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Updated: August 14, 2011 21:42 IST

Implications of a downgrade

C. R. L. NARASIMHAN
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Standard & Poor's first time ever downgrade of long-term U.S. government debt from AAA to AA plus was announced after the markets closed on August 5. One had, therefore, to wait until the following Monday to gauge the reactions of the markets, both global and the U.S., to this historic development.

That there would be a sell off was clear. Not so clear were the extent and even more importantly, where would investors go in such times of extreme global uncertainty. In the event, Wall Street (the S&P 500 Index) was down by 6 per cent at its close on August 8. Skittish investors, already concerned over the economy, struggled to work out the implications of this historic downgrade of the U.S. government's credit rating. The Dow Jones Industrial Average lost some 600 points, its largest one day fall since December, 2008.

But even as investors were selling stocks, one extremely interesting development was taking place. The U.S government treasuries might have been downgraded but even at a time like that it continued to attract a plenty of investor interest. Though it was very early still on Monday last, there was enough indication that the U.S. government paper had not lost its refuge status. On the contrary, even though the rating downgrade of just a day earlier struck at the core of U.S. government's credit worthiness, its treasury instruments gained in popularity with yields on treasuries declining on Monday August 8.

Extreme volatility

Extreme volatility characterised the stock markets' behaviour on Tuesday. The Federal Reserve's much anticipated statement on the economy — that the interest rates will be kept at very low levels until 2013 even though no new proposals were on hand — was not immediately understood by the traders but when its full purport was realised, the markets reacted extremely positively. Short-term interest rates in the U.S. are already at near zero. In agreeing to extend the ultra-low interest regime by a couple of years, Fed is in effect assuring cheap credit to spur the economy.

On Tuesday (August 9) amidst sharp swings, the indices reached high levels. The Dow rose by 429 points (3.98 per cent). The S&P 500 Index rose by 4.7 per cent. It was the biggest gain for both indices since March, 2009.

On Wednesday (August 10), stocks in the U.S. and Europe tanked amidst growing fears over certain European banks' exposure to the sovereign debts of countries such Italy and Greece. As much as the budget problems of the U.S., the Eurozone debt crisis has remained a major area of concern. As bond prices rose, yields dropped as investors dumped equities. Tuesday's gains were wiped out. The Dow was down 520 points and the S&P 500 Index lost 4.4 per cent. Amidst all this mayhem caused by volatility, investors sought safe haven in U.S. government treasuries. The stock markets' roller coaster ride continued on August 11. Buoyed by some positive news on the economy and easing of concerns over Europe's debt problems, investors pushed up the Dow by 420 points (3.9 per cent). The S&P 500 Index was up 4.6 per cent. On each day of last week following the downgrade, American stocks have ricocheted between steep gains and losses to an extent not seen since March, 2009.

Around the world, including in India, stock markets have been volatile, though perhaps not to the same extent in the U.S. It is not denied that local concerns too will influence investor behaviour.

The surge in weekly food inflation to almost double digits in India had a negative impact on stock markets on Thursday. But in the aggregate, the broad pattern of stock market behaviour has tended to be the same around the world.

There are a few important lessons from an analysis of the recent stock market movements in the U.S. Admittedly, a focus on two or three days will not be sufficient to yield meaningful inferences even during a tumultuous period such as what we are witnessing now. Yet, time and again, it is well established that stock markets influence one another substantially. In India, for instance, global cues are cited to explain the domestic stock market trends even if such explanations are not convincing.

Interconnected markets

The message is that there is very little basis for the ‘decoupling' theory. Popular until a few years ago, the theory held that financial markets, especially the stock markets of certain countries like India, have attained a reasonable stature of their own and that while being influenced by the West, are not necessarily guided by them. The great financial crisis (2008-09) and the ongoing developments centred around the U.S. and a few European countries show how integrated the financial markets are and that it is not easy to insulate individual stock markets from the contagion spreading from other markets no matter how hard we might try.

Dollar remains supreme

Ironical as it may seem, in times of great global uncertainty such as the one we are witnessing after the downgrade of American debt, the ‘safe haven status' that the U.S. government paper has had is in no way diminished. In the days following the S&P downgrade yields on treasuries fell as nervous investors flocked to invest in traditional safe havens. The dollar's special position as the numeraire of international transactions, the currency of choice in international trade and the instinctive home for money in troubled times has not changed after the downgrade.

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