As the financial crisis has spiraled downward over the past year, events that were once virtually unthinkable have now become almost commonplace: U.S. housing prices falling nationwide at a double-digit pace, storied names like Lehman Brothers vanishing overnight, the government effectively nationalizing American International Group.
Now, as U.S. commercial banks implode and politicians struggle to put together an unprecedented bailout, some investors and analysts are pondering whether the U.S.’s benchmark credit rating and the dollar’s status as a reserve currency could be the next dominoes to tumble. Although such a scenario is unlikely, at least in the near term, the fact that people are even posing the question underscores the gravity of the situation.
"I don’t think the U.S. is at any serious risk of default, but worries in the market have some basis," says Benn Steil, director of international economics at the Council on Foreign Relations in New York. "We’re as close as we’ve been to a run on the dollar since 1971, when Nixon closed the gold window."
So far there is little evidence that investors are seriously questioning U.S. creditworthiness. In the wake of Lehman’s failure, AIG’s takeover and Merrill Lynch & Co.’s hastily arranged sale to Bank of America Corp. last month, a flight to quality actually pushed yields on U.S. Treasury bills close to zero and drove up the value of the dollar. But credit default swap rates on U.S. Treasuries did spike up to as high as 32 basis points late last month, above comparable rates for France, Germany and Japan. As U.S. liabilities mount, policymakers can’t afford to be complacent.
The credit crisis has been unrelenting in its progression since it erupted with the seizing up of the interbank lending market in August 2007. What initially appeared to be a liquidity crisis — serious but solvable — quickly turned into a solvency crisis as mortgage-backed securities tanked, then morphed into a systemic panic as banks’ capital bases eroded and the contagion spread to commercial real estate, credit cards and other assets.
The scale of the damage is staggering. The International Monetary Fund last month raised its estimate of ultimate credit losses to $1.3 trillion. Others believe even that figure is optimistic. Nouriel Roubini, a professor of economics and international business at New York University’s Stern School of Business whose pessimistic prognostications have largely come true over the past year, believes the bill will hit $2 trillion.
The U.S. Treasury and the Federal Reserve Board have made unprecedented financial commitments to keep the system afloat: up to $29 billion to cover losses at Bear Stearns Cos., $200 billion to recapitalize the now state-owned Fannie Mae and Freddie Mac, $85 billion for AIG and a cool $700 billion to buy bad assets from troubled banks, now that the Bush administration has persuaded Congress to go along. The potential tab is already north of $1 trillion — a lot even by Washington standards — and it isn’t likely to stop there. The economic slowdown will boost the federal budget deficit to $438 billion in the 2009 fiscal year, which began on October 1, up from $407 billion in 2008 and $162 billion in 2007. Expect demands for a new economic stimulus package to add even more red ink.
The Treasury will have to issue a massive amount of bonds to finance those interventions. Fortunately, it starts from a position of relative strength. Federal debt stands at $5.4 trillion, or 38 percent of gross domestic product; add in state and local debt and the ratio is 62.2 percent, lower than in many leading industrial countries. The government’s commitments for 2009, if fully disbursed, would raise the federal debt-to-GDP ratio to 46.1 percent. By comparison, Germany’s ratio is 65 percent, France’s is 64.2 percent and the U.K.’s is 43.8 percent.
"The United States’ main strength is that the U.S. balance sheet is credible," write Simon Johnson, a professor at the MIT Sloan School of Management and former IMF chief economist, and Peter Boone, an associate at the London School of Economics’ Centre for Economic Performance, in their blog, Baseline Scenario. "The U.S. is not going to lose its AAA rating. Because all U.S. debt is in U.S. dollars, there is no danger that exchange-rate depreciation will magnify debt burdens, as occurred in emerging markets. The U.S. balance sheet cannot save everyone in the world, but if necessary it can be used to draw a line in the sand and restore confidence."
The debt ratio tells only part of the story, though. Japan can support an unprecedented debt burden of 195 percent of GDP because the country has a high savings rate and massive foreign exchange reserves. But the U.S., which has been consuming more than it earns for years, depends on the kindness of strangers. Foreign investors, led by central banks or sovereign wealth funds in China, Japan, Saudi Arabia and a handful of other countries, hold 52 percent of all Treasury securities outstanding. Those actors have increased their holdings substantially in recent months, providing a source of stability in the short term but a potential threat in the long run.
"If foreigners decide they’re not going to buy Treasuries anymore, that would be a big problem," says Steven Hess, lead analyst for the U.S. at Moody’s Investors Service in New York. Standard & Poor’s has warned that the bailouts are weakening the U.S. fiscal profile. "There’s no God-given gift of a triple-A rating," S&P analyst John Chambers told Reuters.
Demand for U.S. debt is inextricably linked with the fate of the dollar. China has been buying U.S. Treasuries and agency securities — more than $300 billion worth in the past year alone, according to estimates by Brad Setser, an economist at the Council on Foreign Relations and former U.S. Treasury official — because Beijing wants to limit the yuan’s appreciation against the dollar and keep exports flowing. Indeed, Chinese authorities have virtually put a stop to yuan appreciation in the past two months to safeguard export growth amid the global downturn.
Most countries in the Gulf, led by Saudi Arabia, continue to peg their currencies to the dollar even though its sharp decline over the past two years has been pushing up inflation in the region. But the risk that Gulf states would abandon their pegs appears to have receded, at least for now. U.S. Treasury Secretary Henry Paulson Jr. used muscular language in support of a strong dollar during a visit to the Gulf in early June. Several weeks later the Saudis flouted an OPEC call to reduce oil output, contributing to a sharp drop in oil prices. "The U.S. authorities came to the conclusion that a significant part of the oil price was related to dollar weakness," says Jim O’Neill, the London-based chief economist at Goldman, Sachs & Co.
The dollar has also benefited from the lack of a strong alternative. The euro, the only serious rival as a reserve currency, has fallen by about 13 percent since July, from more than $1.59 to below $1.39 early this month, as several European countries have slipped into recession.
Notwithstanding its recovery, the dollar — and demand for U.S. debt — remains potentially vulnerable. The greenback’s recent rally is not so much a flight to safety as a "flight to liabilities" as U.S. financial institutions sell assets overseas to plug balance-sheet holes at home, contends Jerome Booth, head of research at Ashmore Investment Management in London. "That’s not a vote of confidence in the dollar," he says. To finance its deficits, he adds, "the U.S. has got to sell more goods and services internationally, which means it has to devalue against emerging-markets currencies."
Aggressive actions by the Fed and the Treasury have bolstered confidence in the dollar, notes Barry Eichengreen, an economist at the University of California, Berkeley, but he thinks the credit crisis will exact a heavy toll on the U.S. economy over time. "The price will be higher Treasury yields and a weaker dollar, and ultimately, lower living standards," he says.
The U.S. remains the world’s benchmark credit, and the dollar is the preferred medium of exchange. But as executives at Lehman Brothers and AIG can attest, recent events have demonstrated how quickly confidence can evaporate. Washington policymakers — and the U.S. economy — will need to respond quickly and effectively if they hope to retain the trust of global investors.
