x Abu Dhabi, UAE Thursday 20 July 2017

SWFs must accept credit rating debate is about default risk

If it has felt slightly windier than normal this week, it is very likely due to the enormous vacuum that was switched on in Washington.

If it has felt slightly windier than normal this week, it is very likely due to the enormous vacuum that was switched on in Washington, where Uncle Sam was attempting to suck up US$115 billion (Dh422.39bn) in new borrowing. Now, $115bn is a lot of money, even in Washington. It works out to almost 47 billion gallons of petrol, enough to drive one of GM's gas-guzzling Hummers from Capitol Hill to Beijing and back 57 million times (if Hummers could float). In fact, $115bn is a record amount of weekly borrowing for the US government, topping the last weekly record set back in June, when it borrowed $104bn.

The new borrowing, which the US does by selling bonds, is part of an estimated $2 trillion that the US government will need to borrow this year to help resuscitate the world's largest economy. That's something America's biggest trading partners, such as China, can support, because it means potentially re-starting the heart muscle of consumption that pumps wealth through the global economy. But the same big exporters, more particularly the central banks and sovereign wealth funds (SWFs) that manage their export earnings, are more worried these days about the growing levels of debt in the US and in other developed economies. After making the rounds of six SWFs in Asia and the Gulf, strategists at Nomura in Hong Kong came away with the message that the funds are unhappy that developed economies get such high credit ratings from the likes of Standard & Poor's and less-indebted emerging economies such as, say, China, get such low ones.

Sovereign fund managers work hard to minimise the risk that they'll lose money. And when it comes to bonds, the most widely used measure of risk is a credit rating. What clearly irks the SWFs is that credit ratings no longer strongly correlate with relative returns, since the highest rated debt looks like a bad bet, while there is a better case for buying debt from countries with stronger finances, but lower ratings. But a fixed-income manager at, say, the Abu Dhabi Investment Authority (ADIA), cannot very well start dumping his "AAA"-rated treasuries and buying up "BB plus" Philippine bonds instead without setting off alarm bells inside the ADIA's risk-management department.

So the SWFs are in a quandary: the IMF forecasts that public debt levels in the US and other developed economies in Europe and Japan will rise to 117 per cent of their combined GDP, while in Asia and emerging markets, public debt levels are only 47 per cent of GDP. Like anything that suddenly becomes common, the more bonds a country sells, the less people think they are worth. To sell $1bn in bonds, you have to offer them a higher interest rate, or yield. And, of course, the more you borrow and the higher your interest payments, the more worried people get that you won't be able to pay them back. You have to promise them an even higher yield to compensate for that risk.

The US government's yields have not risen. For one, investors worried about the state of the global economy were too scared to invest in anything else. The US government has traditionally been considered the safest borrower on the planet. Plus, there are so many US bonds out there that if you buy them, you can be pretty sure you can sell them if you need cash fast. They are "liquid". Since the crisis struck, though, the US Treasury has also been able to count on loans from the Federal Reserve, which is determined to keep interest rates low to stimulate the economy. The Fed cannot print dollars, but it can conjure them as if by magic just by buying bonds from the US Treasury. So far, the Fed has snapped up about $220bn worth of US bonds, pumping imaginary dollars to the US government to help the economy and bail out companies such as GM. The Treasury has also found a ready new source of demand in the American public, which thanks to the recession is saving money like it never did before.

But printing imaginary dollars and issuing bonds like confetti makes America's foreign creditors in Asia and the Gulf uneasy. Because most foreign trade is conducted in US dollars, exporting nations tend to squirrel away their dollars in case the flow of money suddenly reverses and they need boatloads of dollars in a hurry. Big exporters such as China and Abu Dhabi also tend to amass more reserves than they really need to keep their own currencies from rising with their trade surpluses, thereby eroding the competitiveness of their exports. China recently announced that in spite of the global recession its own foreign-currency reserves had risen to more than $2tn.

They don't just keep all those dollars in a safe somewhere. They invest them and earn even more. So far they have tended to buy US securities, largely US government bonds, in part because of their low risk, and in part because they want to hold dollars. China, for example, is now America's largest foreign creditor, with at least $800bn in US bonds. The danger for these sovereign funds and central banks has always been that the more dollar bonds they buy, the more vulnerable they are to a decrease in the value of the bonds, or of the dollar. And with the US government issuing more and more bonds and using more and more dollars to buy them, the risk of such a depreciation looks ever greater.

That's why the SWFs are quibbling over the credit ratings. Tough luck, guys. A credit rating is not a measure of currency risk. It is a measure of default risk. And no matter how much they borrow, the US, Europe and Japan have the ability to do something the emerging economies still can't manage: sell debt abroad in their own currencies. That enables rich countries to finance their deficits and, if payments get too tough, print more currency and lower their loan levels in real terms.

At times like these, a weak dollar is in America's best interest, no matter what officials might say when they visit Beijing, Jeddah or Abu Dhabi. If SWFs want to turn the tables, they will have to insist that the US start paying them back in their own currency. And that's a risk most seem unwilling to take. warnold@thenational.ae