People like the analogy.  The rise of Germany after 1890, mismanaged by Germany and its adversaries, and the rise of China today — mismanaged or well-managed?  A NYTimes article today discusses the conflicting claims over rich offshore oil resources in the South China Sea among China and its much smaller neighbors, notably Vietnam, with which China fought a war in 1979 (though that was over Cambodia).  These conflicting claims on China’s flank remain unresolved.  Tension in the South China Sea bubbles dangerously below the surface, not unlike the way Morocco and the Balkans did for decades before WWI.  The US takes no sides in these disputes, but the South China Sea constitutes a potential flashpoint for tension between the US and China, in addition to Taiwan.  Some estimates put the quantity of shipping that takes place through the strategic sea lanes in the South China Sea at around 50% of world shipping, depicted with arrows in the map shown above.

Vietnam is pursuing the negotiating strategy of the weak — internationalize the conflict.  This reminds me of Yasser Arafat’s never-ending call back in the day for an “international conference” over the Arab-Israeli conflict; whereas Israel, like the Chinese, always preferred bilateral talks.  Both China and Israel resist international conferences where smaller countries can gang up on them.  Recall the Madrid Conference on the Mideast in 1991, cobbled together by the Bush administration (with the gifted handiwork of Sec. of State  Jim Baker).  Israel was isolated and ganged up on in Madrid.  Israel ultimately preferred secret bilateral talks with the Palestinians in Oslo.

In any event, the South China Sea issue won’t go away, and one wonders if, like Wilhelmine Germany, China will succeed in alienating everyone with its bullying tactics or will seek to find a mutually beneficial solution.  It is hard to find such a win-win solution in a dispute over territory and resources.

 

Christiaan Tuntono and Dong Tao of CSFB reported today on the only health care reform taking place in the G-2 at the moment, this one in China (see article below).  In the workers’ paradise in East Asia, such welfare state fundamentals as health care, social security, and unemployment insurance are not provided extensively by the state.  This lack is one of the culprits, according to economists, behind China’s sky-high household savings rate that keeps consumption depressed and current account surpluses with the US and others (and therefore China’s fx reserves) in the stratosphere.  Chinese households themselves must save for health care, retirement or job loss.  China is implementing a pilot public hospital program, taking baby steps, designed to yield universal health care by 2020.  This reform is not stuck in some legislature.  This round of reform follows what has been viewed as a failed experiment in introducing market reforms in health care, which only pushed costs higher.  Lessons for America?  Not sure, but have a read of the CSFB report below…

China
Dong Tao
+852 2101 7469
dong.tao@credit-suisse.com
Christiaan Tuntono
+852 2101 7409
christiaan.tuntono@credit-suisse.com
The State Council passed the public hospital reform plan on 3 February, marking another important step in China’s healthcare reforms, in our view, and addressing the problem of over-saving among the public. This policy is in line with the healthcare reform plan announced by the State Council in April 2009, which aims to invest RMB850bn to provide basic medical services to the population by 2011, with the long-term goal of rolling out universal coverage by 2020. Each province will select one to two cities as the trial bases for setting up a public hospital network, according to the policy approved yesterday, while we think 16 small- to medium-sized cities are likely to be selected for the initial launch. In our view, China has reversed the direction of the medical reforms launched by former Premier Zhu Rongji in the late 1990s, which have been widely viewed as a failure. Zhu introduced market mechanisms to the healthcare system, hoping that they could improve efficiency, but that led to a surge in medical costs and a deterioration in service quality at hospitals. The new approach taken by the government now is to identify healthcare as a public non-profit oriented service, and hence the state will assume the main responsibility to provide this, while allowing the existence of private healthcare services. The government will provide subsidies to lower the cost of drugs and other medical fees. High medical costs have been one of the main reasons behind the Chinese population’s high level of precautionary savings. With the aim of promoting private consumption, Beijing is taking steps to address this concern. We believe more fiscal resources will be ploughed into this effort over the coming decade, raising the provision of social benefits.
In other news, it was reported by local journal China Business News that China Investment Corporation (CIC) may receive another $200bn capital injection from the Ministry of Finance. The CIC invested heavily in the second half of 2009, which could have used up a sizable portion of its initial capital. When the CIC was set up in 2007, the Ministry of Finance issued a RMB1.55trn special bond and injected the proceeds into the company as a capital base to purchase $200bn worth of foreign exchange reserves. Given that China now has over $2.4trn of FX reserves, and is expected to maintain a balance of payments surplus in the future, we believe the CIC will accelerate its pace of foreign investments with the aim of diversifying China’s reserve holdings into global blue-chip companies and natural resources.

Image:  Maoist public health poster.  Source: Google Images

 

“Canceling military discussions and calling in the American ambassador have been two standard Chinese measures in response to previous American arms sales to Taiwan. But the announcement of restrictions on the Chinese operations of American companies involved in the arms sales represents an unusual twist…” quoted from a NYTimes article today on the US-Taiwan arms deal.

Update on yesterday’s post on the US-Taiwan arms deal:  China’s reaction is sanctions, a response which apparently goes beyond previous diplomatic action against the U.S. regarding Taiwan.  This raises some questions: First, are the Chinese imposing Iran-style sanctions, that is, similar to sanctions the U.S. advocates to pressure the government of Iran? Is this therefore a diplomatic nose-thumbing at the United States?  Second, do they think they can push President Obama around more than the average American president?  While I am not seeking to question the president’s credibility, it is valid to ask the question — would they have imposed these sanctions on a McCain or a Hillary administration?

 

The government of China has expressed indignation over the Obama administration’s decision to sell $6.4 billion in defensive weapons to Taiwan.  Taiwan is part of China, Beijing argues, and the U.S. is meddling in a domestic dispute.  See article on the arms deal.

Obama — with no “reset” button on China — is acting in accordance with the 1979 Taiwan Relations Act, which was passed after Jimmy Carter chose the Mainland over Taiwan as the “one China” the U.S. would recognize.  The Act nonetheless provided for a defensive arming of Taiwan.  With Reagan in power in the 1980s, the opening to China was not reversed, but the U.S. government “assured” Taiwan it would not recognize Beijing’s sovereignty over Taiwan without negotiations, even though the U.S. position remained that there was only one China.  When I was a US foreign service officer in the 1990s, I remember one of my colleagues having to “resign” temporarily from the foreign service in order to represent the US in its non-embassy in Taipei (called the “American Institute in Taiwan”).  More diplomatic gymnastics than Nadia Comaneci.

The Obama administration, like previous American administrations, heard back from Beijing that this arms transfer would harm US-Chinese relations.  The Chinese weren’t even impressed that President Obama decided not to sell F-16s to Taiwan.  Perhaps these could be construed as offensive weapons.  As crazy John Mearsheimer’s crazy Offensive Realism theory would have it, you can’t trust anyone out there because all weapons, even defensive ones, can be used offensively.  Mearsheimer should be feted in Beijing for this reason,  just as he is in Beirut and Ramallah.  Well, F-16s can be deployed as offensive weapons, John, but the weapons going to Taiwan – helicopters, Patriot missiles, minehunters and communications equipment — are not exactly the basis of a blitzkrieg.  One wonders if a President McCain would have sold Taiwan the F-16s.

The deal seems sizable, though I am no defense analyst, but only a modest economist/political analyst.  Still, Taiwan is not among the largest purchasers of US weaponry.  On an annual basis, the top ten acquirers of US arms in 2008 in descending order were:  Israel (just as you suspected, John), Saudi Arabia, South Korea, Egypt, Poland, Canada, Iraq, Turkey, Jordan and Pakistan, according to data compiled by the Federation of American Scientists.    (Add up all the arms purchased by states Israel has shaky or no diplomatic relations with, John and Steve, and you may understand why the US supplies such a level of arms to Israel — but after all, this post is about Taiwan!)

According to data compiled by the Stockholm International Peace Research Institute (SIPRI), a purveyor of lots of defense-related data, the top ten arms exporters in 2007 in descending order were: the U.S., Russia, Germany, France, the Ukraine, the Netherlands, the UK, South Korea, Italy, and Sweden (found on Wikipedia).  SIPRI also lists the top 10 defense budgets in 2008, spent predominantly on domestic forces: the US, China, France, the UK, Russia, Germany, Japan, Italy, Saudia Arabia, and India.  Here, the US dwarfs everyone, spending over 7 times as much as the number two largest defense spender, China, and over $80 billion more than the 9 next largest spenders combined.  Does this mean Taiwan is safe?  For now perhaps.

China is the 800-pound gorilla, so one understands why most nations see the gorilla as the one and only China.  However, with such a fuss made by Wilsonian defenders of the self-determination of peoples – witness support for Kosovar, Palestinian, Georgian, and other minority rights — why has the world given the shaft to 23 million Taiwanese?  They clearly do not want to become part of the one-party state that governs 1.3 billion people across the straits.  I am no Barry Goldwater, but we should ask this question nonetheless.  Henry Kissinger didn’t, but we should.

Israel has a comparative advantage in medical care and specifically in treating trauma victims, which comes not only from its advanced human capital, especially in technology and health care, but also from vast experience treating victims of terror and war.  Read the NYTimes article  published yesterday on the subject.  Israel has been treating Haiti’s earthquake victims in its mobile tent hospitals set up in the last week in the impoverished Caribbean nation. 

The Times article discusses the ambivalence Israelis are experiencing, concerned about how they treat Palestinians in Gaza, while offering help to Haitians.  There is a difference.  Rockets have rained down on Israeli towns from Gaza for years, where Hamas was elected to office not long ago and where IDF Staff Sgt. Gilad Shalit, 23 years old, has been held hostage for over 3 1/2 years.  Read the hate for Israel contained in the Hamas Covenant to understand the difference between helping Haitian earthquake victims and maintaining a blockade of the Gaza Strip.  This document has been translated and published at the Yale Law School’s Avalon project, where you can go as well for a fairly full documentary history of the Middle East conflict (1916-2010).

…even under Barack Obama.  Nice piece in the FT on European angst about American power, and the continent’s inability as yet to offer a unified foreign policy with punch.  Ideally, EU foreign and defense policies could serve as a counterweight to the G-2, read: China and the U.S.  The latest flare-up of this angst involved a French official complaining about U.S. heavy-handedness in managing relief in Haiti.  Alleged American heavy-handedness – and not from W, but from Barack Obama.  Have a read…

One of the problems the Europeans have had since the end of WWII is their happy laziness with being a “free rider” under the American security umbrella.  No one in Europe wants to increase defense spending so that they would actually be taken seriously as an alternative force in the world.  After tens of millions dead in the first half the 20th century at the hands of European geopolitics, is it simply that they still do not trust themselves?  Probably not.  More likely that it is easy and cheap to remain a free rider.

The New York Times published an editorial yesterday analyzing the Republican win in Massachusetts this week and offering advice to President Obama. 

I’m not sure why the “gray lady” of American journalism is joining the chorus in this country calling for populist policies as a result of the Massachusetts election — sticking it to the banks now that they’re recovering, bailing out people in foreclosed homes, increasing the fiscal stimulus to fight joblessness.  Maybe the New York Times is feeling the pinch from the blogosphere, and especially from such liberal upstarts as the Huffington Post.  Consequently, the editorial board feels a need to draft highly partisan and unsound editorials — to get more people to read the Times web page.

The Editorial asserts that the Mass. election was not a referendum on Obama or health care, but a clamoring from ordinary Americans for policies that will help them keep their jobs and homes.  One way to interpret it. 

Another way is that American voters understand better than most politicians and editorial boards that an America that sticks to its knitting — by following policies that maintain a strong economy, sound public finances, and a healthy banking system — will be an America that remains in control of its destiny.  Most Americans have to balance expenses against income at the proverbial kitchentable; so, perhaps these Americans understand the importance of fiscal rectitude, at least ever since the value of their homes collapsed over a year ago.  An America in which the government continues to bail everyone out — by expanding health care entitlement and foreclosure relief — will be an America that will lose control of its destiny.  Eventually, the financial markets would punish American assets, with the USA possibly losing its AAA credit rating.  Then, the capacity of the American government to spend on things that matter in the future would be compromised, and with it, America’s standing in the world, and with that, the liberal international institutions and world order America crafted so well at the end of WWII.  That is what is at stake. 

It’s hard to get inside the heads of two million plus Massachusetts voters, but perhaps at some level they understood this.  Health care reform that expands the government’s liabilities is unsound right now, however fair it is in the long run.  Doing health care reform today is like refurnishing the interior of your home when you’re running out of money.  The old sofa is tattered, yet functional.  When you are in better times, that is the time to replace the old sofa.  Bailing out banks was the right thing to do, however unfair that was, because it avoided a collapse of the financial system.  That’s like repairing the leaky roof on your house.  There were no lines of people down the street in front of closed banks waiting to withdraw their deposits the way there were in the Great Depression.  Bailing out homeowners and the unemployed, however fair, is not fiscally prudent right now.  Independent voters in Massachusetts perhaps understood this better than Harry Reid, Speaker Pelosi, the arrogant people advising the president, and the president himself.  And…the Times Editorial board.  Robert Gibbs, the president’s press secretary, actually had the hubris to suggest, hours before the Democratic defeat in Massachusetts, that perhaps Americans didn’t understand the benefits of the health care reform on Capitol Hill.  In short, the White House believes that Americans do not know what is best for them. 

The Times board argued that health care reform is essential to an improving economy.  In medicine, a patient may have several ailments — but better to cure the cancer killing him and treat the mild cold later on, no?  America’s ailment right now is its skyrocketing government debt, to reach 90% of GDP this year.  Fixing health care can wait.  It won’t improve the economy now.  Righting our fiscal ship will.

The Times editors joined the chorus of demagogues with scurrilous attacks on Obama’s economic team, read: Timothy Geithner.  The Obama economic team is ”entwined with the people and policies that nearly destroyed the economy.”  Geithner-Bernanke-Paulson-Summers quite simply saved the planet.  Sure, during the go-go period earlier this decade, could our regulators and central bankers have been more prudent?  Yes.  Excessively low interest rates for too long were the main cause of the real estate bubble; if you want to blame one person more than others — and you shouldn’t — blame Sir Alan Greenspan…and perhaps Ayn Rand.  Sure, Bernanke and Geithner were there too and should share some of the blame.  But that doesn’t mean firing them.  It sounds to me a bit like the French Revolution, when everyone eventually got the guillotine, even Danton.  The Gray Lady has turned Jacobin in her desperate lurch to retain readers.

The Times editors likewise suggest that Obama should understand the Scott Brown phenomenon well — a handsome, inexperienced guy comes out of nowhere to obtain high office.  I agree.  But they go on to attribute Obama’s election in 2008 to his vision.  I’m not convinced.  Obama got elected by incessantly denigrating George W. Bush (so it is a wonder to me that the former president was willing to show up at the White House this week to help Obama on Haiti) and by incessantly calling for a full withdrawal from Iraq and an end to the “surge.”  Then, the financial collapse in the fall of 2008 sealed the deal for a Democratic victory (”throw the rascals out”).  Once in office, Obama’s “vision” was to extend Bush’s rescue of the banks and his fiscal stimulus and to apply the Iraqi surge to Afghanistan.  Yes, you can call this vision, but it was W’s vision, not Barack’s.

So, the Times editors, in offering advice to the president, have joined the chorus of irresponsible populists, who seem set to dominate the discourse through the November 2010 midterm elections.  My advice to the president — work diligently at restoring America’s fiscal health, the critical foundation of American power, however unpopular — damn the torpedoes.  And, you may be surprised that this could get you re-elected.

Good friends (Uribe and Obama) vs. Best friends (Uribe and Bush)… Sources:  zimbio.com, AP.

I have long argued that the Democrats have gotten it wrong on Colombia, by parroting the misinformation about this country and its President, Alvaro Uribe, circulated by US labor unions intent on stopping a free trade agreement between two staunch allies.  This is one of those examples political scientists tout of a well-financed interest group successfully killing a policy that would be to the benefit of a broad majority of Americans. 

Alvaro Uribe has warts, true, not least of which include his striking similarity to New York City mayors, such as Bloomberg and Giuliani.  All three have sought to avoid term limits to the chagrin of some and the delight of others.  But, Uribe, like these New York City mayors, has improved the quality of life of his citizens and should be commended and supported for this, no matter what your position is on term limits.  He should in no way be vilified, as uninformed liberals in America have been prone to do.  The latter included candidate Obama in a presidential debate, who merely parrotted the misinformation that appears on the AFL-CIO web site. 

I apologize for what may seem like hyperbolic language, but it is one of those issues in which so many have just gotten it wrong.  It is important to have some straight talk on the matter and to staunch the circulation of lies.  Ask someone you know from Latin America about Alvaro Uribe.  I wrote about this issue a while back in a post.  Have a read…

Today, I want to draw your attention to a fair appraisal of Uribe and Colombia that appeared in the pages of Economist in early January.  First, is the leader, followed by a fuller article.  Enjoy reading and learning…

Even sound actions can have negative consequences.  That is why in times of crisis, policy makers must remain vigilant.  Easing monetary and credit policies last year and keeping them loose made sense.  In an effort to avoid the mistakes of the Great Depression, when governments tightened both monetary and fiscal policies, policy makers this time around gave the wounded private sector what it needed to avert a panic.  But these sound policies now have negative consequences.  The Economist reports in a nice leader this week that financial asset prices the world over have risen too much and do not reflect the reality of economic prospects.  This is called a bubble and we’ve seen them time and time again – the last one being the housing bubble that ended last year, fueled by financial derivatives that bundled risk, too complex to understand.  

Derivatives weren’t born yesterday, however.  During the Golden Age of Holland, when that scrappy nation was a world power and trading juggernaut, there was the infamous tulip bubble of the 1630s (see image above), which was also fueled by derivatives.  Yes, tulips.  Colorful flowers introduced into northern Europe from Ottoman Turkey.  Tulips were what every up-and-comer had to have to prove his/her social status, much like a Manhattan pied-a-terre or a Florida beach house today.  The tulips bloomed in season, but you could buy a futures contract any time of year for delivery of tulips in the future.  This fueled a speculative run-up in tulip prices, which when the bubble burst, left some investors ruined.  After all, they’re only flowers…

Another bubble — this time in stocks and bonds — could burst this year, as the reality of the “new normal” of slow growth (with a side of inflation) sinks in.  Unfortunately, this time around governments are in such a fiscal mess, they will not be able to bail out the private sector.  This could mean a “double dip” Great Recession.   Policy makers should plan for this today — developing medium-term fiscal consolidation plans to bolster credibility, keeping the lid on current spending, scrapping health care “reform,” and perhaps beginning to nudge interest rates higher later this year.  The latter has to be done carefully so as not to spark the very double dip we are trying to avoid.  I never said it would easy.

Image above: Holland’s Tulip Bubble of the 1630s: when derivatives wreaked havoc! Source: heatusa.com

Planet Earth’s critical issue this decade will be whether American power will erode — and if so, what the implications will be for the liberal world order we erected after WWII.  The Obama administration’s fiscal stimulus package cum bank bailout, building on the Paulson-Bush-Geithner-Bernanke efforts of 2008 and the unprecedented coordination of economic policy globally, constituted a brilliant, stage-managed rescue of our planet, nothing less.  However, such a Herculean effort has created its own problems — huge debts, gaping goverment deficits, and a government intrusion in the economy that will be hard to reverse.  As yet, no plans to solve these problems have been offered.

Students of power and prosperity from Paul Kennedy on down know that imperial overextension accelerates the decline of great powers.  From this dynamic, the US is not immune.  While the relative decline of the US has been in place since the 1950s, its rapidity and consequences are far from inevitable.  A too precipitous, disorderly, angry decline that would occur if America does not right its fiscal ship soon would not only injure American prosperity, but would also put at risk our global institutions — the UN, the IMF and World Bank, NATO, the WTO, the G-20, etc.  These institutions have fostered cooperation and peaceful solutions to the world’s problems. 

The symbolic end to this Pax Americana, which has raised billions out of poverty and offered countless millions broader political participation, could be the loss of the AAA rating on US government bonds.  According to Brian Coulton, head of Global Economics at Fitch Ratings, this could occur later this decade if an aggressive fiscal consolidation program is not implemented by the Obama administration (see note below).  A narrow tax base, low discretionary spending (the kind of spending that is easiest to cut) and huge entitlements — including the $900 billion health “reform” up on Capitol Hill, the continued current account deficits in spite of sluggish GDP growth, and our dependence on foreigners for financing together spell a potentially rapid decline of America’s place in the world. 

So, who will fix this?  President Obama has chosen the nerd pictured above.  He is reportedly a bright, driven man.  I am not sure how hard it is to preside over the most massive expansion of entitlement spending in history and to oversee the distribution of hundreds of billions of dollars of stimulus spending to groveling constituencies.  But that was just his first year.  The president’s chief of staff Rahm Emanuel was reported in the New York Times to have said that Office of Management and Budget Director Orszag has “made nerdy sexy,” perhaps with some jealousy.  The Times article this Sunday highlighted Orszag’s loose love life and questions about his commitment to his families.  I am all for keeping a public servant’s private life out of politics in principle, but one wonders how so extravagant a player can be entrusted with the most difficult fiscal consolidation in human history.  I don’t think rating agencies take into account the social life of a sovereign’s budget director in making their rating decisions, but one wonders sometimes if they should.    This seems to be part of the hubris we have seen sometimes in this White House.  I hope he knows what he’s doing, because the stakes couldn’t be higher.

Fitch Affirms United States at ‘AAA’; Outlook Stable   

11 Jan 2010 8:31 AM (EST)

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Fitch Ratings-London/New York-11 January 2010: Fitch Ratings has today affirmed the United States’ (US) Long-term foreign and local currency Issuer Default Ratings (IDRs) at ‘AAA’, respectively. The rating Outlook on the Long-term ratings is Stable. Fitch has simultaneously affirmed the US’ Country Ceiling at ‘AAA’ and the Short-term foreign currency rating at ‘F1+’.

“The near-term risk to the United States’ ‘AAA’ status is minimal given its exceptional financing and economic flexibility and the US dollar’s role as the world’s predominant reserve currency. However, difficult decisions will have to be made regarding spending and tax to underpin market confidence in the long-run sustainability of public finances and the commitment to low inflation,” said Brian Coulton, Head of Global Economics and the Primary Analyst for the US at Fitch.

“In the absence of measures to reduce the budget deficit over the next three-to-five years, government indebtedness will approach levels by the latter half of the decade that will bring pressure to bear on the US’ ‘AAA’ status,” added Coulton.

The US government remains exceptionally creditworthy - supported by its pivotal role in the global financial system and a flexible, diversified and wealthy economy that provides its revenue base - despite an unprecedented deterioration in fiscal performance. The government’s unparalleled financing flexibility enhances debt tolerance even relative to other large ‘AAA’-rated sovereigns, and has allowed the government to take aggressive counter-crisis and counter-cyclical policy measures, which now appear to be working in terms of restoring stability to the US financial sector and the economy.

However, the government faces significant medium term fiscal challenges with a sizeable structural deficit, a narrow tax base, limited expenditure flexibility and exposure to potential interest rate shocks due to the short duration and maturity of US government debt and a heavy reliance on foreign investors. Public debt on a general government (i.e. consolidated federal, state and local) basis is expected to rise to 89% of GDP in 2010 and 94% in 2011 from 79% of GDP in 2009, which would mark the highest level among ‘AAA’-rated sovereigns. Public debt was just 57% at end 2007.

The general government deficit - estimated by Fitch at 11.4% of GDP in 2009 and forecast at 11% in 2010 and 8.5% in 2011 - contains, in Fitch’s opinion, a sizeable structural component that will not be eliminated by the economic recovery and the unwinding of stimulus measures. Corporate taxes, in particular, collapsed in 2009 having been boosted by artificially strong financial sector profits and asset price gains in the years before the recession began and are unlikely to show a strong recovery. Fitch anticipates the economic recovery will be weak by the standards of previous recoveries and less dynamic than assumed in the latest official medium term fiscal forecasts. Deleveraging will continue to weigh on private sector demand, while rising long-term unemployment and the fall in investment through the recession could adversely affect supply side performance. In addition, while TARP related fiscal outlays have been lower than anticipated, fiscal risks relating to the financial sector remain, particularly with regard to Fannie Mae (’AAA’/'F1+’/Outlook Stable) and Freddie Mac (’AAA’/'F1+’/Outlook Stable).

Public debt levels compare particularly poorly with ‘AAA’-rated peers when expressed relative to fiscal revenue. General government debt was equivalent to 330% of revenues at end 2009 (even higher at 437% on a narrower central government basis), the highest among ‘AAA’-rated sovereigns and compared to a long-run ‘AAA’ average of 118%. Amongst high grade sovereigns, only Japan (’AA’/'F1+’/Outlook Stable) and Ireland (’AA-’/'F1+’/Outlook Stable) have higher debt-to-revenue ratios. Debt interest payments are expected to rise to nearly 11% of revenue by 2011 and nearly 13% on a central government basis. Fiscal flexibility is also reduced by the limited scope for sizeable structural reductions in public expenditure, given low discretionary outlays and pressures on entitlement spending.

Both the dollar’s role as the predominant global reserve currency and the benchmark status of US Treasuries significantly reduce the scope for destabilising interest rate shocks. But the economy’s high external debt burden, the ongoing current account deficit and the high share of non-resident holdings of government debt (close to 50%) increase the potential for volatility in US asset prices if foreign investors were to become concerned about public debt sustainability or risks to the credibility of the monetary policy framework. With the average maturity of federal debt having shortened sharply over 2008 and 2009, rising interest rates would feed through to the budget relatively quickly.

Applicable criteria available on Fitch’s website at www.fitchratings.com: ‘Sovereign Rating Methodology’, dated October 16, 2009.

Contact: Brian Coulton, London, Tel: +44 (0) 20 7682 7497; David Riley, + 44 (0) 20 7417 6338; Shelly Shetty, New York + 1 212 980 0234.