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09/19/2011

United States: AmericA

Sal Guatieri, BMO Capital Markets, Toronto.

This article appeared in the August 2011 issue of Current Economics with permission of the author.

Key Concepts: Credit Ratings | Debt|

Key Economies: United States |

 

Standard and Poor (S&P) ended a 70-year tradition and stripped the US government of its triple-A credit rating on August 5, claiming the recent deficit-reduction deal doesn’t go far enough to stabilize the fiscal outlook, and that it has lost confidence in an unpredictable and ineffective political process. Judging by the initial financial market reaction, investors fear the move, though largely symbolic, could be the psychological straw that breaks the economy’s back. Equities, not downgraded Treasuries, were hit hard, with the S&P 500 plunging on Monday by the most since the 2008 financial crisis, though subsequent stronger economic data helped the market recover (Figure 1).

Rubbing salt in the wound, S&P also retained a negative outlook on US debt, suggesting the possibility of another downgrade “within the next two years” if fiscal consolidation disappoints or fiscal pressures intensify (say due to a recession). An S&P official said there was a 1 in 3 chance of another downgrade within 6-to-24 months should the government fail to implement its August 2 deficit-reduction plan. The ongoing risk of another downgrade will weigh on investor and business sentiment, and likely won’t abate until Congress shows more cooperation to rein in the deficit. For now, two other major rating agencies have affirmed the US’s debt rating, giving Congress the benefit of the doubt. This has taken some of the sting out of S&P’s announcement, as did the fact that S&P initially overstated US debt projections by US$2 trillion. Still, Moody’s warned that a downgrade is possible in the next 12-to-18 months should the government fail to implement further budget measures to stabilize the debt. Fitch will conclude its review by the end of August.

The economic impact of the downgrade should be limited. True, if stocks fall further, the loss of wealth from both equities and housing will dampen spending. There is some concern that banks, in a rush to improve liquidity in the face of heightened uncertainty, will tighten lending standards and curb loan growth. Unknown is the psychological impact on fragile business confidence (Figure 2). If companies stop hiring, the consumer will retrench. That said, lower interest rates and oil and food prices will support growth (Figure 3, page 16). The 30-year mortgage rate is down 0.75 percentage points this year, flagging a new wave of money-saving refinancings. Also, the Japanese tsunami disruptions have dissipated.

The US government will not default. The cost to insure US sovereign debt against default hardly moved after the downgrade, and remains below that of many triple-A rated nations, such as the UK, France and Germany. Even S&P says the nation has a “very strong capacity to meet its financial commitments”. Given its enormous wealth and economic potential, and scope to raise taxes, the nation’s default risk is virtually zero. The US is one of the lowest-taxed developed nations, with total government receipts at 32% of GDP in 2010, compared with the Eurozone mean of 45% and OECD norm of 37% (Canada is at 38%). Also, the US has cut tax rates over the past decade, taking the

Figure 1: Investor Confidence
Hit
US investor confidence hit
Figure 2: Another Blow to Business Confidence?
Falling business confidence

ratio of federal net receipts down from 20% of GDP in 2000 to 15% in 2010. Meaningful tax reform or a VAT would go a long way to slashing the structural deficit, as would reforms to entitlement programs. In addition, the outlook for the federal debt held by the public isn’t as grim as often portrayed. S&P projects the debt ratio will climb to 85% of GDP by 2021 (from roughly 71% today), though that’s still short of the 90% threshold that economists Rogoff and Reinhart say impedes economic growth. (While total gross US public debt is higher, at about 101% of GDP, a good portion consists of intergovernmental debt). Many public assets could be privatized to pay down the debt. Also, the federal deficit year-to-date is already down 6% compared to the same period last year, having performed as well as the UK with its draconian spending cuts. In addition, interest payments on the public debt are extremely low today, and with the Federal Reserve’s (Fed) conditional commitment to keep short rates near zero, long-term bond yields have fallen even further. If long rates remain within 1 percentage point of current levels, continued nominal GDP growth should see the debt ratio stabilize and even fall. Because of the minimal risk of default, the deep, liquid Treasury pool will remain the one investors dive into whenever the financial climate heats up.

The downgrade should not stress the financial system. Money market funds will not be forced to sell their Treasury holdings, and banks and insurers will not need to hold more capital. US bank regulators say the downgrade will not affect the risk-weighting of Treasury assets held by banks, while the Fed will continue to accept Treasuries as collateral for loans to banks. Because S&P did not downgrade the US’s short-term credit rating, there should be limited impact on money markets. The four triple-A rated US firms (ADP, ExxonMobil, Microsoft and Johnson & Johnson) were untouched, though five triple-A insurers were downgraded.

Figure 3: Silver Linings

silver linings


On the bright side, the threat of another downgrade could spur a fractious Congress to work together, though it likely precludes further meaningful fiscal stimulus to support the recovery. The new “super committee” tasked to cut the deficit will likely be pressured to find more than the planned US$1.5 trillion in savings in the next decade, and to consider reforms to the tax system and entitlement programs. If so, S&P could restore the US’s triple-A rating, as it did for five other nations—Australia, Finland, Denmark, Sweden, and Canada—and likely a lot sooner than the minimum nine years for those countries.

Longer-term, the downgrade is unlikely to raise US borrowing costs. True, S&P did cut its top rating on thousands of municipal bonds, as well as securities backed by Fannie Mae and Freddie Mac, the nationalized housing agencies that support most new mortgages. Municipal and mortgage rate spreads have subsequently widened a little against Treasuries. Still, Japan and Canada’s experience suggests that interest rates do not rise much, if at all, after a downgrade. Large foreign purchasers are not expected to shun US debt. China holds over US$1tn in Treasuries, and would face a stronger currency and weaker exports if it were to pare its holdings.

The Bottom Line: Despite kicking the economy when it’s down, the downgrade should not trigger a recession. But with growth already near stall speed, the government can’t run the risk of another downgrade, notably from one of the other two major rating agencies.


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