Fitch downgrading US puts Asia’s $3.2 trillion at risk
It’s clear that Asia is in essence trapped with its mountains of dollars
By WILLIAM PESEK
AUGUST 3, 2023
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The Fitch Ratings logo is seen at their offices at Canary Wharf financial district in London,Britain. Photo: Reuters, Reinhard Krause
The Fitch Ratings logo is seen at its offices at Canary Wharf financial district in London. Photo: Reuters / Reinhard Krause
It’s a tale of two downgrades, and the reaction in global markets couldn’t be more different.
When S&P Global Ratings stripped Washington of AAA status in August 2011, all hell broke loose in global markets. The reaction in August 2023 to Fitch Ratings downgrading the US was infinitely less chaotic.
But for Asia, Fitch’s move – and the rationale behind it – is a much bigger headache than the non-reaction in bond and stock markets suggests.
For one thing, it’s a reminder that faith in the linchpin asset of the global financial system is dwindling. For another, this region may be about to get burned on more than US$3.2 trillion of state wealth as Washington fiddles.
The reference here is to the titanically large stockpile of US Treasury securities held by top Asian authorities. Here too, the dynamics surrounding these historical bookends are quite different.
Twelve years ago, the conventional wisdom was that Asian central banks had the leverage. The idea was that if Washington took its top bankers for granted, they could issue history’s most spectacular margin call. This week, it’s clear that Asia is now in essence trapped with its mountains of dollars.
This explains why neither Japan, the top holder of US Treasuries with $1.1 trillion, nor China, the second-biggest with $860 million, has dumped huge blocks of dollar-denominated debt. The same goes for Taiwan ($235 billion), India ($232 billion), Hong Kong ($227 billion), Singapore ($188 billion) or South Korea ($106 billion).
The slightest whiff that Washington’s Asian bankers are bailing on the US Treasury market would destabilize the global financial system.
Not that the US isn’t tempting Asian leaders to do just that. In its rationale for downgrading Washington, Fitch pointed as much to chaotic politics as America’s fiscal trajectory toward the $33 trillion national debt level. The ratings company cited Republicans playing games with the debt ceiling.
“In Fitch’s view, there has been a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters, notwithstanding the June bipartisan agreement to suspend the debt limit until January 2025,” the company said.
Fitch highlighted “expected fiscal deterioration” thanks to a “high and growing” government debt burden. But it also said the January 6, 2021, riot at the US Capitol was a key factor.
As Richard Francis, a co-head of Fitch’s Americas sovereign ratings division, told CNBC: “We’ve seen a pretty steady deterioration in governance over the last couple of decades. You can highlight a few key elements. One would be January 6.”
The “timing surely caught everyone off guard,” says strategist Edward Moya at Oanda.
Calm prevails, so far
For now, global markets are taking the Fitch downgrade significantly better than they did S&P’s in 2011.
“While investors should take the downgrade in their stride since Uncle Sam can easily meet his near-term payments, the action still focuses attention on debt sustainability as US fiscal deficits move towards 6% of GDP during a boom period,” says analyst Tan Kai Xian at Gavekal Dragonomics.
Tan adds that the US Treasury market seems to be reacting with a “casual shrug” for three reasons.
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One, Fitch had flagged the risk of a ratings downgrade in May and kept the US on “negative watch” even after debt-limit agreement between Congress and US President Joe Biden in June.
Two, investors are well aware of the reasons for the downgrade, so aggressive market repricing wasn’t necessary.
And three, the downgrade is unlikely to affect the use of US Treasuries as a bedrock asset.
“After all,” Tan argues, “US Treasuries remain the Federal Reserve’s top choice of collateral for its lending facilities.” For the next 17 months, Tan says, the US can comfortably make payments as the congressional agreement suspends its borrowing constraint until January 2025.
The real question in the short run is whether global markets can absorb the heavy debt issuance the US Treasury is planning without a sharp surge in yields, and with it, Washington’s funding costs.
Earlier this week, the Treasury said new debt issuance would rise to $103 billion in its so-called quarterly refunding auctions next week, slightly more than most dealers expected.
“The question from here is if investors will be willing to buy the dip” or “if the selloff has room to extend” amid debate where US yields are heading, says strategist Benjamin Jeffery at BMO Capital Markets.
On the plus side, Fed chairman Jerome Powell’s team is no longer forecasting a recession. This week, Bank of America became the first major bank to drop its forecast for a recession this year.
“Recent incoming data has made us reassess our prior view that a mild recession in 2024 is the most likely outcome for the US economy,” BofA economists wrote in a note. “Growth in economic activity over the past three quarters has averaged 2.3%, the unemployment rate has remained near all-time lows, and wage and price pressures are moving in the right direction, albeit gradually.”
On Wednesday, ADP, the largest US private payroll supplier, reported that private employers had added 324,000 new jobs in July, far exceeding the 175,000 many economists had been expecting.
“The economy is doing better than expected and a healthy labor market continues to support household spending,” says ADP economist Nela Richardson. “We continue to see a slowdown in pay growth without broad-based job loss.”
As such, some prominent economists agreed with US Treasury Secretary Janet Yellen’s take that the thinking behind the Fitch downgrade is “outdated.” Former Treasury secretary Larry Summers called the decision “bizarre and inept.” Mohamed El-Erian, chief economic adviser to Allianz, was “perplexed” by Fitch’s timing and arguments.
More to come?
Taking a longer-term view, though, some worry Fitch’s downgrade is the tip of the proverbial iceberg where the US is concerned.
“Continued fiscal expansion/deficits could result in additional downgrades from rating agencies,” says Lawrence Gillum, chief fixed-income strategist for LPL Financial. “So until the US government gets its fiscal house in order, we’re likely going to see additional downgrades.”
That’s the last scenario Washington’s top financiers in Asia want to contemplate. Surging US borrowing costs would slam American consumers’ ability to fuel in Asia’s export-driven economies. And trillions of dollars of state wealth is on the line.
It’s a scenario that Chinese leaders have flagged in the past, one more directly than Wen Jiabao, premier from 2003 to 2013.
In 2009, amid the fallout from the 2008 collapse of Lehman Brothers, Wen urged Washington to protect its AAA status. “We have made a huge amount of loans to the United States,” he said. “Of course, we are concerned about the safety of our assets. To be honest, I am a little bit worried.”
Washington, Wen stressed, must “honor its words, stay a credible nation and ensure the safety of Chinese assets.”
Nearly a decade later, in 2018, Cui Tiankai, then China’s ambassador to the US, hinted that Beijing might someday move to reduce Treasuries holdings amid concerns about losses. “We are looking at all options,” he said.
Also in 2018, Fan Gang, a top adviser to China’s central bank, talked publicly about diversifying away from the dollar. “We are a low-income country, but we are a high-wealth country,” Fan said. “We should make better use of capital. Rather than investing in US government debt, it’s better to invest in some real assets.”
De-dollarization
The Fitch news demonstrated why there are intensifying efforts to dislodge the dollar from its perch. Efforts are afoot by a loose grouping in nations including China, Russia, Brazil, Saudi Arabia, the United Arab Emirates and others to find a new reserve currency.
Brazil, for example, this year started doing trade in other currencies such as the Chinese yuan and Russian ruble. In April, Brazilian President Luiz Inacio Lula da Silva threw his support behind creating a BRICS monetary unit to be used by members Brazil, Russia, India, China and South Africa.
“Why can’t an institution like the BRICS bank have a currency to finance trade relations between Brazil and China, between Brazil and all the other BRICS countries?” Lula asked. “Who decided that the dollar was the trade currency after the end of gold parity?”
Or as Lula’s Finance Minister Fernando Haddad puts it: “The advantage is to avoid the straitjacket imposed by necessarily having trade operations settled in the currency of a country not involved in the transaction.”
Lula’s backing is music to Xi Jinping’s ears in Beijing. The Chinese leader is steadily ratcheting up efforts to raise the Global South’s role in geopolitical decision-making. In this, Xi’s third term, he is prioritizing morphing developing countries in the regions from Latin America to Africa to Asia to Oceania into a bigger economic and diplomatic force.
This year, Malaysian Prime Minister Anwar Ibrahim said China is open to discussing the formation of an Asian Monetary Fund, a move that would reduce that International Monetary Fund’s influence in the region.
This would revive a decades-old proposal that most famously reared its head in the late 1990s amid the Asian financial crisis. At the IMF’s annual meeting in September 1997, held in Hong Kong, Asian leaders proposed a bailout fund. This idea was headed off by IMF and US Treasury officials. At the time, Anwar was Malaysia’s finance minister and deputy PM.
Yet the push for an Asian monetary fund comes as China’s currency plays a bigger and bigger role in global trade and finance.
Yuan internationalization dovetails with a flurry of new foreign-exchange arrangements that exclude the dollar: France beginning to conduct some transactions in yuan; China and Brazil agreeing to settle trade in yuan and reais; India and Malaysia increasing use of the rupee in bilateral trade; Beijing and Moscow trading in yuan and rubles.
The 10-member Association of Southeast Asian Nations is joining forces to do more regional trade and investment in local currencies, not dollars. Indonesia, ASEAN’s biggest economy, is working with South Korea to ramp up transactions in rupiah and won.
Pakistan is angling to begin paying Russia for oil imports via yuan. The United Arab Emirates is talking with India about doing more non-oil trade in rupees. Argentina recently doubled its currency-swap line with China to roughly $10 billion. It speaks to the rising anti-dollar movement in South America.
Aside from Washington’s fiscal trajectory, Biden’s move to “weaponize” the dollar to punish Russia over Ukraine further eroded faith in the greenback.
“Despite America’s likely opposition, de-dollarization will persist, as most of the non-Western world wants a trading system that does not make them vulnerable to dollar weaponization or hegemony,” says Frank Giustra, co-chairman of International Crisis Group. “It’s no longer a question of if, but when.”
Fitch’s downgrade is another reason for Asia to worry about the dollar – on top of the 3.2 trillion reasons it already had.
