The downgrade has both financial and political ramifications.  It is sure to increase the country’s cost of borrowing and may even boost the out-of-favor Conservative Party to victory in the next election, which may come as early as next year.

Even though the agency reaffirmed its ‘AAA’ long-term and ‘A-1+’ short-term credit ratings for the United Kingdom, the downgrade may be cause for alarm among its debt holders and citizens.

“We have revised the outlook on the U.K. to negative due to our view that, even assuming additional fiscal tightening, the net general government debt burden could approach 100% of GDP and remain near that level in the medium term,” Standard & Poor’s credit analyst David Beers said in a statement, according to Reuters.

S&P questions the government’s stance regarding “how quickly the erosion in the government’s revenue base may be repaired, the extent to which the growth in government spending can be curtailed, and consequently the pace at which historically high fiscal deficits are likely to narrow,” Beers said in the statement.

Just minutes before S&P announced the ratings cut, the government released figures that revealed the budget deficit hit $13.4 billion (8.5 billion pounds) in April, the most for that month since records began.

Government bond futures, British share prices and the pound fell sharply after the S&P announcement.

Britain’s finance minister Alistair Darling said the economic future is still not clear and S&P could reverse itself if the United Kingdom is able to make significant progress towards reducing its budget deficit to its stated goal of $276 billion (175 billion pounds) this year.

The government has launched a program of quantitative easing to buy a record $340 billion (220 billion pounds) in government bonds, which has ballooned the deficit.  Some analysts have criticized the program and characterized government projections that deficits would shrink in the future and spark economic growth as unrealistic.

But the government is holding to its view.

“There are significant uncertainties in the global economy at the present time and S&P point out that the outlook could be revised back to stable ‘if fiscal outturns are more benign than (they) currently anticipate’,” a Treasury spokesman said, according to Reuters.

“The Budget set out a clear plan to halve the deficit in five years. That judgment was based on a deliberately cautious view of the public finances,” the Treasury added.

S&P said Britain’s high debt ratings were supported by its wealthy, diversified economy, fiscal and monetary policy flexibility, and relatively flexible product and labor markets, Reuters reported.

But in an ominous warning, S&P said that it would consider lowering the U.K.’s top-tier AAA debt rating if the next Government does not take radical measures to reduce the scale of public debt, according to the Daily Telegraph.

“The rating could be lowered if we conclude that, following the election, the next Government’s fiscal consolidation plans are unlikely to put the U.K. debt burden on a secure downward trajectory,” Beers said.

The specter of a divisive election – now likely in 2010 – is raising political uncertainty about how government policy may affect fiscal matters in the future.
Analysts were unsure if fallout from the economic crisis could convince voters to change parties in order to deal with the deteriorating debt situation.  But S&P’s downgrade is sure to bear on the minds of the victorious party.

“Whoever wins the next election, tax hikes and sharp spending cuts will be the order of the day – but today’s announcement by S&P puts that much more pressure on the next government to act quickly,” Colin Ellis of Daiwa Securities Group Inc. told Reuters.

Source: S&P Lowers U.K. Credit Outlook Putting Election in Flux

Many dubious excuses are given – protecting American exports, saving jobs, preventing deflation, for instance – but there is no question that Capitol Hill is actively engineering the dollar’s demise: 18 rate cuts since 2001, three tax cuts, massive deficits, and record money creation bear cold witness to its manipulations.

You don’t spend your way to prosperity; no nation ever has or ever will. But guess what? That very idea is the basis of U.S. and Fed monetary policy. Never in U.S. history have the imbalances in the economy been so pronounced, or so dangerous. “My experience as an emerging markets analyst in the 1990s taught me to be on the lookout for signs of financial vulnerability,” observed analyst Hernando Cortina in a Morgan Stanley research note. [The signs] include ballooning current-account and fiscal deficits, overvalued currencies, dependence on foreign portfolio flows, optimistic stock market valuations coupled with murky earnings, questionable corporate governance, and acrimonious political landscapes. Any one of these signals in an emerging market usually raises a red flag, and a market that combines all of them is almost surely best avoided or at least underweighted. I didn’t imagine back then that one day these indicators would all be flashing red for the world’s biggest and most important market – the U.S. A by-the-numbers analysis of America’s macro accounts in a global context doesn’t paint a flattering picture.”

Yet for growth-starved financial markets, perceptions and hope are often more important than economic reality. According to the macro indicators that the International Monetary Fund (IMF) uses to assess emerging-market economies, the United States fell between Turkey and Brazil.

Hernando Cortina politely concluded: “Investors contemplating the purchase of U.S. dollar-denominated assets would be wise to factor in significant dollar depreciation over the next few years.”

“Households have been on a borrowing spree,” added Northern Trust economist Asha Bangalore. Household borrowing as a percentage of disposable personal income hit a new high of 12.4 percent in the second quarter of 2003. This measure of household borrowing reflects mortgage borrowing, credit card borrowing, borrowing from banks, and the like.

Household borrowing is not only at a record high but a new aspect has emerged – household borrowing advanced during the recession unlike in every other postwar recession when households reduced borrowing. The good news is that consumer demand continues to advance with the support from borrowing.

The bad news is that no economy has ever borrowed its way to prosperity. Despite the conspiracy against it, the dollar has avoided a downright free fall. That’s because dollar investors across the globe are still convinced that, given favorable credit conditions, the U.S. economy will surely reenter the heyday of the late 1990s, taking dollar – denominated assets to new heights. But someday soon, we think, investors will be disabused of their illusions. Sure, the stock market rallied briskly in the recent past, but the U.S. economy continues to struggle. Unemployment persists. And the twin deficits loom larger and larger. If and when America’s creditors – domestic and foreign – decide the country’s massive, record-breaking level of debt is reason enough to get out of their dollar investments, the dollar will have nowhere to go but down, precipitously.

We don’t know when the exact moment of truth will arrive, but we know it cannot be far off. Excessive debt is not the only ominous development in the U.S. economy. Just as foreboding is the American consumers’persistent belief that they are wealthier than they actually are. U.S. financial assets are, once again, in the grip of a large bubble. Take stocks, for instance: It may not be 1999, but investors are sure partying as if it were. If the S & P 500 – an index made up of the country’s largest companies – were to trade at its historical fair value, or at a price-earnings (P/E) ratio of 15, it would have to decline by 50 percent off its high. But bull markets don’t typically start at fair value. If a new bull market were really starting – and stocks were actually undervalued – the S & P would be trading 67 percent lower, at a P/E of 10. But it’s been so long since investors have seen P/E ratios in this range, they seem to believe stocks will never descend from their lofty heights.

The U.S. stock market is once again in the grip of a bubble. The Fed’s frantic reflation campaign, government’s tax cuts, and easy credit have worked their way into stocks, causing the market to burgeon and billow outward in a way completely dissociated from any real measure of value.

In fact, the rally in stocks has been so strong that it has rekindled investors’belief in a new bull market, full economic recovery in the United States, and a return to the glory days of the 1990s. But a funny thing has started to happen. The U.S. stock market is soaring. Normally, that means the dollar would go with it; when a country’s stock market goes up, demand for its financial assets usually goes up, too. But the dollar is being dragged down by debt – government debt, personal debt, and corporate debt. Investors want a bull market, and so they’re making one. But the dollar reflects the real state of the American economy…and it knows better.

Foreign investors are especially burned when stocks and the dollar part company. At first blush, the rallying U.S. stock market seems like a very inviting place for their capital. All denominations are welcome, but not all guests are treated equally well. For example, the S & P 500 soared 26.4 percent in 2004, in U.S. dollar terms. Yet euro – based investors in U.S. stocks would have realized only a 6 percent gain for the year.

Foreign bondholders are faring no better. Foreign central bank holdings of Treasury and agency securities total over $ 1 trillion. So, roughly speaking, every 10 percent drop in the dollar’s value impoverishes our foreign creditors by about $ 100 billion on their U.S. Treasury holdings alone! That’s real money.

How is it possible that stocks continue their winning ways, even while the dollar continues its losing ways? These two inimical trends are strange bedfellows indeed. What makes the pairing particularly bizarre is the fact that our nation relies so heavily upon the enthusiasm of foreign investors for U.S. assets. What is the Fed doing, and why? One writer has pegged the answer:

“The Federal Reserve Board is working to raise the inflation rate, while the U.S. Treasury is trying to talk down the dollar exchange rate. Not every day does the world’s hegemonic power pursue a policy of currency debasement. Still less frequently does it have the courtesy to tell its creditors what it’s doing to them.”

Indeed. The Fed and Treasury are engaged in a kind of collusion to lower the dollar’s value. And that’s a very dangerous game to play, especially for a country like the United States, which relies so heavily upon foreign capital to finance its economy. It has become fashionable in the corridors of power in Washington to advocate “market-based” exchange rates – code for “weak dollar.” A weak dollar, it is widely believed, will lead to a strong economy. Hmm.

In the olden days, of course, the Fed was supposed to pursue “monetary stability.” But in the enlightened twenty-first century, the Fed has much grander designs. It imagines itself a kind of marionette master to the world’s largest economy, making it dance whenever it wishes, simply by tugging on one little interest rate, or by tugging on the dollar. And so it tugs, and tugs, hoping to revive the economy.

The U.S. Treasury Department is also conspiring with the Fed to weaken the dollar. Hasn’t Treasury Secretary Snow touted the weak dollar as a surefire cure for the struggling U.S. manufacturing sector?

And hasn’t the dollar been tumbling? And yet, isn’t the manufacturing sector struggling just as much as it was when the price of a euro was only 83 cents, instead of $ 1.25? It’s obvious to almost every citizen who does not live in Washington, D.C., that devaluing the dollar to stimulate economic growth is a fool’s mission. A couple of years ago, 255 dollar bills purchased one ounce of gold. Today, an ounce of gold costs more than 850 dollar bills. And on the day that an ounce of gold costs 1,000 dollar bills, our manufacturers will have become so competitive that they will be exporting firecrackers to the Chinese, or so the gang on Capitol Hill believes. But in fact, we will all be poorer for embracing the idiocy of “competitive devaluations.” The problem is, once a devaluation trend begins, it is almost impossible to stop.

The solution comes from repositioning, and the best cues for when, how, and where are found in the gold market – which prospers during times of geopolitical uncertainty and traditionally rises in value when the dollar falls. The gold price has jumped 367 percent from April 2001 to January 2008, from $ 255 to $ 936. The metal’s impressive rise inspired a dramatic rally in gold shares that has vaulted the XAU Index of gold stocks to an all-time high of $197.3 on January 14, 2008.

What does the gold market know? That the Fed’s reflation campaign will succeed too well? A little bit of inflation – like a little wildfire – is a difficult thing to contain. And the gold market seems to have caught a whiff of inflationary smoke.

Or does the gold market know that Iraq will continue to serve as a breeding ground for terrorists and a habitat for anti-American terrorist acts? As the Iraq situation continues, the dollar will suffer…a lot. Or maybe the gold market knows only that U.S. financial assets are very expensive, and worries, therefore, that U.S. stocks selling for 35 times earnings and U.S. bonds yielding 4.5 percent are all too pricey for risk-averse investors to own in large quantities. A vicious cycle is hard to stop. The dollar’s descent is the most worrisome – and influential – trend in the financial markets today. And yet, as long as Cisco is “breaking out to the upside,” few investors seem to care about the dollar’s slide into the dustbin of monetary history. The dollar’ s demise is not inevitable, just highly likely.

When a currency falls, in theory anyway, interest rates usually rise. A government whose currency is falling apart tries to make assets denominated in that currency more attractive by paying higher rates of interest to potential investors. And if the government doesn’t raise rates, the market will do it by selling off bonds and driving yields up. And so, in theory, you would normally expect to see a falling U.S. dollar accompanied by rising U.S. interest rates. The difficulty from the Bush/Greenspan/Bernanke perspective is that rising long-term rates pose an enormous problem: They make it significantly more expensive for debtors – from U.S. consumers to the U.S. government – to service their obligations. And these costs are not negligible.

In fiscal year 2007, for example, the government was obliged to pay out a whopping $ 429 billion in interest expense on the public debt outstanding. At a 1 percent rise in interest rates, that would add $ 43 billion in interest expense. And to meet this added interest expense, the government would, of course, have to float even more bonds, and at the higher interest rate.

This scenario is the government’s nightmare. When the falling dollar eventually pushes interest rates up, the Treasury will have to issue more debt at higher interest rates simply to pay off its existing debt. But if the Asian economic juggernaut were to discontinue recycling its excess dollars into U.S. government bonds and Fannie Mae debt, the dollar would suffer mightily. How much longer until our luck runs out?

In some way, shape, or form foreigners lend our consumption-crazed nation $ 1 trillion every year. We Americans, in turn, use the money they send our way to buy SUVs, plasma TVs, and costly military campaigns in distant lands. However, we do not forget to repay our creditors with ever-cheaper dollars. Someday soon, foreigners must lose interest in subsidizing our consumption habit. That the dollar’s decline comes at the urging of the same nation that prints the things is an irony that is not lost on the world’s largest dollar holders. Reading the tea leaves, many Asian central banks are still exploring ways to lighten up on their U.S. dollar holdings.

“The Chinese aren’t lapping up our Treasury paper for its great investment attributes,” writes Stephanie Pomboy of MacroMavens, “but [rather] because of a mechanical need to maintain the yuan/dollar peg.”

The dollar is a currency fated to tumble. The dollar’s resistance to its debt load, fueled by the machinations of central banks and the misguided faith of dollar investors, undoubtedly qualifies as a trend whose premise is false. Sometime soon this trend will be discredited.

Regards,

Addison Wiggin
The Daily Reckoning

P.S. If you haven’t purchased your updated copy of The Demise of the Dollar you can get this must-read here:

The Demise of the Dollar (And Why It’s Even Better for Your Investments)

Now India and Japan appear poised to take up the aggressive pursuit for high returns with SWFs of their own.

India is considering a fund that would seek a higher return on $300 billion in foreign reserves that is currently tied up in U.S. Treasuries and government bonds, the Financial Times reported.

“It may be possible to argue that a part of the reserves, which may be considered in excess of usual requirements, be managed with the primary objective of earning higher returns,” Palaniappan Chidambaram, India’s finance minister, said in a written reply to Parliament.

According to Chidambaram, the Council on Trade and Industry recommended to Prime Minister Manmohan Singh in a Dec. 18 meeting that the government “create a sovereign wealth fund of $5 billion to begin with, for financing acquisition of companies abroad.”

India’s foreign exchange reserves, the third-largest holdings in Asia, stood at a record $311.89 billion as of April 4, compared with China’s record $1.68 trillion, Japan’s $987.7 billion and Russia’s $508 billion.

However, analysts say that while the formation of an Indian SWF is likely, it will be significantly smaller than other funds of the same nature. As one of the world’s leading oil importers, India has not enjoyed the large trade surpluses delivered to other developing economies on the back of a commodities boom. India also maintains sizeable account and fiscal deficits.

The richest sovereign funds include the Abu Dhabi Investment Authority, or AIDA ($875 billion), the Government of Singapore Investment Corp. ($330 billion), and Norway’s Government Pension Fund Global, or GPFG ($322 billion), although several others may be larger.

Meanwhile, Japan may establish a sovereign wealth fund to boost returns on some of its state assets as early as 2009, according to UBS Securities Japan Ltd.

“As cases of inefficient use of the road-specific budget have been disclosed in Diet discussions, the argument that public funds should not be managed by bureaucrats has become convincing,” Takashi Omori, chief Japan economist at UBS AG (UBS) in Tokyo, told Bloomberg News.

A relatively small state fund of between $98 billion (10 trillion yen) and $196 billion (20 trillion yen) may be created, he said.

Sovereign wealth funds currently control an estimated $3 trillion. That’s already believed to be more than the $1.5 trillion to $2 trillion held by worldwide hedge funds [though some sources put the hedge-fund estimate as high as $5 trillion].