RUSSIA | ECONOMICS JULY 29, 2011

Chief Economists View If the US Gets Downgraded So What?

Amid continuous speculation about the debt problems in Europe and the US, rating agencies have kept downgrading European peripheral countries, but have done nothing to US ratings, apart from occasionally sending warnings of a possible downgrade. Meanwhile, European governments eventually were able to agree on a temporary solution for Greece based on a combination of a bailout with public funds and the voluntary restructuring of Greek debt by private bondholders, which many considered a model solution for other indebted European countries. So far, the US has not come up with any solution, but its rating remains at the highest level. Early in the year, S&P downgraded Japans rating to AA on the grounds of the absence of a coherent strategy to curb debt levels. The US administration lacks this strategy as well, but still retains its top rating. Clearly, Japans debt/GDP ratio is twice as high as that in the US, but the bulk of Japanese debt is held by locals, which makes the country less vulnerable. In contrast, around a third of US Sovereign debt is held by foreign investors (over $4.4 trln), such as other countries Sovereign funds and central banks. Given that Japan is a country where inflation is not an issue and deflation used to be quite regular, domestic investors holding low yielding public debt was not the worst option. At least they did not lose money. Rating agencies normally cut ratings when they see a threat of investors losing money, which in some sense occurred in the case of US debt held by foreigners, as the dollar has weakened 12 15% against many currencies. In the past twelve months, for instance, the US currency depreciated around 12% against the Japanese yen thus, Japanese investors, who hold around $0.9 trln in US debt, lost about $0.1 trln. The Korean won, Singapore dollar and the euro also appreciated 11 12% against the dollar over the past year, while the Brazilian real gained over 13% in the same period. That said, in the case of the US, there is a combination of at least three factors that have in the past encouraged rating agencies to downgrade other countries. These include the lack of a coherent strategy of debt reduction, US politicians inability to come up with a mutually acceptable solution regarding the debt ceiling, and the threat of continued loss of external money invested in US government paper, which could eventually undermine the myth of US exclusiveness.

Evgeny Gavrilenkov

Chief Economist, Managing Director Evgeny_Gavrilenkov@troika.ru

In accordance with US SEC Regulation AC, analyst certification can be found at http://www.troika.ru/eng/research/disclosure.wbp. research@troika.ru, www.troika.ru

JULY 29, 2011

CHIEF ECONOMISTS VIEW IF THE US GETS DOWNGRADED SO WHAT?

Decision making in the US has proven to not always be as efficient as it was traditionally considered. Economic and financial issues have become hostages of a political struggle between the two parties. Indeed, the current debate on the debt ceiling centers not around debt reduction strategy (which ideally should be coherent, as required by S&P, for instance), but whether the debt ceiling will be raised to a level sufficient to finance expenditures throughout 2012 or if it will be a series of hikes (say, quarterly). In the latter case, it will be much more difficult for Democrats and President Barack Obama personally to compete with a Republican presidential candidate, as the current US administration will be held on a short leash by Republicans. That said, despite the bombastic populist rhetoric from both sides, economic issues are in fact of secondary importance. Politicians do not care that the uncertainty surrounding the debt ceiling dispute is a less than ideal environment for investors. This is very similar to Russias continuous uncertainty regarding whether the next presidential candidate will be Vladimir Putin or Dmitri Medvedev. Both politicians are trying to keep it a secret so neither becomes a lame duck too early, while the economy and investors interests are considered less important. Taking the above observations into account, it looks as though the US deserves rating cuts, due to remaining double deficits (current account and the budget balance), decelerating growth and a rising debt/GDP ratio. The fact that the greenback has weakened over the past year illustrates that markets, to some extent, have priced this in already. From this standpoint, it is already of secondary importance (albeit, still an essential issue for the markets) whether or not rating agencies downgrade the US and when, should the answer be yes. In our view, quantitative easing alone was enough reason to downgrade US paper, and at minimum, one of the three rating agencies should bring the US down at least one notch relatively soon, which is still a rather modest punishment for long term macroeconomic mismanagement. The problem is that the entire rating system is tied to a single benchmark, namely the US paper, and if the benchmark is moved it is not completely clear what to do with the rest, which is why markets have once again proven to be ahead of rating agencies as the dollar has depreciated. Given that the magnitude of economic imbalances in the US is of far larger scale than that in the Eurozone, further weakening of the dollar will be the most likely outcome, despite the fact that the prospects of eliminating those imbalances are quite unclear on both sides of the Atlantic. Partial forced selling of US government paper (inevitable in the case of a rating downgrade) will inevitably increase borrowing costs nationwide (at least a bit, which might encourage the Fed to resort to a new series of quantitative easing). Higher borrowing costs will look normal. It seems much more abnormal (and unsustainable, as a result) that a country with a weakening currency, sustainable budget deficit of around 9 10% of GDP and debt/GDP ratio of around 100% pays only 0.4% interest on a 2y note. Higher costs of borrowing will most likely accelerate inflation. This may help increase tax collection and slightly soften the debt problem, but not provide a solution, as it will eventually require quite unpleasant and seemingly unacceptable austerity measures aimed at eliminating internal imbalances, such as overeager defense spending (the US share of global defense expenditures is around 50%, while the country produces around 23% of global GDP). Raising domestic fuel taxes is, in theory, another measure to reduce the budget deficit, though it is highly unpopular and seemingly unacceptable at least for now. We are not in the position to discuss in detail how the US administration should try to deal with the budget deficit and debt problems, but some currently unacceptable steps might need to be taken if appetite for US paper goes down amid potential rating downgrades (we do not consider US default a serious option, as, being optimists, we trust that the countrys politicians will eventually discover their long lost common sense). Overall, it looks as though the dollar will remain crippled and could weaken even more, which is what makes the difference between the current situation and the 2008 crisis at that time, investors rushed for safety and moved money to US Treasuries, which caused the dollar to

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CHIEF ECONOMISTS VIEW IF THE US GETS DOWNGRADED SO WHAT?

JULY 29, 2011

appreciate and commodity prices to fall, while these days, such move would not seem logical. Money stopped moving at end 2008 as a result. It looks likely that in the event that the US finds itself in undesirable trouble (such as hypothetical technical default), money will still keep moving at least away from the US dollar. The greenbacks fundamental weakness will maintain commodity prices at a relatively high level a rather comfortable environment for Russia. Moreover, Russias economy currently looks less vulnerable than it did before the Lehman Brothers crash, as the economy is not as overheated as it was three to four years ago. Russia looks to be in quite good shape versus many other economies, demonstrating growth of around 4 5% we think that growth is actually closer to the higher number, while official statistics, which are quite inconsistent, point to the former. Inflation has declined to 0.2 0.4% m o m since February, which could bring y o y inflation to around 6.5% (or even lower) by year end (from 9.6% in January). In 1H11, Russia once again became a twin surplus economy, while the foreign debt/GDP ratio remains below 30%. That said, we expect the Russian market to rally once the dust settles.

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