Economic Insight-Ukraine\'s near term future through the prism of the US credit rating outlook cut

Yesterday, S&P cut its outlook on the US triple-A credit rating to negative. The key rational for the move is to force US authorities to deal with fiscal consolidation. Indeed, there is a political deadlock in the US now over this issue, but it is likely to be resolved. The key outcome of this is tighter fiscal policy in the US going forward. This leaves US authorities with monetary policy that should extend its loose stance for a while, but not necessarily launching QE3. While many EM and Euro-zone countries tighten their monetary policy, thus creating pressure on their currencies to rise, which in turn is opportunistic for the US, which needs a weak US dollar to bolster its global competitiveness and economic growth. For the UAH FX rate, Ukraine will have to join the EM FX currencies club, as it is pressured upward by the USD. Ukraine\'s economy will not be harmed by a stronger currency, in our view, as the UAH has been undervalued for a long time.

The Monday packed with negative news

Yesterday, the global financial markets were shaken by a series of bold news: it began with Finland politics to Greek debt restructuring talks and then, before the US market opened, the S&P cut from \"stable\" to \"negative\" its outlook on the \'AAA\' credit rating of the US. These news items spread shivers across asset classes, causing risky assets to retreat and some safe-haven assets such as gold and silver to surge to new highs. The FX markets zigzagged yesterday as EM currencies, whose value is determined by the markets, dropped substantially, reversing recent gains against the US dollar. The Euro swung as it was being sold on the European news that cast negative sentiment on the Euro-zone to implement a sensible solution on debt issues due to the True Finns\' party gaining a louder voice in the legislature of Finland. Moreover, the Greek news of likely debt restructuring talks also pressured the Euro to slide against the US dollar. The Euro soared briefly in the intraday trading on the back of the S&P\'s negative outlook on the US as demand for safety assets caused increased buying of German government bonds. Indeed, the market behavior on Monday sharply marked investor sentiment switching to risk aversion.

The main news was the S&P decision to cut its outlook on US sovereign debt from \"stable\" to \"negative\". While such a view was widely discussed among the economists long before yesterday, the move by the S&P, probably the most respected of the three major ratings agencies, shocked the markets, as the standard bearer of highest credit rating - US debt - could lose its status.While the FT pointed out yesterday that S&P has rated the US its top triple-A rating since 1941 and has never put the US under a negative outlook since the concept of outlook was implemented by the agency in 1991, yesterday\'s move was indeed unprecedented and historical.

What does it mean to the global economy and markets?

The agency attributed the move to the current political gridlock in the US over fiscal policy, which has been expansionary in recent years to sustain economic demand. There are two key issues of concern. Firstly, the authorities need a credible plan to decrease the fiscal deficit, which has risen to 11% of GDP in 2009 from 2% and 5% of GDP in 2003-08. Secondly, there is a need to stabilize the steadily rising debt-to-GDP ratio. The S&P laid down assumptions (baseline, optimistic and pessimistic), to which the relative debt ratio will rise towards 84%, 80% and 90% of GDP, respectively, till 2013, depending on the pace of economic growth during this period and size of fiscal deficit incurred. Indeed, the situation reflects the rift between the Democratic presidential administration and Republican-led Congress. While both parties agree on the goal of the policy, which is to reduce the budget deficit to a sustainable level, they differ in solutions to the fiscal issue. The former view the solution to be higher taxes on the wealthy, while the latter prefer tax cuts to survive this period of fiscal consolidation. The S&P said in its report on the outlook cut that it views as unclear the prospects of finding a credible fiscal consolidation policy that would length into the future, avoiding amendments to the policy by the new people that would come to power on the back of elections. It underlined that the current political situation will not allow a solution to develop. The agency pointed out that US external debt is the largest among the DM economies, amounting to nearly 300% of expected current account receipts in 2011.

In terms of policymaking, it is clear that US authorities are pressured to start fiscal tightening alongside other DM economies like the UK and leading Euro-zone economies like Germany and France, which, after the fiscal deficits incurred by the 2008 recession, prudently tuned their fiscal policies to reducing those deficits. In the US, such a policy is not yet been implemented by politicians. Since the US economy and its politicians have shown a decent degree of flexibility during these times, we believe a bipartisan solution on deficit reduction policy will eventually be implemented.

Hence, going forward the US economy will be contractionary. The Fed will nevertheless pay top priority to employment, economic activity, and then price stability. Unlike the Euro-zone, inflation in the US, in its headline and core measures, has been inside what the Fed perceives as its zone of comfort. Hence, to support the economy, the authorities will be left again to extend their reliance on monetary policy. The QE2 program by the Fed is widely expected to be stopped on schedule this June. However, a rate hike may not be an option for the Fed until well into 4Q11 as fiscal issue looms large and economic growth is vital to fix it. And particular monetary conditions in the US should not alter into a tightening mode any time soon in 2Q11 and 3Q11, when fiscal policy may prepare to tighten. The Fed will judge the future key rate level from the flow of statistics on economic activity. If fiscal policy contraction may appear harmful to the economy from the early phases of its realization, then the Fed may launch another QE program (the third one), buying long-term assets from the market for another 6-month period. But under any scenario, the Fed (whether it launches QE3 or not while keeping its Fed funds rate at 0.25%) will be much more wary of prices this time as inflation elsewhere in DM and EM economies has become a dominant issue.

For the global economy, it would mean more of the same as seen in the past six months, when loose monetary conditions in the US pressured commodities and EM FX rates to rise. In this environment, when a lot of economies are tightening monetary conditions due to inflationary pressures while the US (due to fiscal policy) decides to leave its loose monetary policy intact for the time being, we anticipate further appreciation of EM FX against the weakening US dollar. Then, the weaker dollar will help fuel economic growth in the US on the back of greater external demand as the global economy recovers from the current phase of tighter monetary conditions in the EM economies.

What does it mean to the Ukraine?

For Ukraine, yesterday\'s news naturally increases local financial market nervousness about high risk that may intensify (first of all, in the stock market) if global markets extend sell-offs. But, in our view, the global market reaction should be short-lived after the S&P cut news, and market sentiment should return to fundamentals. Ukraine\'s FX market may mirror yesterday\'s trends in other EM FX markets, but the central bank\'s ability to manage the rate within its desired band is still firm. Hence, we do not see current FX risk to the UAH. In the long run, instead, if US policymaking proceeds as planned, the UAH should join the club of EM FX currencies that are under pressure to rise against the weak US dollar.