Kuwait Financial Centre “Markaz” RESEARCH
How is GCC preparing for a “AA+” World? One more crisis to live with
Research Highlights: Analyzing the implications of the US credit downgrade on the GCC region
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M.R. Raghu CFA, FRM Head of Research +965 2224 8280 firstname.lastname@example.org Layla Al-Ammar Assistant Manager +965 2224 8000 ext. 1205 email@example.com Madhu Soothanan Senior Research Analyst +965 2224 8000 ext. 4603 Msoothanan@markaz.com
The rating downgrade that rattled financial markets in August 2011 was of milder intensity compared to the 2008 tsunami financial crisis, whose impact is still being felt. However, the downgrade enabled to perpetuate one thing i.e., maintain the policy response intact which is where the catch is. The world will have a low interest rate environment at least for another one to two years and may lay the foundation for yet another “Bubble-Burst” scenario. The impact assessment of GCC is what this paper is all about. Successful articulation of polices will need to keep in mind several key and collateral risks that have erupted as a result of series of crisis including the latest downgrade crisis. In our opinion, the biggest challenge in a crisis ridden world will be to efficiently and effectively manage the surplus generated in good times. This will enable the GCC governments to progress with their investment program which brings us back to the question of managing risks. GCC Impact Areas Surplus
Oil Price Kuwait Financial Centre S.A.K. “Markaz” P.O. Box 23444, Safat 13095, Kuwait Tel: +965 2224 8000 Fax: +965 2242 5828 markaz.com
Assessment The biggest challenge to GCC would be to deploy effectively and efficiently its huge surplus generated through the oil boom of recent years. With limited absorptive capacity inside, and a crisis ridden world outside, the deployment challenge will be onerous. The rating downgrade does not directly trigger an oil price fall. It may happen indirectly through triggering a double dip recession which in turn pulls down the oil price. However, having built sufficient reserves, the region can weather weak oil prices for a stretch of time before it hurts them. US dollar is clearly declining in value and credibility and so the issue of the GCC currency pegs will come increasingly into focus. However, US dollar weakness was accounted for even before the downgrade. Lack of alternatives also gives some comfort GCC governments have undertaken large domestic investment programs based on their huge reserves. Being non-reliant on foreign investments is a huge plus.
RESEARCH September 2011 Implications for the GCC As with most international events, the implications for the GCC are largely related to oil demand and price fluctuations. However, there are also implications for the region’s equity and debt markets. Saudi Arabia
Saudi Arabia is considered one of the world’s 10 ‘safest’ sovereigns, and attracts foreign investments of USD 1020 bn a year
Oil: While the downgrade has triggered a fear of global double dip recession, it has not yet triggered an oil price collapse. In fact, oil prices have strengthened based on supply concerns. Even in a scenario of low prices as a consequence of double dip recession, the Kingdom sits on a pile of reserves that can see it through its spending program. Saudi Arabia requires a breakeven oil price of $72/barrel to balance its budget at current levels. Pursuant to increase in government expenditure (though mostly current than capital), the breakeven oil price has been growing at a CAGR of 12% during the last 8 years. Assuming a CAGR of about 5% to continue, it will take another 10 years for the breakeven oil price to reach the current level of $120/bbl1, while the Institute of International Finance (IIF) anticipates another 15 years before breakeven oil prices top $110/bbl. Hence, we see that risks triggered by rating downgrade resulting in oil price crash is misplaced at least for the short term. Domestic Investments: Saudi Arabia has been on a strong investment drive over the last few years and this is expected to continue irrespective of global events. Motivation behind such investments (for e.g., employment) is too strategic to sway year on year based on global developments. Continuation of such domestic investment program in light of strong liquidity is a strong possibility.
Banks will get a knock-on effect to all of this as conduits to the efficient and productive operation of the economy
Foreign Investments: Foreign investments, especially in the equity market, could see a decrease as investors turn risk averse in a tentative global economy. Although, given that Saudi Arabia is considered one of the world’s 10 ‘safest’ sovereigns, and attracts foreign investments of USD 10-20 bn a year, we do not foresee a significant decrease in the same in the Kingdom. Stock Market: The stock market has already reacted to the US downgrade, however, further negative cues, such as a downgrade by Moody’s (Fitch has already affirmed its Outlook) would lead to further declines. The TASI is down 7.5% for the year and saw a 5.5% drop on the day following the downgrade. Furthermore, if cost of equity goes on the rise, it would have a declining effect on company valuations which may cause a sell-off as brokers decrease their Fair Value assessment of firms. Banks will get a knock-on effect to all of this as conduits to the efficient and productive operation of the economy, i.e. if government spending decreases, the economy slows and the stock market shows lackluster performance, it will create an environment that is not conducive to bank lending thereby denting performance. Furthermore, if further downgrades occur, banks could see an increase in risk-weighted assets as they reclassify holdings based on new ratings.
Jadwa Investment, Saudi Arabia’s coming oil and fiscal challenge, July 2011
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RESEARCH September 2011 SWF: Lower state revenues will also have implications for the Kingdom’s Sovereign Wealth Fund (SWF). The SWF and Monetary Authority’s reserves and investments are mostly held in USD denominated investments and US treasuries; this exposure insolated the SWF in the 2009 global financial crisis The stock market has already where its portfolio actually gained in value versus peers like ADIA and KIA. declined 17% for the year and The SWF might not be so lucky this time around as it will be hit both with the currency factor of a weakening dollar in addition to a hit in treasuries. tumbled 2.5% on the day following the US downgrade Kuwait Oil
Oil: Like Saudi Arabia, Kuwait has built considerable reserves during the oil boom. Measured in GDP terms, in fact, it has performed even better than Saudi Arabia in terms of reserve building as budget expenditure grew more moderately during the last few years when benchmarked with Saudi Arabia. At a breakeven oil price of $70/bbl the current oil price provides a cushion of $50/bbl. Even in a scenario where oil price reaches the breakeven level, the State of Kuwait can begin to draw on its reserve pile for a long time before it drains out.
The Real Estate and Investment sectors make up the bulk of the market and remain distressed post the financial crisis of 2008/2009
Domestic Investments: Kuwait’s domestic investments have been lagging for some time. The country’s Development Plan came in to sort out this problem; much of the USD 125 bn plan is built on government spending coupled with increasing the attractiveness of Kuwait to Foreign Investors. While the cost of finance will rise pursuant to US debt downgrade, it may not reach a point where the domestic investments could be scaled down. Foreign investment in the country is weak by regional standards, at less than USD 150 mn a year2. Stock Market: The stock market has already declined 15% for the year and tumbled 2.5% on the day following the US downgrade. The Kuwait market has become hypersensitive to global cues; consequently, sustained negative news (such as a worsening of the Euro-crisis, a further downgrade of the US or a downgrade of another G7 nation) would cause further declines to the market. According to the IMF, the State’s banks are well-capitalized; the sector’s Capital Adequacy Ratio (CAR) increased to 19% in 2010 (17% in 2009) due to capital increases during the year while leverage ratios are averaging about 13%. NPLs are down to about 9% in 2010 (11.5% in 2009) though still high by regional standards. Bank’s loans are heavily concentrated on Real Estate (26%), Retail loans (33%) and non-bank financial institutions (12%) which are essentially Investment Companies3. The Real Estate and Investment sectors make up the bulk of the market and remain distressed post the financial crisis of 2008/2009. An increase in cost of equity and weakening of the dollar could be detrimental to the sector’s balance sheet which would ultimately impact the bank’s loan portfolios. SWF: The sovereign wealth fund, Kuwait Investment Authority (KIA), receives the majority of the government’s revenues for investment purposes; and the same is deployed on a globally spread portfolio across various asset classes. To the extent the SWF investments are exposed to US treasuries and the US$ currency, it runs the risk of value erosion. However, we don’t foresee a significant decline in KIA’s earnings as investments tend to be
The World Bank IMF Country Report, July 2011
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RESEARCH September 2011 geographically spread4 rather than concentrated in one country or riskbracket. The Abu Dhabi stock market has remained relatively well isolated from negative global market cues
Given that much of Abu Dhabi’s economic growth and diversification strategy is dependent on government spending of oil revenues, a prolonged decline in oil prices due to a slowing world economy could put a damper on progress. However, we believe that given the reserves built up in addition to the wealth generated and deployed by the Abu Dhabi Investment Authority (whose assets are reportedly upwards of USD 630 bn5), the emirate should be able to maintain its spending plans despite any nominal decline in the value of its reserve assets. The Abu Dhabi stock market has remained relatively well isolated from negative global market cues; it remains one of the best performer in the GCC on a year to date basis (-5%), despite suffering a 2.5% drop following the US downgrade. Abu Dhabi banks have also held up relatively well during the downturn, 2Q11 net earnings came in at USD 1.17bn, a 74% YoY increase, while 1H11 net profits were at USD 2.12bn, a 38% YoY increase. We expect the banks to continue to be supported by strong government spending in addition to healthy economic growth.
Dubai is in a slightly more precarious situation given the declines suffered as A further downgrade in the US a result of the global credit crisis, which it is still recovering from, in addition and/or another G7 nation could to the fact that it has more of a global linkage than Abu Dhabi. result in cost increases for Given that the Dubai economy is reliant mainly on Trade and Tourism for GDP foreign and local firms growth, these may see a decline should world economic growth decline. Should economic growth in Dubai be hindered, it could prove detrimental to domestic investment by the government and private sector. This may also affect the confidence factor for foreign investors, who would increase their risk premium on Dubai post the US debt downgrade. However, one should note the fact that Dubai has strong ties with foreign institutions which have been reaffirmed post-crisis through successful bond raises and continuation of major infrastructure projects across the emirate. A further downgrade in the US and/or another G7 nation could result in cost increases for foreign and local firms. Additionally, declining global growth and poor market conditions could increase risk aversion among foreign investors, leading to a pull out of Arab markets. Banks could see an escalation of risky assets as ratings change leading to a squeeze on capital adequacy ratios, which coupled with an increase in provisions would dent bottom line performance going forward. Additionally, the stock market has been performing poorly for the year, down by about
based on news articles and anecdotal evidence Sovereign Wealth Fund Institute
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RESEARCH September 2011 11%, and we expect it to continue to be hypersensitive to global and regional cues. Qatar
Qatar is currently implementing many regulatory reforms and developments
Qatar enjoys similar comfort as that of Saudi Arabia, Kuwait, and Abu Dhabi when viewed from oil and gas resources and reserves. Hence, we perceive lower risk on that account. Qatar has also been one of the best performing markets in the GCC over the last two years, successfully skirting the global financial crisis while maintaining its growth trajectory. Consequently, we see a mid-level risk in terms of the stock market, which is down about 3% for the year. Despite the fact that the economy is highly dependent on LNG production, we expect the reserves and revenues built up by the State through the years to allow it to continue to implement large-scale development plans such as the USD 125 bn National Development Strategy which was put in place this year. Lower state revenues may have implications for Qatarâ€™s Sovereign Wealth Fund (SWF) whose reserves and investments most likely have a US bias (detailed information on holdings is unavailable) which may see a nominal devaluation as the dollar weakens.
Oman and Bahrain have both had a relatively difficult 1H11
Furthermore, Qatar is currently implementing many regulatory reforms and developments, such as encouraging firms to lower Foreign Ownership Limits (in order to be upgraded to MSCI Emerging Market status) in addition to setting up an organized bond market. These measures, coupled with largescale projects relating to the World Cup 2022 event, should keep foreign investor interest sustained. Oman and Bahrain Domestic Investments
Oman and Bahrain have both had a relatively difficult 1H11 with political turmoil dampening the economy and market sentiment. Oman, down 15%, is the worst performing GCC for the year while Bahrain, down 12%, is only marginally better. Lower global growth and dampened oil demand would make it relatively more difficult for Oman to enact domestic investment programs. This difficulty is compounded by the lingering political issues, mainly relating to unemployment, which the government must address. As for the banking sector, it will be affected by a slowing economy and lackluster market conditions. The impact in Bahrain is expected to be higher; the country does not have oil revenues to fall back on (the economy depends on tourism and the financial sector) in order to boost public spending and consequently, any further strain on the economy will lead to declining domestic investments. Moreover, the government currently runs a deficit of about -6% of GDP, placing further strain on government spending. Furthermore, banks have already suffered Kuwait Financial Centre â€œMarkazâ€?
RESEARCH September 2011 during the year, due to political strife, with some businesses moving offices to ‘safer’ locales like Qatar or Dubai. Consequently, the risk perception of the country has risen, with 5 yr CDS spreads up 42% for the year, which would make it difficult to attract foreign investors back. The short term effect has been felt already with the GCC stock markets experiencing large declines following the announcement
GCC Equity Markets-Post AAA Downgrade The short term effect has been felt already with the GCC stock markets experiencing large declines following the announcement; Saudi’s Tadawul tumbled 5.5% on the 6th of August (Table 1). When other GCC markets opened on Sunday, they experienced sharp declines; Qatar and Dubai were down 5% at the open while Kuwait quickly shed around 3%. However, the markets managed to regain some of the lost ground, but still closed in the red. Qatar and Kuwait (weighted index) both closed down 2.51% while Dubai lost 3.7%. GCC stock markets have shed USD 31 bn in market cap since the announcement of the US debt deal at the end of July. The stock markets could decline further as international markets fluctuate wildly on varying risk assessments.
Table 1: Immediate Impact of Downgrade on Local Exchanges Index losses 1st Day Impact* (Rating Downgrade) 27th July – 10th Aug (Debt Deal announcement)
S&P GCC Index
USD bn Market Cap Decline -21 -4 -1 -1 -3 -1 (27 July – 10th Aug) Note: Kuwait represents Kuwait Weighted Index Note*: 1st Day Impact represents 6th of August for Saudi Arabia and 7th of August for other GCC Markets. Source: Reuters Eikon, Markaz Research
-5.32% GCC Total
CDS spreads, which give an indication to the level of risk perceived in a market, saw increases across the board following the US debt deal and downgrade (Figure 1). All markets saw spreads jump between 7.5% and 22% in the case of Oman. We would expect CDS spreads to remain volatile while equity markets fluctuate. Figure 1: Impact on CDS Spreads (5 yr USD)
We would expect CDS spreads to remain volatile while equity markets fluctuate
As global equity markets re-price risk, prices will undoubtedly be affected. Regional Brokers / financial institutions will have to come to terms on whether Kuwait Financial Centre “Markaz”
RESEARCH September 2011 they will accept US Treasuries as collateral for their short term funding requirement. While it may take time to come to a consensus on this, in the short term, it will surely affect capital markets. The situation will become more important if any other agency downgrades US, leading to a systemic problem of triggering margin calls. On the longer-term, there is expected to be some implication for oil prices in light of a weakening US economy and decreasing forecasted demand
Oil On the longer-term, there is expected to be some implication for oil prices in light of a weakening US economy and decreasing forecasted demand. Specifically, US forecasted oil demand has been tempered by the near stalling of economic growth in 2011. In light of a downward revision in forecasted 2011 US GDP growth (to between 2%-2.5% from a previous forecast of around 3%6), Deutsche Bank brought down its US oil demand growth forecast by half to about 100,000 b/d7. A point to note here is that, US accounts for nearly 22% of global oil consumption. Figure 2: Crude Oil (Brent)
The US Dollar has seen wild swings post-downgrade Analysts are expecting crude (Brent) to come down to the mid-$90 range by the end of the year; not exceedingly troubling for the GCC but could place constraints on less oil-rich members. US Dollar & Reserves Apart from oil being billed in dollars, most GCC currencies are pegged to the dollar, so any serious fall in US dollar value might put a strain on government finances. The US Dollar has seen wild swings post-downgrade; the greenback tumbled 1.63% against the Euro immediately following the downgrade before rebounding sharply the following sessions. The currency continues to fluctuate with market swings and mixed cues.
Consensus of estimates including IMF Bloomberg
Kuwait Financial Centre â€œMarkazâ€?
RESEARCH September 2011 Figure 3: USD Impact
US forecasted oil demand has been tempered by the near stalling of economic growth in 2011
Corporates will have to pay more for their imports billed in other currencies. GCC countries depend on imports for most food items; any increase in food prices will stroke inflation fears affecting economic growth. Table 2: GCC Economic Indicators USD bn Reserves ex. gold Imports % of GDP Inflation (ave. % change) Source: IIF
2007 421 403 33.2 6.9
2008 513 510 34.0 11.1
2009f 503 428 35.6 2.7
2010f 546 472 34.1 3.3
2011f 601 484 NA 4.4
Gulf countries and sovereign wealth funds are estimated to hold a large amount of US Treasuries and dollar denominated assets which will depreciate impacting mark to market valuations. Private Banks and other financial institutions also have exposure to US Treasury, a mark down in their value will affect profitability – despite it being a notional loss. The US Dollar has seen wild swings post-downgrade
Officials from the UAE and Oman have already indicated that they are in no hurry to discontinue their dollar peg. In fact, following the conclusion of the debt deal, but prior to the downgrade, the UAE central bank made a surprise announcement that it had no US Treasury Bills in its reserves or any other financial instrument issued by the US government, citing “very low return”. The announcement came as a surprise given the currency peg to the Dollar. Anecdotal evidence suggests that the Central Bank has turned to Japan for Dollar-denominated government debt. Given declining credibility in the US government, further dollar weakening and a larger divorce between economic realities between the two, the GCC governments may wish to revisit and speed up plans to create a unified GCC currency as pegging to dollar leaves policymakers with limited room to implement independent monetary policy decisions. Cost of borrowing could see an increase thereby affecting corporate balance sheets. Should US Treasury yields reverse their current course and begin rising, cost of equity would see an increase thereby affecting not only Kuwait Financial Centre “Markaz”
RESEARCH September 2011 corporate balance sheets but also valuation of said companies which may Any increase in food prices will have stock market implications. stroke inflation fears affecting Floating rate bonds which are linked to US LIBOR rate might see increase in economic growth yields. Short term funding and refinancing will take a hit if liquidity dries up in the market. As S&P downgrades other institutions related to US government, counterparty credit risk will increase leading to liquidity problems. Will the sovereign wealth funds step in this time to support US Treasuries remains a big question.
Kuwait Financial Centre â€œMarkazâ€?
RESEARCH September 2011 Appendix1: AAA Fiasco: A Primer On the 5th of August 2011 the S&P ratings agency downgraded the U.S.'s AAA credit rating for the first time, slamming the nation's political process and criticizing lawmakers for failing to cut spending enough to reduce record budget deficits. The historic move signals a blow to the world’s largest economy and throws doubt on an already tentative global economic recovery. S&P downgraded the rating by one notch from AAA to AA+ with a “negative” long-term outlook, implying that the agency could lower the long-term rating to 'AA' within the next two years if there is less reduction in spending than agreed to, a rise in US interest rates, or new fiscal pressures resulting in higher general government debt. The downgrade has wide-ranging implications in terms of not only borrowing costs, but also casting doubt on the US status as a global reserve currency. According to JPMorgan Chase & Co, the downgrade could raise the US’ borrowing cost by about $100 bn a year. There are also significant medium and long term implications for currencies, commodities and the already fragile global economic recovery. S&P’s decision follows Moody's and Fitch which affirmed their AAA credit ratings following the signing of the $2.1 trillion deficit-reduction plan which includes a decision to increase the debt-ceiling. Moody's and Fitch also said that downgrades were possible if lawmakers fail to enact debt reduction measures in addition to the economy weakening further. Chinese credit rating agency Dagong has also downgraded US credit rating from A+ to A with a negative outlook. Rising public debt burden and policy uncertainty were the primary reasons behind the downgrade. Under S&P’s base case fiscal scenario net general government debt is expected to rise from an estimated 74% of GDP by the end of 2011 to 79% in 2015 and 85% by 2021. Meanwhile, Fitch projects U.S. government debt, including debt incurred by state and local governments, to reach 100% of GDP by 2012, and continue to rise over the medium term. What is behind the downgrade? This is not the first time the US faced a downgrade threat; a similar crisis loomed in 1995. It is worth noting that at the time, the debt was at just $4.9 trillion8 (or 71% of GDP) versus over $14 trillion (or 91.5% of GDP) currently. However, at that time, the US economy was on a steady growth trajectory, growing at about 4% a year versus current sluggish growth. Given the political deadlocks which formed the backdrop of the US debt crisis (See Appendix 2 for a timeline of events), much of the S&P downgrade report spoke of the inadequacy of the US government and fractious political leadership which has proven unable, or unwilling, to efficiently lead the country’s fiscal management versus an inability to repay debts. S&P advocated a mixed solution of spending cuts and revenue growth. But as the recent negotiations made it clear, the Republicans have been unwilling to allow any tax increases. The fact remains that a downgrade has been a long time coming and there are structural issues within the US economy and fiscal situation that the governing parties have been largely unwilling to deal with in a meaningful way. Debt A statutory limitation on federal debt is a long standing feature of the US fiscal framework and applies to nearly all Treasury debt. The debt limit has been changed many times in the past — ten in the last decade and twice in 2009 alone. The agreement passed on August 2nd provides for an initial increase of the debt limit of $400 bn and introduces procedures that would allow the limit to be raised further in two additional steps, for a cumulative increase of between $2.1 trillion and $2.4 trillion by end-2011. The debt deal also calls for as much as $2.4 trillion of reductions in expenditure over the next decade. These cuts will be implemented in two steps: the $917 bn agreed to initially, followed by an additional $1.5 trillion that the newly formed Congressional Joint Select Committee on Deficit Reduction is supposed to recommend by November 2011. The act contains no measures to raise taxes or otherwise enhance revenues, though the committee could recommend them.
AP, August 3rd 2011
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RESEARCH September 2011 Figure 4: USA Federal Debt as % of GDP, 1940 – 2010
Public Debt as % of GDP
World War II
2010 Public Debt = 62% of GDP
Source: White House Office of Management and Budget
Deficit Critics of the last-ditch deficit-reduction plan say it amounts to little more than “can kicking” as it does not solve the major spending issues related to Social Security, Medicare and Medicaid and existing tax benefits to the wealthy and business segments. Analysts have also been critical of the fact that the plan is largely dependent on spending cuts which could further derail the already tentative economic recovery. In addition to nearly $10 trillion of outstanding treasury debt, the US is estimated to have $66 trillion of future liabilities at “net present cost”. Payments due from Medicaid, Medicare & Social Security alone are over six times the current obligations of Treasury debt9. Social entitlement programs currently account for 58% of US expenses amounting to nearly $2 trillion in 2010. The US has been running budget deficit for the last 9 years continuously and suffers long-run fiscal problems of rising health costs, an aging population, and a staunch unwillingness to raise taxes. Figure 5: US Fiscal Budget
Source: White House Office of Management and Budget.
Can the US get its rating back? There are currently 18 countries which enjoy a AAA rating, following the downgrade of the US to AA+ status. The US was the oldest member of the club, followed by France. The US is certainly not the first, nor will it be the last, to lose the coveted AAA status. However, it has been shown that once losing the rating, it can be very difficult to recover (Table). According to S&P, restoring the AAA rating can take a country
Kleiner Perkins Caulfield & Byers
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RESEARCH September 2011 between nine and eighteen years. Moreover, once a country has been downgraded, it has a 52% chance of being downgraded further within two years, but only a 9% chance of being upgraded10. Table 4: Countries which lost & regained AAA status Country
Number of Years
Finland (Republic of)
Sweden (Kingdom of)
Australia (Commonwealth of)
Denmark (Kingdom of) 06-Jan-83 27-Feb-01 Source: Standard & Poor’s Global Credit Portal, August 2011
Two relatively recent experiences shed some light on how difficult it can be to regain a lost rating. Australia lost its rating in 1986 and was returned to AAA only in 2003. Canada is the other example and also holds the record for quickest return to AAA status. The country was downgraded in 1992 and managed to regain the rating by 2002. Both countries were required to endure strict spending and budgetary constraints in addition to taking severe measures to control debt. However, it must be noted that, in both cases, the economies were showing healthy growth rates; Real GDP in Australia and Canada grew at an average of 3.5% each during their ‘downgraded’ periods11. Additionally, the world economy was performing relatively well at the time; growing between 3%-4% throughout the period with Australia benefitting from the high growth in the Chinese economy during that timeframe. Conversely, the US is still struggling with a fragile and tentative recovery, seeing sub-standard growth rates and a near stalling of the economy thus far in 2011 (Real GDP has been bumbling along with a 1% ann. growth rate in 1H1112). Such conditions are not conducive to the type of spending cuts and debt management measures required to return the country to a state whereby a AAA rating would again be warranted. Regaining the coveted rating will take a combination of medium-long term measures aimed at addressing the country’s underlying financial issues in a meaningful and coherent manner. An indication of just how difficult it is to regain the rating is illustrated below. Table 5: Countries which lost and are yet to regain AAA status Lost
Years since Downgrade
United States of America (unsolicited)
Ireland (Republic of)
Spain (Kingdom of)
Venezuela (Bolivarian Republic of)
New Zealand 01-Nov-76 Source: Standard & Poor’s Global Credit Portal, August 2011
Global Implications Equities: There has already been a severe correction across US and International Equity markets in light of the downgrade. A reported $2.5 trillion was wiped off global markets13 during the weak as the US debt saga reached fever pitch. Equity markets are expected to continue to be hyper-sensitive to negative cues, not solely due to the downgrade (which, after all, was not entirely unexpected), but in larger part due to continued economic weakness in addition to poor progress with the sovereign debt issues in the Eurozone. Treasuries: There is not expected to be a flight out of Treasuries given that the US issues almost 60% of the world’s sovereign debt while the 2nd and 3rd largest issuers (France and Germany) are embroiled in their own debt issues within Europe. Moreover, no other debt market can match the US in terms of liquidity and debt.
The New York Times For Australia: 1989-2003; For Canada: 1993-2002 12 US Bureau of Economic Analysis 13 Reuters 11
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RESEARCH September 2011 US 10 year treasuries tumbled 8% prior to the downgrade before jumping 6.5% post-announcement. Yields have been pushed down to 10-month lows (down to 2%), reinforcing belief in the US’ creditworthiness. Japan, the 2nd largest holder of treasuries, indicated that despite the downgrade, they remain attractive investment targets. Treasury yields could come back up by 60-70bps over the “medium-term”14. According to Citi, given the distribution of US Treasuries, we are unlikely to see a flight from the asset either willingly or through mechanical or ‘forced’ selling. Institutions, Funds, the Fed and non-US Central Banks and SWFs hold about 70% of the pie; these entities would either a) be willing and able to hold non-AAA rated debt, or b) be unwilling to drop the paper for various political and economic reasons. The question mark here, as Citi sees it, lies with the non-US Private Investors, who hold about 13% of the total. It is unclear whether they would move into other, more highly rated debt or into other US-denominated instruments. Figure 6: US Treasury Ownership by Segment
What about China? China, which is the largest holder of US Treasuries, has repeatedly pushed Washington towards increased fiscal responsibility given the contagion it would have in the global monetary system. Following the downgrade, China condemned the US for its “debt addiction” stating that given China’s position as “the largest creditor of the world's sole superpower, [it] has every right now to demand the United States address its structural debt problems and ensure the safety of China's dollar assets.15” Table 7: Major Foreign Holders of Treasury Securities as at May-11 Country China Japan UK Oil Exporters# Brazil Others Total
Value (USD bn) 1,160 912 347 230 211 1,654 4,514
- Oil exporters include Ecuador, Venezuela, Indonesia, Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, the United Arab Emirates, Algeria, Gabon, Libya, and Nigeria Source: Dept of Treasury
China urged the US to cut military and social welfare spending (which make up the bulk of “sticky” expenditures) and make serious changes to its fiscal management to avoid further downgrades which could trigger widespread financial turmoil. The country went further by calling for “international supervision over the issue of the U.S. dollar and a new, stable and secured global reserve currency” as “an option to avert a catastrophe caused by any single country.” US Monetary Policy: the enacting of QE3 seems more likely than ever as the Fed has already announced intentions to keep interest rates low for an extended period.
JPMorgan Chase Xinhua news agency, August 5th 2011
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RESEARCH September 2011 Commodities: Gold’s status as a safe haven is likely to be reinforced by the rating downgrade; the precious metal is already at record highs (hovering around $1,858/oz), a gain of 31% YTD. Silver is already up about 39% for the year and is unlikely to see as much benefit from the uncertainty given that it has an industrial component which will be negatively affected by weaker economic growth. Currencies: The move will likely see a further weakening of the US Dollar, which is already down 7% against the Euro for the year. The other two “safe” currencies, i.e. Swiss Franc and Japanese Yen, are likely to gain from the Greenback’s decline, at least in the short-term. The Yen is already up about 6% against the Dollar for the year. Given the increased likelihood of QE3 coupled with a view (at least in some quarters) that this might be the first in a series of downgrades (especially given the Negative outlook by S&P and Moody’s), the US Dollar is likely to weaken further in the medium term as Central Banks and sovereign institutions move out of USD and into other, ‘safer’ currencies. Questions are also being raised about America’s ability to continue to print the world’s reserve currency. With European Union not showing any stability, US dollar will retain its status to be the world’s reserve currency at least in the medium term albeit with decreasing share of global reserves. Appendix 2: International & Regional Viewpoints Mohamed A. El-Erian, PIMCO – El-Erian expects that credit costs for American borrowers will be higher over time and there will be an increase in risk premiums and volatility. He said “Animal spirits, already hobbled by the debt ceiling debacle, will again be dampened, constituting yet another headwind to the generation of investment and employment”. El-Erian feels that the US Dollar’s status as the global reserve currency is not in jeopardy following the downgrade. While criticism is sure to follow, at the moment, there is simply no alternative to the greenback. “… No other country is able and willing to replace the US at the core of the global system…. Specifically, will it simply come to a new normality, with an AA+ at its core, or are further structural changes now inevitable?” China - In its commentary, Chinese state-run Xinhua News Agency issued government statements which severely criticized the US for living beyond its means and heralding the S&P downgrade as a sign that the days of unlimited borrowing are gone. The agency urged citizens to become more self-disciplined and contribute towards rebuilding the economy “…. mounting debts and ridiculous political wrestling in Washington have damaged America's image abroad. All Americans, both beltway politicians and those on Main Street, have to do some serious soul-searching to bring their country back from a potential financial abyss.” The country went further by calling for international supervision over the US Dollar: “a new, stable and secured global reserve currency may also be an option to avert a catastrophe caused by any single country.” Citigroup Global Markets – According to Citigroup, the rating was not only expected, but was entirely justified given the lack of fiscal leadership and inability to agree on appropriate debt and deficit reduction measures in the US. They also believe that downgrades could now spread across other developed nations such as France and Germany. “We could be moving towards a world without AAA G7 sovereigns. The criteria applied by the rating agencies to the G7 sovereigns in the past have been, in our view, far too lenient.” Citigroup indicates that post-World War II, there has been a severe erosion in “tax administration capacity, diminishing tax compliance in the private sector, and the evolution of political decision-making institutions, processes and practices that make it possible to mandate public spending without ensuring sustainable funding for these expenditures.” The US downgrade brings an end to the time where a AAA rating for advanced countries was not only ‘correct’, but a ‘right’. “Only a few small countries with a surviving culture of tax compliance and political institutions that effectively impose the government’s intertemporal budget constraint may have AAA ratings in the not too distant future. For portfolio allocation, relative risk will be the driver now that 'risk free' is no longer an option.” Absolute Return Partners - In a letter to investors, the firm said that it feels the rating downgrade doesn’t carry any meaning as the U.S. has only dollar denominated debt. “A nation that issues debt denominated solely in its own currency and which is in full control of its monetary policy, cannot default unwillingly. Nations default because they run out of foreign currency to service their debt, but the U.S. doesn’t need foreign currency to service its debt”. The letter also stated that this downgrade might have be a precursor to further downgrades in Europe as well. “With its downgrade of U.S. sovereign debt, Standard and Poor’s has started a chain of events which can only make things worse in an already crisis hit eurozone. Kuwait Financial Centre “Markaz”
RESEARCH September 2011 For that reason, the decision to downgrade was not only badly timed but also ill considered; that it was probably justified is of little relevance at the moment.” JPMorgan Chase & Co.’s - Terry Belton on a conference call hosted by the Securities Industry and Financial Markets Association forecasted that a rating cut could increase borrowing costs. “A U.S. creditrating cut would likely raise the nation’s borrowing costs by increasing Treasury yields by 60 to 70 basis points over the medium term”. He also predicted that “$100 billion a year is money being used for higher interest rates and that’s money being taken away from other goods and services.” Barclay’s Capital – The firm is of the view that the US debt downgrade will be a positive for dollar. "We separate our discussion of the impact of a potential US downgrade into two – the immediate and the slightly longer-run consequences… The immediate effect would be one in which risk aversion increases and liquidity decreases, both of which support the USD.” Over the long term, Barclay’s Capital sees growth getting curtailed because of tight monetary policies. “However, the fact that this is a US-driven risk, the USD will likely lag other safe-haven currencies (such as the JPY and CHF). Further out, we see fiscal tightening weighing on growth and the USD weakening further, as monetary policy is kept looser for longer than the market is expecting." Stephan S. Roach, Non-Executive Chairman of Morgan Stanley Asia - In a commentary on change in Chinese policies indicated that China has lost confidence in America’s government and will not risk its economic stability on Washington’s promises. “In recent years, Chinese Premier Wen Jiabao and President Hu Jintao have repeatedly expressed concerns about US fiscal policy and the safe-haven status of Treasuries….” He also pointed out that the Chinese are revisiting their strategy of export-led growth and massive accumulation of dollar-denominated assets. “Those days are over. China recognizes that it no longer makes sense to stay with its current growth strategy – one that relies heavily on a combination of exports and a massive buffer of dollar-denominated foreign-exchange reserves… Long the most powerful driver of Chinese growth, there is now considerable downside to an export-led impetus” David A. Rosenberg, Gluskin Sheff - In a recent report, indicated that the downgrade will lead to tightening of budgets which is a positive for bond markets. He expects equity prices to come under pressure because of sluggish demand growth. “The big news is that the screws have been tightened on the fiscal stimulus front. So on net, the downgrade is a deflationary event and as such is not negative but positive for the bond market. History shows that every time a AAA country gets downgraded, the budgetary belt is tightened and yields decline every time.” Rosenberg also feels that there will not be a huge impact because of rating downgrade given that US is still the reserve currency and S&P’s emphasis was more on political factors. “The U.S. can print its own money and certainly has the wherewithal to pay its debts so the downgrade is more symbolic than real…. But default risks are no different today than they were last Friday morning, and the Treasury had already said repeatedly that bondholders would be made whole even if there was to be a government shutdown.” Regional Ibrahim Dabdoub, CEO of National Bank of Kuwait – Mr. Dabdoub feels that the US rating downgrade was not a surprise and does not expect it to affect the economy. “….dollar remains the first reserve currency worldwide. Thus, the recent cut will unlikely have great influence on the US economy, on condition that the US government takes the right measures to slash spending.” Ibrahim Dabdoub doesn’t foresee any major negative impact on GCC economies, because of large surpluses and government spending programs. “….government spending remains the main driver for the GCC economies, expecting expenditure to accelerate in H2-11, after falling shy of expectations in the first half.” Said A. Al Shaik, Group Chief Economist of NCB – In a recent report indicated that the near term implications will be minimal but expects negative impact on US Dollar over the long term. “The longer-term effects are driven primarily by whether international markets will eventually also downgrade the US. Consequently, the biggest impact should be through the effect on the US dollar as a reserve currency”. Al Shaik feels that the downgrade will impact Saudi Arabia in three ways – Crude Oil demand & price changes, US Dollar movement and through official holdings of US treasuries. “Holders of US treasuries like Saudi Arabia should not be concerned that they may not receive interest payments on US bonds. However, the value of those payments will essentially decline, given the fact that with more dollars in circulation due to the printing presses….” Kuwait Financial Centre “Markaz”
RESEARCH September 2011 Jadwa Investment in its report titled “Debt, downgrade and Saudi Arabia” expects US to continue its position as a safe haven despite the downgrade. “The breadth, depth and liquidity of the US financial markets also support its safe haven status. No other financial market is of a comparable size or has the same variety of financial instruments as the US”. They are also of the view that Saudi economy will not face any major negative consequences and that currency peg will continue. “We do not think ongoing events will have too great an impact on the Saudi economy, as the growth momentum is coming from high government spending that can be afforded comfortably…. We do not think the downgrade will have an impact on the exchange rate peg between the riyal and the dollar.” Alshall Consulting in its Weekly Economic report indicated that US will continue its dominant position in the world. “The USA will remain for one to two decades as the largest global economy, trustworthy, and the first destination for creditors and investors”. They are also of the view that there will be gradual transition of economic power and search for substitutes for US Dollar as reserve currency will take place. ”What is happening is a more significant indicator for the beginning of an era in history during which the economic weight will shift from the West to the East and will gradually introduce alternatives and partners to the dollar as a global reserve currency.” Appendix 3: The US Downgrade: A Timeline16 The S&P downgrade is the culmination of a saga which began in late 2010 concerning the US’ rampant debt and runaway deficit growth. The government has been running a rapidly widening deficit for the last decade with high debt accumulation. Dec. 1, 2010 - A bipartisan deficit-reduction panel issues a report advocating a 10 yr plan which includes $3 trillion in spending cuts and $1 trillion in revenue increases. January 2011 - Six Republican and Democratic senators, known as the "Gang of Six," begin talks on a long-term deficit-reduction deal. Feb. 19 - The House passes a current fiscal year budget that would cut $61 bn in spending. The Democratic-controlled Senate defeats it one month later. April 9 – The US government approaches a shutdown before Obama and congressional leaders cut an 11th hour deal and agree on a fiscal budget that cuts $38 bn in spending. Billed as the largest spending cut in U.S. history, it actually causes the government to spend $3.2 bn more in the short term. April 13 - After Obama's initial proposal is deemed inadequate, the president lays out a new deficitreduction plan that would save $4 trn over 12 yrs. April 15 - The House passes a budget which cuts spending by $6 trillion over 10 yrs, in part by scaling back medical care for the elderly and the poor. May 9 - House Speaker John Boehner (Republican), says any increase in debt ceiling must be matched by an equal amount of spending cuts. The Treasury estimates it needs at least $2 trn to cover borrowing through the 2012 elections. May 11 - House Republicans release a spending outline for the coming fiscal year that has deep cuts in education, labor and health programs which are highly prized by Democrats. May 16 - The United States reaches its $14.3 trillion debt limit. The Treasury Department begins tapping other sources of money to cover the debt. June 9 - Treasury Secretary, Timothy Geithner argues that tax increases need to be part of any debt deal, but Republicans remain unmoved. 16
Reuters, July 25th 2011
Kuwait Financial Centre “Markaz”
RESEARCH September 2011 June 23 - Republicans declare an impasse in talks with the White House, saying Democrats are insisting on roughly $400 bn in new revenue by closing tax breaks for the wealthy and certain business sectors. June 29 - The International Monetary Fund says the United States must lift its debt limit soon to avoid a "severe shock" to global markets and a still-fragile economic recovery. Obama calls for new steps to spur job growth and tax hikes on the rich, irking Republicans who remain focused on deficit cuts. July 3 - Obama and Boehner discuss "grand bargain" that would save $4 trn over 10 yrs through a tax code overhaul and trims to benefit programs. July 8 - A dismal jobs report focuses new attention on the sputtering economy. Obama says uncertainty about the debt ceiling talks is hurting economic expansion. July 9 - Boehner says grand bargain is out of reach because Republicans will not accept the tax increases Democrats are demanding. He calls for a more modest $2 trillion package that would rely mostly on spending cuts. July 13 - Moody's puts the US on review for possible downgrade. Obama meets lawmakers for nearly two hours but a deal remains elusive. July 14 – S&P Ratings says there is a 50% chance it could cut the U.S. credit rating if talks remain stalemated. Obama suspends talks and gives party leaders 24-36 hours to deliver a deadlock-breaking "plan of action." July 18 - Republicans push for a measure that would cut and cap government spending and require an amendment to the U.S. Constitution requiring a balanced budget. Obama says he will veto it should Congress send it to his desk. July 19 - The "Gang of Six" resurfaces with a deficit reduction plan that proposes $3.75 trillion in savings over 10 years and contains $1.2 trillion in new revenues. Obama pushes Congress to take serious consideration of it. July 21 - Obama and Boehner discuss a possible $3 trillion deficit-cutting deal that upsets Democrats for not including enough tax rises to offset spending cuts. Obama repeats some revenues will need to be part of any accord. July 22 - Boehner breaks off talks with Obama over impasse on revenue increases, raising concerns about whether a deal can come together by the August 2nd deadline. July 24 - Republicans and Democrats retreat to their corners and focus on separate plans to avert default. Democrats meet with Obama to discuss a proposal to cut $2.5 trillion in spending without revenue. Boehner urges Republicans to stay united to secure the most budget cuts possible. July 31 – Leaders of both political parties reach a last minute deal which aims to raise the debt ceiling by $2.1 trillion with a plan to cut the fiscal deficit by up to $2.4 trillion over a 10 year period. The plan also includes the formation of a bipartisan committee to seek out $1.2 trillion in spending cuts by the end of the year. August 2 – Moody’s affirms US credit rating, but places the country on “Negative” outlook, indicating a possible downgrade over 12-18 months. Fitch announces that it will provide its rating by end of August. August 5 – S&P Ratings downgrades US long-term credit rating from AAA to AA+ with a “Negative” outlook, implying the chance for further downgrade within 2 years. The move causes the S&P 500 to finish with its largest weekly decline since November 2008 (7.2%); other US and world indices see heavy declines.
Kuwait Financial Centre “Markaz”
RESEARCH September 2011 Appendix 4a: S&P Global Ratings AAA
United States of America (UR)
Germany (UR) Guernsey Hong Kong Isle of Man Liechtenstein Luxembourg Netherlands (UR) Norway Singapore (UR) Sweden Swiss Confederation (UR) United Kingdom (UR) A+
Emirate of Ras Al Khaimah
Israel Korea Malta Oman Trinidad and Tobago Note: (UR) indicates Unsolicited Rating Source: Standard & Poor’s
Kuwait Financial Centre “Markaz”
RESEARCH September 2011 Appendix 4b: S&P Global Ratings (B & C Group) BBB+
United Mexican States
Iceland India (UR) Montserrat Morocco Panama Peru Portugal
Republic of Angola
Bosnia and Herzegovina
Papua New Guinea Paraguay Republic of Albania Republic of Zambia Senegal Sri Lanka Suriname Uganda Ukraine CC Hellenic Republic Note: (UR) indicates Unsolicited Rating Source: Standard & Poor’s
Kuwait Financial Centre “Markaz”
RESEARCH September 2011
Kuwait Financial Centre “Markaz”
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