Alec Phillips, Goldman Sachs; US Daily: Q&A on the US Sovereign Debt Rating
On June 11, Fitch Ratings affirmed the US sovereign credit rating at AAA and continued its negative outlook. This comes roughly one month after Standard and Poor’s (S&P) affirmed its AA+ rating, also with a negative outlook. However, all three rating agencies look likely to reassess the rating over the next year or so. In light of the recent announcements and upcoming fiscal events that could influence the rating, Goldman Sachs Economics team provides some updated thoughts on the intersection of fiscal policy and the US sovereign rating, in Q&A form.
Q: Is the US federal government likely to be downgraded this year?
A: Probably not. As noted above two of the rating agencies just affirmed their rating, and it is unlikely they would do so if a change were likely in the near future. Moody's has not affirmed its rating as recently, but its most recent commentary published in May did not imply a change in the rating was likely in the near term. Moreover, it is very unlikely that there will be any significant fiscal policy developments until the end of the year, when Congress may address the "fiscal cliff." With few policy developments to react to ahead of year-end but plenty to react to after that, a near-term rating change seems unlikely.
Q: When will the risk of a downgrade reemerge?
A: In 2013. All three of the major ratings agencies have indicated they will reassess their rating over the next year or so. Moody's most recently indicated that any outlook change would most likely not occur until "sometime in 2013," while Fitch stated in their recent rating affirmation that they would resolve the negative outlook on the US rating in the later half of 2013. S&P has not given a specific guidance on timing, saying only that their negative outlook reflects "risks that could build to the point of leading us to lower our AA+ long-term rating by 2014."
Q: What would the catalyst be for a downgrade, if one were to occur?
A: There are several possibilities, but the most likely is failure to reach any type of medium-term fiscal agreement. In addition to the guidance given by the rating agencies that they are likely to reassess the US rating next year, all three of the major rating agencies indicate that the primary means the US has of maintaining its current rating is to agree on a deficit reduction plan that would stabilize the debt to GDP ratio by the middle of the decade. Just as importantly, the agencies also appear to be in agreement that failure to agree on such a plan over the next year would put pressure on the rating, potentially leading to a downgrade next year. There are three obvious events we anticipate that could prompt ratings action (either positive or negative):
- The fiscal cliff. Decisions at year end choices could lead to ratings pressure in 2013; how Congress deals with the "sequester" appears to be the most important consideration (see below).
- The debt limit. We currently expect the Treasury to reach the statutory limit late in 2012, and we expect the limit to constrain Treasury financing ability unless Congress acts by February 2013. The political debate surrounding the debt limit increase in 2011 was the proximate cause of S&P's downgrade, along with disappointment at the amount of deficit reduction agreed to in the Budget Control Act (BCA). The upcoming debate could be at least as difficult to resolve, though this depends in part on the election.
- Failure to enact a medium-term fiscal agreement. Policymakers in both political parties anticipate a broad fiscal debate in 2013, partly as a means of addressing the two items just noted. More importantly (from a ratings perspective) the rating agencies appear to expect an agreement next year that will produce a substantial improvement in the debt/GDP ratio over the medium term compared to projections that assume current policy will be extended. While the fiscal cliff and debt limit have a greater potential for near-term market and economic dislocation and have thus received more focus among market participants lately, we expect that the potential agreement (or lack thereof) on broader fiscal issues in 2013 will be the most important event for the US sovereign rating.
A: It varies, but in general they assume most of the expiring policies will be extended. Fitch assumes a decline in the federal budget deficit of 1.5% of GDP in 2013 over 2012, which appears to reflect mainly cyclical improvement. Fitch explicitly assumes extension of the payroll tax cut, emergency unemployment benefits, and the 2001/2003 tax cuts. S&P assumes that the 2001/2003 tax cuts remain in place indefinitely but that the spending caps under the BCA are maintained and the additional spending cuts scheduled to take place at year end under the "sequester" are allowed to take effect. Moody's appears to have a less specific view apart from the view that Congress is likely to address these issues in late 2012 or early 2013. However, as of May 15, Moody's projects a decline in the primary general government balance of 4% of GDP, roughly the size of the "fiscal cliff."
The upshot is that congressional action to head off the fiscal cliff seems to be expected by all three major agencies, though for the most part there is also an expectation that the "sequester" spending cuts will remain in place. Since the rating agencies have tended to view "medium-term" fiscal consolidation to be much more important than near-term fiscal restraint, it seems likely that they would be supportive of reducing the sequester-related spending cuts for 2013 in return for deficit reduction of a similar or greater amount spread over several years. In fact, last year's "super committee" was tasked to do just that--reduce the deficit by $1.2 trillion gradually over ten years, rather impose the full amount of deficit reduction in the first year. The rating agencies viewed the super committee's failure as a minor negative, so it should follow that they should see replacing the sequester with savings spread over several years as preferable to allowing the cuts to take effect as planned. That said, one risk is that the congressional budget process usually counts as deficit-neutral any policy that does not change the cumulative deficit (in nominal terms) over the next ten years. The rating agencies typically focus on a shorter time frame of three to five years, and may take a more skeptical view of proposals to delay savings from the sequester or other deficit reduction measures until late in the ten-year period.
Q: Does the economy also pose a risk to the rating?
A: Not under our forecast, though the rating agencies assume slightly faster growth than we do this year and next. Fitch and Moody's share very similar economic outlooks, calling for growth of 2.2% and 2.3% respectively in 2012 and 2.3% and 2.6% in 2013. S&P is slightly below those levels, at 2.1% for 2012 and 2.4% for 2013. Our own forecast assumes growth of 2.0% this year and 1.9% next year. Every one percentage point of growth disappointment tends to result in around 0.4 percentage point of GDP deterioration in the budget balance, so differences of this magnitude are unlikely to affect the outlook for the US sovereign rating if they persist for only one year. Not surprisingly, one of the economic risks mentioned by all three rating agencies is the "fiscal cliff".
Q: What fiscal measures are most important to the rating agencies?
A: Each agency emphasizes different factors, but the debt to GDP ratio and the interest expense to revenue ratio tend to be most important. The rating agencies typically consider political and institutional factors along with economic, monetary and of course fiscal factors in determining the rating. Among the fiscal factors, which for advanced economies appear to be the most important to the rating, the primary factors often considered are the ratio of government debt net of financial assets to GDP and the ratio of interest expense to revenues. While the debt/GDP ratio is fairly intuitive and is something that is forecasted regularly by federal budget agencies like the Congressional Budget Office and the White House Office of Management and Budget, the relationship of federal interest payments to revenues is not something frequently considered in fiscal policymaking in at the federal level in the US.
Q: How does the US look on those measures?
A: On the cusp between AAA and AA territory. The chart below shows how the US compares to other ‘advanced’ economies for which data are readily available from the IMF or OECD, using 2011 data. For simplicity, we group sovereigns with ratings within one notch of AA, A, BBB and BB together (i.e., AA+ rated sovereigns are grouped with AA and AA-). Since ratings from the three major rating agencies differ for some sovereigns, we also differentiate those governments with uniform ratings and those with mixed ratings (i.e., the US with its two AAA ratings and one AA+ rating would be classified as AAA, mixed). The upshot is that the US is at the edge of "AAA space" using these two common measures, and is in fact close to comparable sovereigns with mixed AAA and AA+ ratings.
Sovereign ratings by debt/GDP and interest/revenue ratios
Q: If a downgrade occurred, what would the consequence be?
A: The market reaction would presumably be negative, but there would be few practical consequences of a single notch downgrade. A downgrade, particularly if it came as a surprise to the market, could obviously be destabilizing at least temporarily. That said, in prior research we found little reason to expect forced selling of Treasury securities due to regulatory constraints or investment mandates.
