thus giving it the function as the global store of value.

Since almost all countries hold the major portion of their foreign reserves in US dollar assets (especially US Treasury bills), there has been increasing worldwide fears over the safety and value of their US investments.

First, there was the scare of possible default by the US government in debt servicing, because of the White House-Democrats-Republican wrangling on the government’s debt ceiling.  On 1 August, just a day before the deadline, a deal was struck in which the debt ceiling would be raised by US$2.1 trillion, provided the government slashes the same amount in its budget deficit over ten years,  with the bulk of how to do that to be decided by a bipartisan committee later.

This gives temporary respite, and the world will likely witness a repeat of the messy Washington budget conflict just a little while later when the committee starts work.  As a caustic commentary in Xinhua news agency put it, the higher debt ceiling “failed to defuse Washington’s debt bomb for good, only delaying an immediate detonation by making the fuse an inch longer.”

Second, the S&P’s credit downgrade has articulated the fears of the investment and policy-making circles that the confused and confusing atmosphere surrounding Washington politics has seriously eroded confidence in the ability of the US to handle its budget, debt, fiscal, financial and economic policy issues.

Only those political analysts who specialize in US politics can fully explain and anticipate the intricacies and implications of the views and tendencies of the various branches of the Republican party (especially its Tea Party component and its effects on the Party’s congressional positions), the Democratic party and the Administration.

But even non-specialists comprehend that there is a serious governance problem in the US which is affecting the rest of the world.  Its political system is experiencing a gridlock which will affect the US dollar, the US economy and thus the world economy’s prospects for what seems to be a long time to come.

Third, the US economy shows increasing signs of stalling and a new recession. Last week’s indicators for consumer spending, manufacturing and services output were negative, and some prominent economists give a 50:50 chance of a double dip recession.

Recession is made more likely by the inability of the Obama administration to take effective recession-busting measures.  Congress will block any new significant fiscal stimulus (as the debt ceiling crisis and solution show), while a new round of printing and injecting money through quantitative easing, which is being considered, may have only limited positive effects.

All these point to a further weakening of the US economy and the US currency, at least in the short term.

These three developments, all in one week, have galvanised those in business, trade, finance and policy making to re-think the role of the dollar and the US economy in the global economy.

In the short run, it is difficult to find alternatives to the dollar as a unit of exchange or as a store of value, mainly because the euro is in a crisis of its own, the Japanese economy faces its own difficulties and the Chinese currency is not convertible enough.

But many agree that in the longer run, a solution or solutions must be found, otherwise the global trading and monetary systems could be in disarray.

There is nothing like a crisis or an emergency to collapse the long run into the short run.  If the US and European crises continue to unfold without respite, the world is in for financial and economic turmoil similar to or even worse than the recent 2008-2009 great recession.  Solutions will therefore have to be urgently sought.

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*          Malaysian newspaper