To tell the consequence of the unimaginable, we can dissect the issues into layers, the primary effect,loss to the holder of the bond. Parallel to that, its’ impact on global trade and economic activities, especially export-driven economies in Asia. In short, the primary loss would be the major Asia sovereign, and shake-out of the smaller emerging Asia players, whereas its’ drop in trade is estimated to be around 7 to 8% of US’s consumption market.
Primary effect: loss from downgrade
The loss from the bond holder would be significant but will not hurt anyone like you and me but the government. Even though Asian countries owned 57% of UST as of May 2011. Reason is that the bond sit in the foreign reserve in most of Asian Countries, e.g. China and Japan. What can the government do if your mount of foreign reserve got eaten? For export-driven pocket rich North Asian countries ( excluding South Korea), there would not be any issues. (Yes, I am implying that the South East Asians with low foreign reserve would be in big big trouble in keeping the value of their currency!). The remaining goes to the banks or social security funds of China, that is where it eat into Asians people’s pockets. In China, it’s the banks, which will see its capital eroded. In Japan, it’s the pension fund that suffers. I really doubt that in times like this people rushing to invest into Asian’s High Yield/ emerging countries bond as the safe harbor. If it’s Japan, China and Singapore, I can still see reasons behind that. And for the rest of Asia, please kindly suggest me a name that could stand with its foreign reserve collapses.
If it were to hedge against any loss, the obvious choice is CHF-bond and Bullion, the less obvious one could be the German bond (the bund), as the country is back by solid output to the world. My view on Euro is that the worst is to disband the idea of Euro, which brings no harm to Germany at all. Not to mention the up-side of it in the longer term.
Immense loss could be incurred from investment of the derivative products. When you think again, derivative is a zero-sum game, which actually do not concern me. Yeah, big banks or big corp collapses but there are always some winners. What I worry now is the default rate caused by rising interest payment, incurred at compound rate. Given that the downgrade from AAA to AA, the implied default rate will move by infinitely, from near zero to approx 10bps. That eat into the real economy…
Reduction of Trade (consumption)
Downgrade will weaken the consumer market by doubling the interest rate paid by consumers. The implied interest rate of AA is near double of AAA, downgrade by one notch will double the interest rate payment. Given that the average consumer unit in US paid 7% interest, caused by the downgrade, there will be another 7% additional interest payment, to 14% of anyone’s expenditure. Given that the consumer income does not increase, the rest of the consumer expenditure would reduce proportionally by 7-8%. The world won’t simply stop. At least it’s quantifiable. As the key driver of the global economy, we are yet to see how the emerging market can take up higher share of the global consumption market. But the point is that it’s not the end of the world.
The only thing I cannot account for, and no one can account for, is the animal spirit of the global market. Usually it’s the volatility that kills people. Let’s hold our breath and embrace!
My views so far
To reiterate my view so far in sectors of Asia, I am pro-transportation (for Japan), entertainment positive for China and Taiwan, negative on banks in general (exception: Apart from Korean banks, Yen’s rise can fuel M&A fee for the Japanese ibanks) . For consumer electronic, I still think that it is one global market and actually beyond my horizon so far. But I will see Korean and Taiwanese advanced gradually in the value chain of this industry.
Earlier, I had my view on HK’s cross-border shipping. Statistics released recently proved that I was wrong. I also see that the economic recovery would delay for another 3 quarters as soverigns and investors are moving away from US-based asset. This is something very critical and thus drastically change my view.
