A $2 Trillion Mistake

According to a release on the US Treasury website, the analysis done by S&P on the US credit rating contained a material error where the agency had inflated US deficits by $2 trillion due to a simple arithmetic mistake.

The Treasury stated that the S&P had originally downgraded the US on the primary basis that debt/GDP was projected to increase rapidly. However, in their corrected estimates, S&P's estimate of debt/GDP was significantly lowered, meaning their primary rationale for the downgrade contained flaws. While S&P acknowledged their mistake to the Treasury on Friday and publicly on Saturday, they simply removed a significant section of their report (part of their primary rationale) and reiterated their decision of downgrading the US without taking any time to re-evaluate their analysis. We believe this certainly raises some questions regarding the credibility and integrity of S&P and also the validity of their analysis.

For more details, visit the release on the US Treasury site.

Further Thoughts on the Downgrade

The impact of the US credit rating downgrade on the US Treasury market is likely very small as it is unlikely institutional investors will sell Treasuries given there is no other good place for them to put their money. Furthermore, credit ratings do not embody actual risk; the investors are the ones who should assess credit worthiness. What is more likely is that rationale investors will simply place lower weighting on the credit rating while maintaining their positions in Treasuries given the limited number of safe havens in today's environment.

While the impact to the US may not be significant, there are broader implications to the downgrade. First, the downgrade adds further downside to an already weak equities market and we will likely see further correction in the market as investor sentiment remains poor. Second, the downgrade has investors even more worried about the European debt crisis. The European Financial Stability Facility will not be running until at least next month and even then, it is difficult to tell whether it will be enough to save both Greece and Italy. Investors are also concerned over whether France and the UK will be able to maintain their AAA credit ratings. In light of these concerns, risky assets will remain volatile in the near term, with further sell out to safe havens expected. The recent market correction is largely driven by bearish sentiment and how quickly investors regain confidence remains uncertain. However, we think that this is also a good time to stay on top of the market and look for an opportune time to step in.

China is the largest foreign buyer of US debt and you can be sure they are watching the US debt crisis very closely as they are at risk of losing a significant chunk of their $1.2 trillion investments in US Treasuries. Dagong, China's private credit rating agency, has already downgraded the US debt credit rating to A+ over he past year, ahead of the US credit rating agencies, and warns of further downgrades.

China previously placed its foreign currency reserves in US Treasuries because it had to keep it somewhere in order to keep the renminbi low and to keep exports cheap, relying on exports and capital spending to drive the country's rapid growth. However, the country has another option to drive growth: domestic consumption. It is already quite clear this is the direction the Chinese government is heading towards; its new 12th Five Year Plan is an economic restructuring that favours domestic consumption, focusing on urbanization, creating jobs in the services industry, and massive investment in infrastructure (like high-speed rail).

The latest debt ceiling and budget deficit crisis in the US, could possibly be the last straw for the Chinese; senior officials have already been quite vocal in expressing how appalled they are at how the US have allowed politics to come first before the financial health of the country. China's concerns about the US Treasuries will surely compound the difficult problems being faced by the US.

On July 23, 2011, two high-speed trains in China collided and derailed in Wenzhou, Zhejiang province. State-run media confirmed 39 deaths, with at least 192 people hospitalized and 12 severely injured. The incident sparked nation-wide controversy when authorities hastily used heavy machinery to destroy and bury the wreckage, a move criticized by many as an attempt to destroy evidence. Authorities have since dug up the wreckage and reportedly sent it off for further investigation.

The Chinese government has already invested billions into its high-speed railway network and is expected to continue investing heavily over the next decade, with the network expected to rapidly expand from over 8,500 km at the end of 2010 to 13,000 km by 2012 and 16,000 km by 2020. The Wenzhou accident comes only after a few short weeks since the official launch of the Beijing-Shanghai high-speed line, and raises significant concerns on the safety of the country's hastily-built high-speed railway. It also raises acute awareness that the country is still laggard on many terms, despite it being on the economic fast track. Economic growth is important, but policy makers need to ensure it does not trump over public safety and other important things.

A popular comment has been circulating the Internet, summarizing the sentiments of many citizens: "When a country is corrupt to the point that a single lightening strike can cause a train crash, the passing of a truck can collapse a bridge, and drinking a few bags of milk powder can cause kidney stones, none of us are exempted. China today is a train traveling through a lightening storm. None of us are spectators; all of us are passengers."

Stock Impact

In terms of the impact to China railway-related stocks, such as CSR Corp. (the state-owned enterprise that produced the trains involved in the crash), some analysts have commented that investor sentiment will remain weak for these stocks in the short-term but they see virtually no impact in the long-term. I think the impact is not just simply temporary weak investor sentiment; there is a definite risk for new policies and regulations to be enacted and more stringent requirements for quality controls, which would lower margins and negatively impact the bottom-line. The Wenzhou incident will also hurt Chinese plans of selling high-speed trains to foreign markets and they may never fully regain the confidence they have lost as a result of this incident.