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Busch: The Debt-Interest Rate Paradox

There appears to be a race to see who can warn and downgrade the most from the ratings agencies. Yesterday, Fitch downgraded Mexico's foreign currency rating to BBB on the ability of the government to meet their fiscal obligations (reduced maneuverability of fiscal accounts) and their increasing debt to GDP. Today, they warned about Japanese banks saying that weaker loan quality may put pressure on Japan's "mega" banks' performance and in turn capitalization, which remains somewhat weak by international standards, especially in terms of the "core" capital levels.

The FT reports that S&P released a study of the world's major banks that uses the risk adjusted capital ratios (RAC) that foreshadow the new capital ratio structure expected to be set by the Basel committee on banking supervision next year. S&P's Bernard de Longevialle said: “Our study shows that capital for the majority of banks remains a relative weakness.” Moody's cautions India today that deteriorating credit conditions in their banking system have raised concerns about rising problem loans and weakening bank profitability. “The rapid expansion of retail lending in recent years, combined with the slowdown of the Indian economy, has led to increased delinquency rates, especially for unsecured retail loans,” according to Nondas Nicolaides a senior analyst at Moody’s and author of the report.

Extending this theme, China’s five largest banks submitted preliminary plans for raising capital to the industry regulator after they extended unprecedented amounts of new loans this year, according Bloomberg. The China Banking Regulatory Commission evaluated the finances of Industrial & Commercial Bank of China Ltd., China Construction Bank Corp., Bank of China Ltd., Agricultural Bank of China and Bank of Communications Ltd. last week. Lenders were told to estimate potential capital shortfalls in 2010 based on their own lending forecasts and capital ratio targets for the year, and to make plans to plug the deficits. Remember, Chinese bank loan volume exceeded their full-year targets in July.

This Chinese story caused a shift in market sentiment as Risk Off has regained preeminence for the day. Yesterday's BU discussed the fiscal problems of governments around the world struggling with spending and debt levels. The above stories show that the world still has a major problem with debt. Today's US GDP report shows growth has not yet returned to levels that can support this debt.

This is the critical issue going forward for governments. By piling every increasing amounts of debt on to the market and on to the backs of taxpayers shoulders, they are stealing future growth. This is why interest rates can paradoxically go down while debt levels go up. It is Japan and it is our future if governments continue down this path.

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Andrew B. Busch is Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.