how is gcc preparing for a 'aa' world
DESCRIPTION
How is GCC Preparing for a 'AA' WorldTRANSCRIPT
Kuwait Financial Centre “Markaz”
R E S E A R C H
How is GCC preparing for a “AA+” World? One more crisis to live with
The rating downgrade that rattled financial markets in August 2011 was of milder intensity compared to the 2008 tsunami financial crisis, whose impact
is still being felt. However, the downgrade enabled to perpetuate one thing i.e., maintain the policy response intact which is where the catch is. The world
will have a low interest rate environment at least for another one to two years
and may lay the foundation for yet another “Bubble-Burst” scenario.
The impact assessment of GCC is what this paper is all about. Successful articulation of polices will need to keep in mind several key and collateral risks
that have erupted as a result of series of crisis including the latest downgrade
crisis. In our opinion, the biggest challenge in a crisis ridden world will be to efficiently and effectively manage the surplus generated in good times. This will enable the GCC governments to progress with their investment program which brings us back to the question of managing risks.
GCC Impact
Areas
Assessment
Surplus The biggest challenge to GCC would be to deploy effectively
and efficiently its huge surplus generated through the oil boom of recent years. With limited absorptive capacity inside,
and a crisis ridden world outside, the deployment challenge will be onerous.
Oil Price The rating downgrade does not directly trigger an oil price
fall. It may happen indirectly through triggering a double dip recession which in turn pulls down the oil price. However,
having built sufficient reserves, the region can weather weak oil prices for a stretch of time before it hurts them.
Currency US dollar is clearly declining in value and credibility and so the
issue of the GCC currency pegs will come increasingly into focus. However, US dollar weakness was accounted for even
before the downgrade. Lack of alternatives also gives some
comfort
Investments GCC governments have undertaken large domestic investment programs based on their huge reserves. Being non-reliant on foreign investments is a huge plus.
September 2011
Research Highlights:
Analyzing the implications of the US credit downgrade on
the GCC region
Markaz Research is
available on Bloomberg
Type “MRKZ” <Go>
M.R. Raghu CFA, FRM
Head of Research
+965 2224 8280 [email protected]
Layla Al-Ammar
Assistant Manager
+965 2224 8000 ext. 1205 [email protected]
Madhu Soothanan
Senior Research Analyst
+965 2224 8000 ext. 4603 [email protected]
Kuwait Financial Centre
S.A.K. “Markaz”
P.O. Box 23444, Safat 13095, Kuwait
Tel: +965 2224 8000
Fax: +965 2242 5828 markaz.com
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
2
Implications for the GCC
As with most international events, the implications for the GCC are largely
related to oil demand and price fluctuations. However, there are also implications for the region’s equity and debt markets.
Saudi Arabia
Oil Domestic Investments Foreign Investments Stock Market SWF
Low Low Med High Med
Oil: While the downgrade has triggered a fear of global double dip recession,
it has not yet triggered an oil price collapse. In fact, oil prices have
strengthened based on supply concerns. Even in a scenario of low prices as a consequence of double dip recession, the Kingdom sits on a pile of reserves
that can see it through its spending program. Saudi Arabia requires a breakeven oil price of $72/barrel to balance its budget at current levels.
Pursuant to increase in government expenditure (though mostly current than capital), the breakeven oil price has been growing at a CAGR of 12% during
the last 8 years. Assuming a CAGR of about 5% to continue, it will take
another 10 years for the breakeven oil price to reach the current level of $120/bbl1, while the Institute of International Finance (IIF) anticipates another 15 years before breakeven oil prices top $110/bbl. Hence, we see that risks triggered by rating downgrade resulting in oil price crash is
misplaced at least for the short term.
Domestic Investments: Saudi Arabia has been on a strong investment
drive over the last few years and this is expected to continue irrespective of global events. Motivation behind such investments (for e.g., employment) is
too strategic to sway year on year based on global developments. Continuation of such domestic investment program in light of strong liquidity
is a strong possibility.
Foreign Investments: Foreign investments, especially in the equity market,
could see a decrease as investors turn risk averse in a tentative global economy. Although, given that Saudi Arabia is considered one of the world’s
10 ‘safest’ sovereigns, and attracts foreign investments of USD 10-20 bn a
year, we do not foresee a significant decrease in the same in the Kingdom.
Stock Market: The stock market has already reacted to the US downgrade, however, further negative cues, such as a downgrade by Moody’s (Fitch has
already affirmed its Outlook) would lead to further declines. The TASI is down
7.5% for the year and saw a 5.5% drop on the day following the downgrade. Furthermore, if cost of equity goes on the rise, it would have a declining
effect on company valuations which may cause a sell-off as brokers decrease their Fair Value assessment of firms. Banks will get a knock-on effect to all of
this as conduits to the efficient and productive operation of the economy, i.e. if government spending decreases, the economy slows and the stock market
shows lackluster performance, it will create an environment that is not conducive to bank lending thereby denting performance. Furthermore, if further downgrades occur, banks could see an increase in risk-weighted
assets as they reclassify holdings based on new ratings.
1 Jadwa Investment, Saudi Arabia’s coming oil and fiscal challenge, July 2011
Saudi Arabia is considered one
of the world’s 10 ‘safest’ sovereigns, and attracts foreign investments of USD 10-20 bn a year
Banks will get a knock-on
effect to all of this as conduits to the efficient and productive
operation of the economy
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
3
SWF: Lower state revenues will also have implications for the Kingdom’s Sovereign Wealth Fund (SWF). The SWF and Monetary Authority’s reserves
and investments are mostly held in USD denominated investments and US
treasuries; this exposure insolated the SWF in the 2009 global financial crisis where its portfolio actually gained in value versus peers like ADIA and KIA.
The SWF might not be so lucky this time around as it will be hit both with the currency factor of a weakening dollar in addition to a hit in treasuries.
Kuwait
Oil Domestic Investments Stock Market SWF
Low Low High Med
Oil: Like Saudi Arabia, Kuwait has built considerable reserves during the oil boom. Measured in GDP terms, in fact, it has performed even better than
Saudi Arabia in terms of reserve building as budget expenditure grew more
moderately during the last few years when benchmarked with Saudi Arabia. At a breakeven oil price of $70/bbl the current oil price provides a cushion of
$50/bbl. Even in a scenario where oil price reaches the breakeven level, the State of Kuwait can begin to draw on its reserve pile for a long time before it
drains out.
Domestic Investments: Kuwait’s domestic investments have been lagging
for some time. The country’s Development Plan came in to sort out this problem; much of the USD 125 bn plan is built on government spending
coupled with increasing the attractiveness of Kuwait to Foreign Investors. While the cost of finance will rise pursuant to US debt downgrade, it may not
reach a point where the domestic investments could be scaled down. Foreign
investment in the country is weak by regional standards, at less than USD 150 mn a year2.
Stock Market: The stock market has already declined 15% for the year and
tumbled 2.5% on the day following the US downgrade. The Kuwait market
has become hypersensitive to global cues; consequently, sustained negative news (such as a worsening of the Euro-crisis, a further downgrade of the US or a downgrade of another G7 nation) would cause further declines to the market. According to the IMF, the State’s banks are well-capitalized; the
sector’s Capital Adequacy Ratio (CAR) increased to 19% in 2010 (17% in 2009) due to capital increases during the year while leverage ratios are
averaging about 13%. NPLs are down to about 9% in 2010 (11.5% in 2009)
though still high by regional standards. Bank’s loans are heavily concentrated on Real Estate (26%), Retail loans (33%) and non-bank financial institutions
(12%) which are essentially Investment Companies3. The Real Estate and Investment sectors make up the bulk of the market and remain distressed
post the financial crisis of 2008/2009. An increase in cost of equity and
weakening of the dollar could be detrimental to the sector’s balance sheet which would ultimately impact the bank’s loan portfolios.
SWF: The sovereign wealth fund, Kuwait Investment Authority (KIA),
receives the majority of the government’s revenues for investment purposes;
and the same is deployed on a globally spread portfolio across various asset classes. To the extent the SWF investments are exposed to US treasuries and
the US$ currency, it runs the risk of value erosion. However, we don’t foresee a significant decline in KIA’s earnings as investments tend to be
2 The World Bank 3 IMF Country Report, July 2011
The stock market has already
declined 17% for the year and
tumbled 2.5% on the day following the US downgrade
The Real Estate and Investment sectors make up
the bulk of the market and remain distressed post the financial crisis of 2008/2009
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
4
geographically spread4 rather than concentrated in one country or risk-bracket.
UAE
Oil Domestic Investments Stock Market SWF
Abu Dhabi Low Low Med Med
Given that much of Abu Dhabi’s economic growth and diversification strategy is dependent on government spending of oil revenues, a prolonged decline in
oil prices due to a slowing world economy could put a damper on progress. However, we believe that given the reserves built up in addition to the wealth
generated and deployed by the Abu Dhabi Investment Authority (whose
assets are reportedly upwards of USD 630 bn5), the emirate should be able to maintain its spending plans despite any nominal decline in the value of its
reserve assets.
The Abu Dhabi stock market has remained relatively well isolated from negative global market cues; it remains one of the best performer in the GCC
on a year to date basis (-5%), despite suffering a 2.5% drop following the US
downgrade. Abu Dhabi banks have also held up relatively well during the downturn, 2Q11 net earnings came in at USD 1.17bn, a 74% YoY increase,
while 1H11 net profits were at USD 2.12bn, a 38% YoY increase. We expect the banks to continue to be supported by strong government spending in
addition to healthy economic growth.
Domestic
Investments Foreign
Investments Stock Market
Bond Market
Dubai High High High Med
Dubai is in a slightly more precarious situation given the declines suffered as
a result of the global credit crisis, which it is still recovering from, in addition to the fact that it has more of a global linkage than Abu Dhabi.
Given that the Dubai economy is reliant mainly on Trade and Tourism for GDP growth, these may see a decline should world economic growth decline.
Should economic growth in Dubai be hindered, it could prove detrimental to domestic investment by the government and private sector. This may also
affect the confidence factor for foreign investors, who would increase their
risk premium on Dubai post the US debt downgrade. However, one should note the fact that Dubai has strong ties with foreign institutions which have
been reaffirmed post-crisis through successful bond raises and continuation of major infrastructure projects across the emirate.
A further downgrade in the US and/or another G7 nation could result in cost
increases for foreign and local firms. Additionally, declining global growth and
poor market conditions could increase risk aversion among foreign investors, leading to a pull out of Arab markets.
Banks could see an escalation of risky assets as ratings change leading to a
squeeze on capital adequacy ratios, which coupled with an increase in
provisions would dent bottom line performance going forward. Additionally, the stock market has been performing poorly for the year, down by about
4 based on news articles and anecdotal evidence 5 Sovereign Wealth Fund Institute
The Abu Dhabi stock market
has remained relatively well isolated from negative global
market cues
A further downgrade in the US
and/or another G7 nation could result in cost increases for
foreign and local firms
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
5
11%, and we expect it to continue to be hypersensitive to global and regional cues.
Qatar
Oil Domestic
Investments Foreign
Investments Stock Market
Bond Market SWF
Low Low Med Med Med Med
Qatar enjoys similar comfort as that of Saudi Arabia, Kuwait, and Abu Dhabi when viewed from oil and gas resources and reserves. Hence, we perceive
lower risk on that account. Qatar has also been one of the best performing markets in the GCC over the last two years, successfully skirting the global
financial crisis while maintaining its growth trajectory. Consequently, we see a
mid-level risk in terms of the stock market, which is down about 3% for the year.
Despite the fact that the economy is highly dependent on LNG production, we
expect the reserves and revenues built up by the State through the years to allow it to continue to implement large-scale development plans such as the
USD 125 bn National Development Strategy which was put in place this year.
Lower state revenues may have implications for Qatar’s Sovereign Wealth
Fund (SWF) whose reserves and investments most likely have a US bias (detailed information on holdings is unavailable) which may see a nominal
devaluation as the dollar weakens.
Furthermore, Qatar is currently implementing many regulatory reforms and
developments, such as encouraging firms to lower Foreign Ownership Limits (in order to be upgraded to MSCI Emerging Market status) in addition to
setting up an organized bond market. These measures, coupled with large-scale projects relating to the World Cup 2022 event, should keep foreign
investor interest sustained.
Oman and Bahrain
Domestic Investments Foreign Investments
Oman High -
Bahrain High High
Oman and Bahrain have both had a relatively difficult 1H11 with political
turmoil dampening the economy and market sentiment. Oman, down 15%, is the worst performing GCC for the year while Bahrain, down 12%, is only
marginally better.
Lower global growth and dampened oil demand would make it relatively more difficult for Oman to enact domestic investment programs. This difficulty is
compounded by the lingering political issues, mainly relating to unemployment, which the government must address. As for the banking sector, it will be affected by a slowing economy and lackluster market
conditions.
The impact in Bahrain is expected to be higher; the country does not have oil
revenues to fall back on (the economy depends on tourism and the financial sector) in order to boost public spending and consequently, any further strain
on the economy will lead to declining domestic investments. Moreover, the government currently runs a deficit of about -6% of GDP, placing further
strain on government spending. Furthermore, banks have already suffered
Qatar is currently implementing many regulatory
reforms and developments
Oman and Bahrain have both
had a relatively difficult 1H11
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
6
during the year, due to political strife, with some businesses moving offices to ‘safer’ locales like Qatar or Dubai. Consequently, the risk perception of the
country has risen, with 5 yr CDS spreads up 42% for the year, which would
make it difficult to attract foreign investors back.
GCC Equity Markets-Post AAA Downgrade
The short term effect has been felt already with the GCC stock markets
experiencing large declines following the announcement; Saudi’s Tadawul tumbled 5.5% on the 6th of August (Table 1). When other GCC markets
opened on Sunday, they experienced sharp declines; Qatar and Dubai were down 5% at the open while Kuwait quickly shed around 3%. However, the markets managed to regain some of the lost ground, but still closed in the
red. Qatar and Kuwait (weighted index) both closed down 2.51% while Dubai lost 3.7%. GCC stock markets have shed USD 31 bn in market cap since the
announcement of the US debt deal at the end of July. The stock markets could decline further as international markets fluctuate wildly on varying risk
assessments.
Table 1: Immediate Impact of Downgrade on Local Exchanges
Index losses Saudi Arabia
Kuwait Dubai Abu Dhabi
Qatar Oman Bahrain S&P GCC Index
1st Day Impact* (Rating Downgrade)
-5.50% -2.51% -3.70% -2.53% -2.51% -1.87% -0.33% -1.20%
27th July – 10th Aug (Debt Deal announcement)
-6.30% -3.55% -3.05% -1.44% -2.95% -7.66% -2.53% -5.32%
USD bn GCC Total
Market Cap Decline (27 July – 10th Aug)
-21 -4 -1 -1 -3 -1 0 -31
Note: Kuwait represents Kuwait Weighted Index Note*: 1st Day Impact represents 6th of August for Saudi Arabia and 7th of August for other GCC Markets. Source: Reuters Eikon, Markaz Research
CDS spreads, which give an indication to the level of risk perceived in a
market, saw increases across the board following the US debt deal and downgrade (Figure 1). All markets saw spreads jump between 7.5% and 22%
in the case of Oman. We would expect CDS spreads to remain volatile while equity markets fluctuate.
Figure 1: Impact on CDS Spreads (5 yr USD)
As global equity markets re-price risk, prices will undoubtedly be affected. Regional Brokers / financial institutions will have to come to terms on whether
The short term effect has been
felt already with the GCC stock
markets experiencing large declines following the
announcement
We would expect CDS spreads to remain volatile while equity markets fluctuate
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
7
they will accept US Treasuries as collateral for their short term funding requirement. While it may take time to come to a consensus on this, in the
short term, it will surely affect capital markets. The situation will become
more important if any other agency downgrades US, leading to a systemic problem of triggering margin calls.
Oil
On the longer-term, there is expected to be some implication for oil prices in light of a weakening US economy and decreasing forecasted demand.
Specifically, US forecasted oil demand has been tempered by the near stalling of economic growth in 2011. In light of a downward revision in forecasted 2011 US GDP growth (to between 2%-2.5% from a previous forecast of
around 3%6), Deutsche Bank brought down its US oil demand growth forecast by half to about 100,000 b/d7. A point to note here is that, US accounts for
nearly 22% of global oil consumption.
Figure 2: Crude Oil (Brent)
Analysts are expecting crude (Brent) to come down to the mid-$90 range by
the end of the year; not exceedingly troubling for the GCC but could place
constraints on less oil-rich members. US Dollar & Reserves
Apart from oil being billed in dollars, most GCC currencies are pegged to the dollar, so any serious fall in US dollar value might put a strain on government
finances. The US Dollar has seen wild swings post-downgrade; the greenback
tumbled 1.63% against the Euro immediately following the downgrade before rebounding sharply the following sessions. The currency continues to
fluctuate with market swings and mixed cues.
6 Consensus of estimates including IMF 7 Bloomberg
On the longer-term, there is expected to be some
implication for oil prices in light of a weakening US economy
and decreasing forecasted demand
The US Dollar has seen wild swings post-downgrade
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
8
Figure 3: USD Impact
Corporates will have to pay more for their imports billed in other currencies. GCC countries depend on imports for most food items; any increase in food
prices will stroke inflation fears affecting economic growth.
Table 2: GCC Economic Indicators
USD bn 2007 2008 2009f 2010f 2011f
Reserves ex. gold 421 513 503 546 601
Imports 403 510 428 472 484
% of GDP 33.2 34.0 35.6 34.1 NA
Inflation (ave. % change) 6.9 11.1 2.7 3.3 4.4
Source: IIF
Gulf countries and sovereign wealth funds are estimated to hold a large amount of US Treasuries and dollar denominated assets which will depreciate
impacting mark to market valuations. Private Banks and other financial
institutions also have exposure to US Treasury, a mark down in their value will affect profitability – despite it being a notional loss. Officials from the UAE and Oman have already indicated that they are in no
hurry to discontinue their dollar peg. In fact, following the conclusion of the
debt deal, but prior to the downgrade, the UAE central bank made a surprise announcement that it had no US Treasury Bills in its reserves or any other
financial instrument issued by the US government, citing “very low return”. The announcement came as a surprise given the currency peg to the Dollar.
Anecdotal evidence suggests that the Central Bank has turned to Japan for Dollar-denominated government debt.
Given declining credibility in the US government, further dollar weakening and a larger divorce between economic realities between the two, the GCC
governments may wish to revisit and speed up plans to create a unified GCC currency as pegging to dollar leaves policymakers with limited room to
implement independent monetary policy decisions.
Cost of borrowing could see an increase thereby affecting corporate balance
sheets. Should US Treasury yields reverse their current course and begin rising, cost of equity would see an increase thereby affecting not only
US forecasted oil demand has been tempered by the near
stalling of economic growth in 2011
The US Dollar has seen wild
swings post-downgrade
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
9
corporate balance sheets but also valuation of said companies which may have stock market implications.
Floating rate bonds which are linked to US LIBOR rate might see increase in yields. Short term funding and refinancing will take a hit if liquidity dries up in
the market. As S&P downgrades other institutions related to US government, counterparty credit risk will increase leading to liquidity problems.
Will the sovereign wealth funds step in this time to support US Treasuries remains a big question.
Any increase in food prices will
stroke inflation fears affecting economic growth
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
10
Appendix1: AAA Fiasco: A Primer
On the 5th of August 2011 the S&P ratings agency downgraded the U.S.'s AAA credit rating for the first time,
slamming the nation's political process and criticizing lawmakers for failing to cut spending enough to reduce record budget deficits. The historic move signals a blow to the world’s largest economy and throws doubt on
an already tentative global economic recovery. S&P downgraded the rating by one notch from AAA to AA+ with a “negative” long-term outlook, implying that the agency could lower the long-term rating to 'AA' within
the next two years if there is less reduction in spending than agreed to, a rise in US interest rates, or new
fiscal pressures resulting in higher general government debt. The downgrade has wide-ranging implications in terms of not only borrowing costs, but also casting doubt on the US status as a global reserve currency.
According to JPMorgan Chase & Co, the downgrade could raise the US’ borrowing cost by about $100 bn a year. There are also significant medium and long term implications for currencies, commodities and the already fragile global economic recovery.
S&P’s decision follows Moody's and Fitch which affirmed their AAA credit ratings following the signing of the
$2.1 trillion deficit-reduction plan which includes a decision to increase the debt-ceiling. Moody's and Fitch also said that downgrades were possible if lawmakers fail to enact debt reduction measures in addition to
the economy weakening further. Chinese credit rating agency Dagong has also downgraded US credit rating from A+ to A with a negative outlook.
Rising public debt burden and policy uncertainty were the primary reasons behind the downgrade. Under S&P’s base case fiscal scenario net general government debt is expected to rise from an estimated 74% of
GDP by the end of 2011 to 79% in 2015 and 85% by 2021. Meanwhile, Fitch projects U.S. government debt, including debt incurred by state and local governments, to reach 100% of GDP by 2012, and continue to rise
over the medium term.
What is behind the downgrade?
This is not the first time the US faced a downgrade threat; a similar crisis loomed in 1995. It is worth noting that at the time, the debt was at just $4.9 trillion8 (or 71% of GDP) versus over $14 trillion (or 91.5% of
GDP) currently. However, at that time, the US economy was on a steady growth trajectory, growing at about 4% a year versus current sluggish growth. Given the political deadlocks which formed the backdrop of the
US debt crisis (See Appendix 2 for a timeline of events), much of the S&P downgrade report spoke of the
inadequacy of the US government and fractious political leadership which has proven unable, or unwilling, to efficiently lead the country’s fiscal management versus an inability to repay debts. S&P advocated a mixed
solution of spending cuts and revenue growth. But as the recent negotiations made it clear, the Republicans have been unwilling to allow any tax increases.
The fact remains that a downgrade has been a long time coming and there are structural issues within the US economy and fiscal situation that the governing parties have been largely unwilling to deal with in a
meaningful way.
Debt
A statutory limitation on federal debt is a long standing feature of the US fiscal framework and applies to nearly all Treasury debt. The debt limit has been changed many times in the past — ten in the last decade
and twice in 2009 alone. The agreement passed on August 2nd provides for an initial increase of the debt limit of $400 bn and introduces procedures that would allow the limit to be raised further in two additional
steps, for a cumulative increase of between $2.1 trillion and $2.4 trillion by end-2011. The debt deal also calls for as much as $2.4 trillion of reductions in expenditure over the next decade. These cuts will be
implemented in two steps: the $917 bn agreed to initially, followed by an additional $1.5 trillion that the
newly formed Congressional Joint Select Committee on Deficit Reduction is supposed to recommend by November 2011. The act contains no measures to raise taxes or otherwise enhance revenues, though the
committee could recommend them.
8 AP, August 3rd 2011
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
11
Figure 4: USA Federal Debt as % of GDP, 1940 – 2010
0
20
40
60
80
100
120
1940
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
Pu
bli
c D
ebt
as %
of
GD
P
Source: White House Office of Management and Budget
Deficit Critics of the last-ditch deficit-reduction plan say it amounts to little more than “can kicking” as it does not solve the major spending issues related to Social Security, Medicare and Medicaid and existing tax benefits
to the wealthy and business segments. Analysts have also been critical of the fact that the plan is largely dependent on spending cuts which could further derail the already tentative economic recovery. In addition
to nearly $10 trillion of outstanding treasury debt, the US is estimated to have $66 trillion of future liabilities at “net present cost”. Payments due from Medicaid, Medicare & Social Security alone are over six times the
current obligations of Treasury debt9. Social entitlement programs currently account for 58% of US expenses
amounting to nearly $2 trillion in 2010.
The US has been running budget deficit for the last 9 years continuously and suffers long-run fiscal problems of rising health costs, an aging population, and a staunch unwillingness to raise taxes.
Figure 5: US Fiscal Budget
Source: White House Office of Management and Budget.
Can the US get its rating back?
There are currently 18 countries which enjoy a AAA rating, following the downgrade of the US to AA+ status. The US was the oldest member of the club, followed by France. The US is certainly not the first, nor
will it be the last, to lose the coveted AAA status. However, it has been shown that once losing the rating, it can be very difficult to recover (Table). According to S&P, restoring the AAA rating can take a country
9 Kleiner Perkins Caulfield & Byers
World War II
2010 Public Debt = 62% of GDP
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
12
between nine and eighteen years. Moreover, once a country has been downgraded, it has a 52% chance of being downgraded further within two years, but only a 9% chance of being upgraded10.
Table 4: Countries which lost & regained AAA status
Country Lost Regained Number of Years
Canada 14-Oct-92 29-Jul-02 9.8
Finland (Republic of) 03-Mar-92 01-Feb-02 9.9
Sweden (Kingdom of) 22-Mar-93 16-Feb-04 10.9
Australia (Commonwealth of) 02-Dec-86 17-Feb-03 16.2
Denmark (Kingdom of) 06-Jan-83 27-Feb-01 18.2
Source: Standard & Poor’s Global Credit Portal, August 2011
Two relatively recent experiences shed some light on how difficult it can be to regain a lost rating. Australia lost its rating in 1986 and was returned to AAA only in 2003. Canada is the other example and also holds the record for quickest return to AAA status. The country was downgraded in 1992 and managed to regain the rating by 2002. Both countries were required to endure strict spending and budgetary constraints in addition
to taking severe measures to control debt. However, it must be noted that, in both cases, the economies
were showing healthy growth rates; Real GDP in Australia and Canada grew at an average of 3.5% each during their ‘downgraded’ periods11. Additionally, the world economy was performing relatively well at the
time; growing between 3%-4% throughout the period with Australia benefitting from the high growth in the Chinese economy during that timeframe.
Conversely, the US is still struggling with a fragile and tentative recovery, seeing sub-standard growth rates
and a near stalling of the economy thus far in 2011 (Real GDP has been bumbling along with a 1% ann.
growth rate in 1H1112). Such conditions are not conducive to the type of spending cuts and debt management measures required to return the country to a state whereby a AAA rating would again be
warranted. Regaining the coveted rating will take a combination of medium-long term measures aimed at addressing the country’s underlying financial issues in a meaningful and coherent manner. An indication of
just how difficult it is to regain the rating is illustrated below.
Table 5: Countries which lost and are yet to regain AAA status
Country Lost Years since Downgrade
United States of America (unsolicited) 05-Aug-11 0.0
Ireland (Republic of) 30-Mar-09 2.4
Spain (Kingdom of) 19-Jan-09 2.6
Japan (unsolicited) 22-Feb-01 10.5
Venezuela (Bolivarian Republic of) 13-Aug-82 29.0
New Zealand 01-Nov-76 34.8
Source: Standard & Poor’s Global Credit Portal, August 2011
Global Implications
Equities: There has already been a severe correction across US and International Equity markets in light of
the downgrade. A reported $2.5 trillion was wiped off global markets13 during the weak as the US debt saga reached fever pitch. Equity markets are expected to continue to be hyper-sensitive to negative cues, not
solely due to the downgrade (which, after all, was not entirely unexpected), but in larger part due to continued economic weakness in addition to poor progress with the sovereign debt issues in the Eurozone.
Treasuries: There is not expected to be a flight out of Treasuries given that the US issues almost 60% of
the world’s sovereign debt while the 2nd and 3rd largest issuers (France and Germany) are embroiled in their own debt issues within Europe. Moreover, no other debt market can match the US in terms of liquidity and
debt.
10 The New York Times 11 For Australia: 1989-2003; For Canada: 1993-2002 12 US Bureau of Economic Analysis 13 Reuters
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
13
US 10 year treasuries tumbled 8% prior to the downgrade before jumping 6.5% post-announcement. Yields have been pushed down to 10-month lows (down to 2%), reinforcing belief in the US’ creditworthiness.
Japan, the 2nd largest holder of treasuries, indicated that despite the downgrade, they remain attractive
investment targets. Treasury yields could come back up by 60-70bps over the “medium-term”14. According to Citi, given the distribution of US Treasuries, we are unlikely to see a flight from the asset either
willingly or through mechanical or ‘forced’ selling. Institutions, Funds, the Fed and non-US Central Banks and SWFs hold about 70% of the pie; these entities would either a) be willing and able to hold non-AAA rated
debt, or b) be unwilling to drop the paper for various political and economic reasons. The question mark
here, as Citi sees it, lies with the non-US Private Investors, who hold about 13% of the total. It is unclear whether they would move into other, more highly rated debt or into other US-denominated instruments.
Figure 6: US Treasury Ownership by Segment
What about China?
China, which is the largest holder of US Treasuries, has repeatedly pushed Washington towards increased
fiscal responsibility given the contagion it would have in the global monetary system. Following the
downgrade, China condemned the US for its “debt addiction” stating that given China’s position as “the largest creditor of the world's sole superpower, [it] has every right now to demand the United States
address its structural debt problems and ensure the safety of China's dollar assets.15” Table 7: Major Foreign Holders of Treasury Securities as at May-11
Country Value (USD bn)
China 1,160
Japan 912
UK 347
Oil Exporters# 230
Brazil 211
Others 1,654
Total 4,514 # - Oil exporters include Ecuador, Venezuela, Indonesia, Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia, the United Arab
Emirates, Algeria, Gabon, Libya, and Nigeria
Source: Dept of Treasury
China urged the US to cut military and social welfare spending (which make up the bulk of “sticky” expenditures) and make serious changes to its fiscal management to avoid further downgrades which could
trigger widespread financial turmoil. The country went further by calling for “international supervision over
the issue of the U.S. dollar and a new, stable and secured global reserve currency” as “an option to avert a catastrophe caused by any single country.”
US Monetary Policy: the enacting of QE3 seems more likely than ever as the Fed has already announced
intentions to keep interest rates low for an extended period.
14 JPMorgan Chase 15 Xinhua news agency, August 5th 2011
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
14
Commodities: Gold’s status as a safe haven is likely to be reinforced by the rating downgrade; the precious metal is already at record highs (hovering around $1,858/oz), a gain of 31% YTD. Silver is already up about
39% for the year and is unlikely to see as much benefit from the uncertainty given that it has an industrial
component which will be negatively affected by weaker economic growth.
Currencies: The move will likely see a further weakening of the US Dollar, which is already down 7% against the Euro for the year. The other two “safe” currencies, i.e. Swiss Franc and Japanese Yen, are likely
to gain from the Greenback’s decline, at least in the short-term. The Yen is already up about 6% against the
Dollar for the year. Given the increased likelihood of QE3 coupled with a view (at least in some quarters) that this might be the first in a series of downgrades (especially given the Negative outlook by S&P and
Moody’s), the US Dollar is likely to weaken further in the medium term as Central Banks and sovereign institutions move out of USD and into other, ‘safer’ currencies. Questions are also being raised about America’s ability to continue to print the world’s reserve currency. With European Union not showing any
stability, US dollar will retain its status to be the world’s reserve currency at least in the medium term albeit with decreasing share of global reserves.
Appendix 2: International & Regional Viewpoints
Mohamed A. El-Erian, PIMCO – El-Erian expects that credit costs for American borrowers will be higher
over time and there will be an increase in risk premiums and volatility. He said “Animal spirits, already hobbled by the debt ceiling debacle, will again be dampened, constituting yet another headwind to the
generation of investment and employment”. El-Erian feels that the US Dollar’s status as the global reserve
currency is not in jeopardy following the downgrade. While criticism is sure to follow, at the moment, there is simply no alternative to the greenback. “… No other country is able and willing to replace the US at the
core of the global system…. Specifically, will it simply come to a new normality, with an AA+ at its core, or are further structural changes now inevitable?”
China - In its commentary, Chinese state-run Xinhua News Agency issued government statements which
severely criticized the US for living beyond its means and heralding the S&P downgrade as a sign that the
days of unlimited borrowing are gone. The agency urged citizens to become more self-disciplined and contribute towards rebuilding the economy “…. mounting debts and ridiculous political wrestling in
Washington have damaged America's image abroad. All Americans, both beltway politicians and those on Main Street, have to do some serious soul-searching to bring their country back from a potential financial
abyss.” The country went further by calling for international supervision over the US Dollar: “a new, stable
and secured global reserve currency may also be an option to avert a catastrophe caused by any single country.”
Citigroup Global Markets – According to Citigroup, the rating was not only expected, but was entirely
justified given the lack of fiscal leadership and inability to agree on appropriate debt and deficit reduction measures in the US. They also believe that downgrades could now spread across other developed nations
such as France and Germany. “We could be moving towards a world without AAA G7 sovereigns. The criteria applied by the rating agencies to the G7 sovereigns in the past have been, in our view, far too lenient.” Citigroup indicates that post-World War II, there has been a severe erosion in “tax administration capacity,
diminishing tax compliance in the private sector, and the evolution of political decision-making institutions, processes and practices that make it possible to mandate public spending without ensuring sustainable
funding for these expenditures.” The US downgrade brings an end to the time where a AAA rating for
advanced countries was not only ‘correct’, but a ‘right’. “Only a few small countries with a surviving culture of tax compliance and political institutions that effectively impose the government’s intertemporal budget
constraint may have AAA ratings in the not too distant future. For portfolio allocation, relative risk will be the driver now that 'risk free' is no longer an option.” Absolute Return Partners - In a letter to investors, the firm said that it feels the rating downgrade
doesn’t carry any meaning as the U.S. has only dollar denominated debt. “A nation that issues debt denominated solely in its own currency and which is in full control of its monetary policy, cannot default
unwillingly. Nations default because they run out of foreign currency to service their debt, but the U.S.
doesn’t need foreign currency to service its debt”. The letter also stated that this downgrade might have be a precursor to further downgrades in Europe as well. “With its downgrade of U.S. sovereign debt, Standard
and Poor’s has started a chain of events which can only make things worse in an already crisis hit eurozone.
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
15
For that reason, the decision to downgrade was not only badly timed but also ill considered; that it was probably justified is of little relevance at the moment.”
JPMorgan Chase & Co.’s - Terry Belton on a conference call hosted by the Securities Industry and Financial Markets Association forecasted that a rating cut could increase borrowing costs. “A U.S. credit-
rating cut would likely raise the nation’s borrowing costs by increasing Treasury yields by 60 to 70 basis points over the medium term”. He also predicted that “$100 billion a year is money being used for higher
interest rates and that’s money being taken away from other goods and services.”
Barclay’s Capital – The firm is of the view that the US debt downgrade will be a positive for dollar. "We
separate our discussion of the impact of a potential US downgrade into two – the immediate and the slightly longer-run consequences… The immediate effect would be one in which risk aversion increases and liquidity decreases, both of which support the USD.” Over the long term, Barclay’s Capital sees growth getting
curtailed because of tight monetary policies. “However, the fact that this is a US-driven risk, the USD will likely lag other safe-haven currencies (such as the JPY and CHF). Further out, we see fiscal tightening
weighing on growth and the USD weakening further, as monetary policy is kept looser for longer than the market is expecting."
Stephan S. Roach, Non-Executive Chairman of Morgan Stanley Asia - In a commentary on change
in Chinese policies indicated that China has lost confidence in America’s government and will not risk its
economic stability on Washington’s promises. “In recent years, Chinese Premier Wen Jiabao and President Hu Jintao have repeatedly expressed concerns about US fiscal policy and the safe-haven status of
Treasuries….” He also pointed out that the Chinese are revisiting their strategy of export-led growth and massive accumulation of dollar-denominated assets. “Those days are over. China recognizes that it no
longer makes sense to stay with its current growth strategy – one that relies heavily on a combination of
exports and a massive buffer of dollar-denominated foreign-exchange reserves… Long the most powerful driver of Chinese growth, there is now considerable downside to an export-led impetus”
David A. Rosenberg, Gluskin Sheff - In a recent report, indicated that the downgrade will lead to
tightening of budgets which is a positive for bond markets. He expects equity prices to come under pressure because of sluggish demand growth. “The big news is that the screws have been tightened on the fiscal
stimulus front. So on net, the downgrade is a deflationary event and as such is not negative but positive for
the bond market. History shows that every time a AAA country gets downgraded, the budgetary belt is tightened and yields decline every time.” Rosenberg also feels that there will not be a huge impact because
of rating downgrade given that US is still the reserve currency and S&P’s emphasis was more on political factors. “The U.S. can print its own money and certainly has the wherewithal to pay its debts so the
downgrade is more symbolic than real…. But default risks are no different today than they were last Friday
morning, and the Treasury had already said repeatedly that bondholders would be made whole even if there was to be a government shutdown.”
Regional
Ibrahim Dabdoub, CEO of National Bank of Kuwait – Mr. Dabdoub feels that the US rating downgrade
was not a surprise and does not expect it to affect the economy. “….dollar remains the first reserve currency worldwide. Thus, the recent cut will unlikely have great influence on the US economy, on condition that the
US government takes the right measures to slash spending.” Ibrahim Dabdoub doesn’t foresee any major negative impact on GCC economies, because of large surpluses and government spending programs.
“….government spending remains the main driver for the GCC economies, expecting expenditure to accelerate in H2-11, after falling shy of expectations in the first half.”
Said A. Al Shaik, Group Chief Economist of NCB – In a recent report indicated that the near term implications will be minimal but expects negative impact on US Dollar over the long term. “The longer-term
effects are driven primarily by whether international markets will eventually also downgrade the US. Consequently, the biggest impact should be through the effect on the US dollar as a reserve currency”. Al
Shaik feels that the downgrade will impact Saudi Arabia in three ways – Crude Oil demand & price changes,
US Dollar movement and through official holdings of US treasuries. “Holders of US treasuries like Saudi Arabia should not be concerned that they may not receive interest payments on US bonds. However, the
value of those payments will essentially decline, given the fact that with more dollars in circulation due to the printing presses….”
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
16
Jadwa Investment in its report titled “Debt, downgrade and Saudi Arabia” expects US to continue its position as a safe haven despite the downgrade. “The breadth, depth and liquidity of the US financial
markets also support its safe haven status. No other financial market is of a comparable size or has the
same variety of financial instruments as the US”. They are also of the view that Saudi economy will not face any major negative consequences and that currency peg will continue. “We do not think ongoing events will
have too great an impact on the Saudi economy, as the growth momentum is coming from high government spending that can be afforded comfortably…. We do not think the downgrade will have an impact on the
exchange rate peg between the riyal and the dollar.”
Alshall Consulting in its Weekly Economic report indicated that US will continue its dominant position in
the world. “The USA will remain for one to two decades as the largest global economy, trustworthy, and the first destination for creditors and investors”. They are also of the view that there will be gradual transition of economic power and search for substitutes for US Dollar as reserve currency will take place. ”What is
happening is a more significant indicator for the beginning of an era in history during which the economic weight will shift from the West to the East and will gradually introduce alternatives and partners to the dollar
as a global reserve currency.”
Appendix 3: The US Downgrade: A Timeline16
The S&P downgrade is the culmination of a saga which began in late 2010 concerning the US’ rampant debt
and runaway deficit growth. The government has been running a rapidly widening deficit for the last decade with high debt accumulation.
Dec. 1, 2010 - A bipartisan deficit-reduction panel issues a report advocating a 10 yr plan which includes $3 trillion in spending cuts and $1 trillion in revenue increases.
January 2011 - Six Republican and Democratic senators, known as the "Gang of Six," begin talks on a
long-term deficit-reduction deal.
Feb. 19 - The House passes a current fiscal year budget that would cut $61 bn in spending. The
Democratic-controlled Senate defeats it one month later.
April 9 – The US government approaches a shutdown before Obama and congressional leaders cut an 11th
hour deal and agree on a fiscal budget that cuts $38 bn in spending. Billed as the largest spending cut in U.S. history, it actually causes the government to spend $3.2 bn more in the short term.
April 13 - After Obama's initial proposal is deemed inadequate, the president lays out a new deficit-
reduction plan that would save $4 trn over 12 yrs.
April 15 - The House passes a budget which cuts spending by $6 trillion over 10 yrs, in part by scaling back
medical care for the elderly and the poor.
May 9 - House Speaker John Boehner (Republican), says any increase in debt ceiling must be matched by
an equal amount of spending cuts. The Treasury estimates it needs at least $2 trn to cover borrowing through the 2012 elections.
May 11 - House Republicans release a spending outline for the coming fiscal year that has deep cuts in
education, labor and health programs which are highly prized by Democrats.
May 16 - The United States reaches its $14.3 trillion debt limit. The Treasury Department begins tapping other sources of money to cover the debt.
June 9 - Treasury Secretary, Timothy Geithner argues that tax increases need to be part of any debt deal,
but Republicans remain unmoved.
16 Reuters, July 25th 2011
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
17
June 23 - Republicans declare an impasse in talks with the White House, saying Democrats are insisting on roughly $400 bn in new revenue by closing tax breaks for the wealthy and certain business sectors.
June 29 - The International Monetary Fund says the United States must lift its debt limit soon to avoid a "severe shock" to global markets and a still-fragile economic recovery. Obama calls for new steps to spur job
growth and tax hikes on the rich, irking Republicans who remain focused on deficit cuts.
July 3 - Obama and Boehner discuss "grand bargain" that would save $4 trn over 10 yrs through a tax code
overhaul and trims to benefit programs.
July 8 - A dismal jobs report focuses new attention on the sputtering economy. Obama says uncertainty
about the debt ceiling talks is hurting economic expansion.
July 9 - Boehner says grand bargain is out of reach because Republicans will not accept the tax increases Democrats are demanding. He calls for a more modest $2 trillion package that would rely mostly on
spending cuts.
July 13 - Moody's puts the US on review for possible downgrade. Obama meets lawmakers for nearly two hours but a deal remains elusive.
July 14 – S&P Ratings says there is a 50% chance it could cut the U.S. credit rating if talks remain
stalemated. Obama suspends talks and gives party leaders 24-36 hours to deliver a deadlock-breaking "plan of action."
July 18 - Republicans push for a measure that would cut and cap government spending and require an amendment to the U.S. Constitution requiring a balanced budget. Obama says he will veto it should
Congress send it to his desk.
July 19 - The "Gang of Six" resurfaces with a deficit reduction plan that proposes $3.75 trillion in savings
over 10 years and contains $1.2 trillion in new revenues. Obama pushes Congress to take serious consideration of it.
July 21 - Obama and Boehner discuss a possible $3 trillion deficit-cutting deal that upsets Democrats for
not including enough tax rises to offset spending cuts. Obama repeats some revenues will need to be part of
any accord.
July 22 - Boehner breaks off talks with Obama over impasse on revenue increases, raising concerns about whether a deal can come together by the August 2nd deadline.
July 24 - Republicans and Democrats retreat to their corners and focus on separate plans to avert default. Democrats meet with Obama to discuss a proposal to cut $2.5 trillion in spending without revenue. Boehner
urges Republicans to stay united to secure the most budget cuts possible.
July 31 – Leaders of both political parties reach a last minute deal which aims to raise the debt ceiling by
$2.1 trillion with a plan to cut the fiscal deficit by up to $2.4 trillion over a 10 year period. The plan also includes the formation of a bipartisan committee to seek out $1.2 trillion in spending cuts by the end of the
year.
August 2 – Moody’s affirms US credit rating, but places the country on “Negative” outlook, indicating a
possible downgrade over 12-18 months. Fitch announces that it will provide its rating by end of August.
August 5 – S&P Ratings downgrades US long-term credit rating from AAA to AA+ with a “Negative” outlook, implying the chance for further downgrade within 2 years. The move causes the S&P 500 to finish
with its largest weekly decline since November 2008 (7.2%); other US and world indices see heavy declines.
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
18
Appendix 4a: S&P Global Ratings
AAA AA+ AA AA-
Australia (UR) Belgium (UR) Abu Dhabi China
Austria New Zealand Bermuda Japan (UR)
Canada United States of America (UR) Kuwait Saudi Arabia
Denmark
Qatar Taiwan (UR)
Finland
Slovenia
France (UR)
Spain
Germany (UR)
Guernsey
Hong Kong
Isle of Man
Liechtenstein
Luxembourg
Netherlands (UR)
Norway
Singapore (UR)
Sweden
Swiss Confederation (UR)
United Kingdom (UR)
A+ A A-
Chile Andorra Aruba
Italy (UR) Czech Republic Botswana
Slovak Republic Emirate of Ras Al Khaimah Malaysia
Estonia Poland
Israel
Korea
Malta
Oman
Trinidad and Tobago
Note: (UR) indicates Unsolicited Rating Source: Standard & Poor’s
R E S E A R C H September 2011
Kuwait Financial Centre “Markaz”
19
Appendix 4b: S&P Global Ratings (B & C Group)
BBB+ BBB BBB-
Bahamas Bahrain Barbados
Cyprus Bulgaria Brazil
Ireland Kazakhstan Colombia
South Africa Lithuania Croatia
Thailand Russian Federation Hungary
United Mexican States Iceland
India (UR)
Montserrat
Morocco
Panama
Peru
Portugal
Tunisia
BB+ BB BB-
Azerbaijan Costa Rica Bangladesh
Indonesia Egypt Cook Islands
Latvia Guatemala El Salvador
Uruguay Jordan Gabonese Republic
Macedonia Mongolia
Montenegro Republic of Angola
Philippines Venezuela
Serbia Vietnam
Turkey
B+ B B-
Bolivia Argentina (UR) Belize
Bosnia and Herzegovina Belarus Ecuador
Cambodia (UR) Benin Grenada
Cape Verde Burkina Faso Jamaica
Dominican Republic Cameroon Pakistan
Georgia Fiji Islands
Kenya Ghana
Mozambique Honduras
Nigeria Lebanon
Papua New Guinea
Paraguay
Republic of Albania
Republic of Zambia
Senegal
Sri Lanka
Suriname
Uganda
Ukraine
CC
Hellenic Republic Note: (UR) indicates Unsolicited Rating
Source: Standard & Poor’s
R E S E A R C H September 2011
Disclaimer
This report has been prepared and issued by Kuwait Financial Centre S.A.K (Markaz), which is regulated by
the Central Bank of Kuwait. The report is owned by Markaz and is privileged and proprietary and is subject
to copyrights. Sale of any copies of this report is strictly prohibited. This report cannot be quoted without the
prior written consent of Markaz. Any user after obtaining Markaz permission to use this report must clearly
mention the source as “Markaz “.This Report is intended to be circulated for general information only and
should not to be construed as an offer to buy or sell or a solicitation of an offer to buy or sell any financial
instruments or to participate in any particular trading strategy in any jurisdiction. The information and
statistical data herein have been obtained from sources we believe to be reliable but in no way are
warranted by us as to its accuracy or completeness. Markaz has no obligation to update, modify or amend
this report.
This report does not have regard to the specific investment objectives, financial situation and the particular
needs of any specific person who may receive this report. Investors are urged to seek financial advice
regarding the appropriateness of investing in any securities or investment strategies discussed or
recommended in this report and to understand that statements regarding future prospects may not be
realized. Investors should note that income from such securities, if any, may fluctuate and that each
security’s price or value may rise or fall. Investors should be able and willing to accept a total or partial loss
of their investment. Accordingly, investors may receive back less than originally invested. Past performance
is historical and is not necessarily indicative of future performance.
Kuwait Financial Centre S.A.K (Markaz) does and seeks to do business, including investment banking deals,
with companies covered in its research reports. As a result, investors should be aware that the firm may
have a conflict of interest that could affect the objectivity of this report. For further information, please contact ‘Markaz’ at P.O. Box 23444, Safat 13095, Kuwait. Tel: 00965 1804800 Fax: 00965
22450647. Email: [email protected]