Central Banks and Sovereigns Most Affected by the US Downgrade

Central Banks and Sovereign investors are the most affected by the downgrade of the US to AA+ by S&P. This is because that group of investors tends to be restricted to highly-rated Government guaranteed sovereign bonds. If there is going to be a material impact on the holdings of US Treasury securities following the downgrade then this group of investors will decide. Sovereign investors tend to require a AAA-rating or, more commonly, a AA+ average rating for their portfolios as a whole.

There is some USD 5T worth of foreign reserves held by Central Bank’s and Sovereign Wealth Fund’s in Asia and the Middle East. I estimate that 75% of this is invested in government bonds and the majority is in US Treasuries. Will these countries be forced to sell? Probably not judging by their collective reaction to the downgrade of Japanese debt a decade ago when JGB’s were exempted from AAA guideline restrictions governing reserves management. But, future purchases may be limited and future downgrades will trigger selling…

It is not surprising therefore to read the stinging attack on the US by China, which has upwards of 50% of their USD 2.5T reserves in US Treasuries. The one-notch downgrade has a significant effect on their portfolio’s average credit rating. While some commentators view the attack as a political one, the truth is far from it – further downgrades will cause the average rating to fall below AA+ and force China’s hand to start selling US Treasuries.

DaGong, the Chinese rating agency, already rates the US at single-A. If S&P follows this path, which they will in the absence of any US budget surplus, then Sovereign investors will start selling.