The United States has lost it top AAA credit rating fo the first time On August 5 in a move that could severely undermine the recovery of the world’s largest economy and prompt further calamitous falls on world stock markets in the following week.

Emerging markets stocks and currencies plummeted on August 8， after the downgrade of the US’s credit rating. At the same day， SP downgraded the credit ratings of Fannie Mae and Freddie Mac and other agencies linked to long-term U.S. debt.

The agency also lowered the ratings for: farm lenders; long-term U.S. government-backed debt issued by 32 banks and credit unions; and three major clearinghouses， which are used to execute trades of stocks， bonds and options.

All the downgrades were from the top rating of AAA to AA+， reflecting the same downgrade SP made of long-term U.S. government debt.

Obviously， the downgrade can intensify concerns about the risks that remain for US fiscal policy and the economy as a whole.

Downgrade impacts

Financial markets operate on the assumption that US sovereign debt is“risk-free”. It is understandable that stock markets plunged when Standard Poor’s said that it was putting US debt on to negative outlook.

On August 8， the Dow Jones industrial average fell more than 300 points， or 5.5 percent. The SP 500 stock index tumbled 3.4 percent. Chinese also shares plummeted. The benchmark Shanghai Composite Index slumped 3.79 percent to close at 2，526.82. The Shenzhen Component Index lost 3.33 percent to finish at 11，312.63， triggering investor worries of a new global recession.

There are wider systemic effects. With America occupying the core of the world’s financial system， downgrade will erode the standing of its global public goods， from the dollar as the world’s reserve currency to its financial markets as the best place for other countries to deposit savings. This will weaken the effectiveness of the US as the global anchor， accelerating the unsteady migra- tion to a multipolar system.

Moreover， there is a sliver of a silver lining given that the downgrade may serve as a wake-up call for US policymakers. It is an unambiguous and loud signal of America’s eroding economic strength and global standing; and renders urgent need for America to regain the initiative through better economic policymaking and more coherent governance.

The global system must adjust

America has always had the top triple-A rating since 1941. This historic action that SP cuts US’s credit rating for the first time has taken place， and the global system must adjust.

The greatest impact of SP’s move， and the reason the price of Treasury bonds actually rose on the news， could be political. The deficit is a political problem. Politicians normally require a full-blown financial crisis to galvanize them into action. SP’s move is a sensible attempt to get Washington to act， without putting everyone through another financial crisis.

Global financial markets reopen to a changed reality. There are immediate operational consequences， from recoding risk and trading systems to evaluating collateral and liquidity management. Important market segments will be closely watched， including the money market complex and the reaction of America’s largest foreign creditors.

China’s measures

As the largest foreign holder of US Treasuries， a downgrade would bring huge losses.

China holds a large stash of dollar-denominated foreign assets， as well as significant amounts of renminbi-denominated liabilities. Clearly， the currency structure of assets and liabilities makes its net international investment position very vulnerable to devaluation of the dollar against the renminbi.

China has run a trade surplus for over two decades. Inevitably this has led to an accumulation of foreign reserves. It is clear， however， that running these surpluses persistently is not in China’s best interests. A developing country， with per capita income ranking below the 100th in the world， lending to the world’s richest country for decades is not reasonable.

China has tried various measures to slow down the growth of these reserves and protect the value of its existing stock. This has included demand stimulation， allowing the renminbi to appreciate gradually and creating sovereign wealth funds. It has also promoted reform of international monetary systems and the internationalization of the renminbi. However， China’s foreign exchange reserves have continued to rise rapidly. China should rethink its past policies. It is time that China break free of the dollar trap.