Are Status-quo Powers’ AAA ratings vulnerable?

Standard & Poor's Logo    Source: Bloomberg

S&P thinks so.  Moody’s and Fitch do not.

Actually, it is more nuanced than that.  A number of what we might call Status-quo or even declining, though still formidable, great powers — including the U.S., U.K., Germany and France – have sustained dramatic negative consequences from the global recession, including rapidly rising government debt levels.  It is a time of testing our assumptions about what makes a great power, what makes a strong economy, and what makes a wealthy society.  And, however painful, we must revise our assessments of relative power and sovereign creditworthiness as needed.   

No doubt such rising powers as China, India and Brazil are poorer – especially in terms of per capita income, but among advanced countries, the economic growth outlook over the medium term looks dismal, as government seeps into more corners of the economy, controlling banking systems and industrial companies, which if not reversed, could eventually stifle private initiative.  In addition, if gaping government deficits are reversed over the medium term via higher taxes, rather than through spending cuts, the government’s stranglehold on the economy will persist.  No matter what, things should get a lot worse before they get better.  Whether or not they get better is in the hands of policy makers.

The U.S. and its allies in Europe are undergoing exactly what Paul Kennedy warned against over twenty years ago in his book, The Rise and Fall of the Great Powers.  Sovereign financial solvency is the foundation on which military and political power can be projected, and this foundation crumbles when governments ignore deteriorating finances.  Governments today must act quickly to cut deficits, once signs of a durable recovery are clear.

The rating agencies remain relatively sanguine.  With the exception of S&P, they don’t expect the major countries to lose their coveted AAA status, as Japan did over a decade ago.  Moody’s even points out that if all AAA’s deteriorate together, they can all remain AAA because ratings are comparative.  However, what is required right now is to compare these AAA’s to lower-rated credits, for example, to such emerging markets as China and Singapore, Hong Kong, Korea and Saudi Arabia.  In spite of what a revision of the relative assessment of, say, the U.K. versus Kuwait might say for how wrong sovereign analysts were in the past, this reassessment must be done.

As for the U.S. and the U.K., the two economies experiencing the textbook example of the current crisis — with declining real estate values, indebted consumers, and failing banks — Fitch Ratings says they:

“possess strong capacity for adjustment, thanks partly to supply-side flexibility, a track record of fiscal consolidation, as well as exceptionally strong balance sheet and financing flexibility.”

 and,

 “Benchmark borrower and reserve currency status are two key features of this financing flexibility.”

 About the U.K. and the U.S., Moody’s says, they:

 “are being tested because of a shock to their growth model and large contingent liabilities. However, in our opinion, these countries display an adequate reaction capacity to rise to the challenge.”

Yet S&P a couple of weeks ago revised the Outlook on the U.K.’s AAA rating to Negative, saying that:  

“in light of the challenges to strengthen the tax base and contain public expenditures, the U.K. government debt burden could approach 100% of GDP by 2013 and remain near that level thereafter. The rating could be lowered if we conclude that, following the forthcoming general election, the next government’s fiscal consolidation plans are unlikely to put the U.K. debt burden on a secure downward trajectory over the medium term.”

S&P, in its report of June 4, forecasts the U.K.’s government debt burden to rise above most other AAA’s, including the U.S., by 2011.  Although the U.K.’s exposure to the current crisis is similar to America’s, its boom in credit to the private sector surpassed that which occurred in the US, with domestic credit to the private sector (and public corporations) representing approximately 200% of GDP in the U.K. versus approximately 150% in the U.S. and a AAA median closer to 130%.   The run-up in U.K. government debt is expected to be even more dramatic than in the U.S.   

Likewise, the U.K.’s GDP growth outlook looks worse in the coming years than its AAA peers’.

Paul Kennedy warned us that “The relative strengths of the leading nations in world affairs never remain constant, principally because of the uneven rate of growth among different societies and of the technological and organizational breakthroughs which bring a greater advantage to one society than to another.”  And, that history shows, “a very significant correlation over the longer term between productive and revenue-raising capacities on the one hand and military strength on the other.”

Kennedy argued that:  1) competition and commercial advances in western Europe in the centuries up to the 16th allowed this region to eclipse other power centers – Ming China, the Ottoman Empire, Mogul India, Muscovy, and Tokugawa Japan – which suffered from excessive centralization of authority; 2) the Habsburgs over-extended themselves militarily relative to their weakening economic base in the 150 years up to the mid 17th century; 3) Great Britain emerged as an economic superpower and a military power that could balance rivalries in Europe, by virtue of innovation in banking, shipping and manufacturing; 4) rapid shifts in economic power up through the turn of the 20th century made for unstable relationships among the rising and status-quo powers; and 5) the the U.S. economy has been in relative decline since the middle of the 20th century with the emergence of the rising powers. 

 The more rapid the shifts in relative power, the more unstable the international system can be – risking war – as the distribution of authority and responsibility rushes to catch up with power realities.  The relative decline of such powers as the U.S. and Europe over the long term cannot be avoided, as poorer nations such as China gain technological know-how to rapidly increase per capita income.  However, the speed and size of the relative decline and its management (i.e. through diplomacy) will determine how shocking this change will be (i.e. through war or through peace). 

Which is all to say that AAA sovereigns, such as the U.K. and U.S., would be well-advised to seek substantive fiscal consolidation (read: cut deficits, especially through spending cuts), once there is confidence the worst of the financial crisis is over.

See:  Standard & Poor’s report on the United Kingdom of June 4, 2009, Moody’s report “How Far Can Aaa Governments Stretch Their Balance Sheets” of February 2009, and Fitch’s report “High-Grade Sovereigns and the Global Financial Crisis” of March 17, 2009.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s


%d bloggers like this: