Market dives on US downgrade, China demands new reserve currency
Monday, 8 August 2011 12:30pm

The Australian share market dropped sharply on the open as nervous investors reacted to Standard & Poor's historic weekend downgrade of US sovereign credit.

At time of writing the All Ordinaries Index had fallen 66.1 points or 1.59% to 4103.6 while the S&P/ASX 200 was down 62.3 points or 1.52% to 4042.9.

US Treasury debt had been widely regarded as the safest security in the world, rated AAA.

The S&P downgrade shook that pillar of confidence by reducing its official opinion of US creditworthiness to AA+, below that of AAA-ranked countries such as Britain, Australia, Germany and Canada.

It is expected to have an effect on US bonds, pushing yields up and prices down, increasing the cost of borrowing in the US.

The US has accused S&P of basing its decision on a US$2 trillion mistake.

But the ratings house has stuck to its position and placed the US on negative outlook, threatening future downgrades.

Bondholders have been concerned by the size of US debt and the decline in value of the US dollar, eroding the purchasing power of their investments.

Bill Gross, managing director of bond fund PIMCO, sold out of US Treasuries in March.

In his August investment outlook, he wrote that investors should logically ask how the US would meet its obligations.

"In addition to an existing nearly US$10 trillion of outstanding Treasury Debt, the US has a near-unfathomable US$66 trillion of future liabilities," he said.

He highlighted currency depreciation as a potential risk.

"One rather clever way for the US to pay its bills to foreign creditors is to pay them in depreciated dollars," he wrote.

"The Chinese and other offshore holders wind up getting not only .05% interest on their Treasury Bills, but 12 months later - voila! - their Bills are worth only 85 cents on the dollar in global purchasing power."

China, the largest foreign holder of US bonds with US$1.16 trillion worth of Treasuries as of May, called for international supervision of the issuance of US dollars and a new global reserve currency after the downgrade.

"China, the largest creditor of the world's sole superpower, has every right now to demand the United States address its structural debt problems and ensure the safety of China's dollar assets," China's official Xinhua news agency said.

But Warren Hogan, chief economist at ANZ, attacked ratings agency credibility, pointing to their role in the global financial crisis and said the US downgrade shouldn't be a surprise.

"They're a lagging indicator, they don't tell us anything the market has not already factored in," he said.

"Sure the US financial situation is quite severe but it's not acute. They do still hold the reserve benchmark monetary standard and the US dollar."

"We see the situation as a little less dire than some were predicting. I think the US economy can recover and can grow and of course the best way to get their financial house in order is through a strong economy."

* For more on the bond market see the upcoming August 15 print edition of Financial Standard.

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