S&P Downgrade Positive for China’s Stock Market in the Long Run

Tr he Standard Poor’s (SP) ating agency announced Friday night (August 5) that it has downgraded the U.S. debt from a stellar AAA rating by a notch to AA+， and lowered the outlook on the new U.S. credit rating to “negative”， indicating that another downgrade was possible within one year or two. After the downgrade， it was largely expected that such a decision would pose a real threat to the value and role of the dollar and the status of this currency would start to topple. China， which holds large amounts of US debt and dollar assets， would inevitably suffer a heavy blow， especially its stock market.

In fact， the impact of the downgrade on the dollar’s role as the world’s most important currency is not as serious as expected. China， the largest creditor of the world’s largest economy， even sees a positive effect of the downgrade on its macro economy in a long and medium term， though SP’s move was really a sucker punch to China’s already tottering stock market.

SP’s decision to lower U.S.’s top credit rating for the first time， stripping the elite standing this country has held in global market for nearly a century， would surely stir up the whole world， particularly a shock to US consumers. This indicates that the world’s largest economy is encountering a double-dip downturn. However， the outlook isn’t all that gloomy at this moment as the recession process will be anything but short. In a medium term， the U.S dollar will remain as the key reserve currency in the global market.

Within a short and medium period， the United States is not likely to default on its debts. But this cannot be guaranteed in near future， if the growth rate of the loan-based economy remains below the interest rate of its treasury bonds. It is also not possible， at least within the following two decades， for this country to risk its status as the world’s sole superpower on defaults， which is a lesson it has learned from the default-led disintegration of the Soviet Union.

The downgrade， which has caused a ripple effect around the world， served as a timely wake-up call for the United States and other performers on the international market， especially China. It has sounded an alarm bell for the U.S. to address its debt addiction and stop “running a deficit without tears” (quoted from Charles De Gaulle)， for the whole world to be more rational in purchasing U.S. Treasury bonds — which turn out not to be risk-free havens. However， SP’s seemed to be sending a just-intime warning， not necessarily casting suspicion on the ability of the U.S. to pay its debts: the risk still remains at a psychological level. As for China， the largest overseas holder of treasury bonds and dollar assets， it is still not a wise choice to berate US on the downgrade. Instead， China should make full use of the dollar assets and reverse the negative effect of the downgrade.

Will SP’s downgrade be fatal to the value of the US dollar? The answer will be Yes if US bonds were the only issued bonds or the only excessively bonds in the world market. But the fact is， almost all developed countries are overly relying on issuing bonds， some of which are more addicted than the US， including the “piigs” (namely Portugal， Italy， Ireland， Greece and Spain)， France and Britain in Europe and Japan in Asia.

Therefore， with euro being the reference currency， the dollar is not likely to plunge in its value.

Under such circumstances， Chinese government will be more prudent in dealing with the debt crisis in Europe and the United States. It will continue to steadily buy U.S. Treasury debts and in the meantime， moderately diversify its foreign exchange reserves， avoiding a massive sell-off of the two debts.

China now holds huge U.S. debt， but not to the point where it has to be chained to the economic climate in the U.S. or in Europe. The amount is “just right.” Against the backdrop of the current economic situation， on the one hand， China should maintain proper scale of foreign exchange reserves so as to have its voice heard in the international stage. On the other hand， it is not a wise choice for China to “wean” itself off reliance on dollar and euro reserves by dumping their debts; instead， it should eye on stable and quality assets in the future.

In response to the worsening debt crisis in U.S. and Europe and unprecedented cut of U.S. credit rating， there will be a new round of quantitative easing monetary policy adopted by major central banks， including those vowing to battle inflations. In light of this， the central bank of China will also be more prudent in shifting to tightening monetary policy in the future.

(Author: Senior economist at the Agricultural Bank of China)