Will coming debt ceiling deal save America’s AAA credit rating?
Keeping America’s gold-plated credit rating may take both a deal to raise the debt ceiling (which will happen) and a meaningful deficit reduction plan of around $4 trillion (which is not happening). Moody’s says it wants a “deficit trajectory that leads to stabilization and then decline in the ratios of federal government to GDP and debt to revenue beginning within the next few years.” And here is Standard & Poor’s in a report released last night:
If a debt ceiling agreement does not include a plan that seems likely to us to credibly stabilize the U.S.’ medium-term debt dynamics but the result of the debt ceiling negotiations leads us to believe that such a plan could be negotiated within a few months, all other things unchanged, we expect to affirm both the long- and short-term ratings and assign a negative outlook, If such an agreement is reached, but we do not believe that it likely will stabilize the U.S.’ debt dynamics, we, again all other things unchanged, would expect to lower the long-term ‘AAA rating, affirm the ‘A-1+’ short-term rating, and assign a negative outlook on the long-term rating.
Looking at the most likely scenario out there right now, Goldman Sachs has its doubts (bold is mine):
Using our baseline projections as a starting point, the $1.7trn agreement we outline would represent substantial progress, but would probably fall short of Moody’s criteria. That said, we view any agreement that is reached this year as a first step; tax and entitlement reform efforts look likely following the election in 2013. With a cyclically-adjusted primary deficit of around 6% of GDP in 2011, additional consolidation clearly will be necessary, and thus we view this as the first round of what will ultimately need to be multiple deficit reduction measures over the next few years.
Here is the deal Goldman is looking at (from its report):
1) An agreement that involves primary deficit reduction of $1.5trn to $1.7trn
2) Roughly $1.1 trillion in savings from the discretionary budget, which would be achieved through spending caps; roughly $350 bn in health-related savings, mainly from Medicare; and around $250bn in savings from other areas of the “mandatory” budget such as agricultural subsidies, federal retirement benefits, and fees charged by the GSEs.
3) $2.4trn debt limit increase structured in a similar manner to what Senate Minority Leader McConnell proposed earlier this week.
4) Our hypothetical agreement assumes that the 2% payroll tax cut will be extended through next year, at a cost of $111bn spread over FY2012 and FY2013, and that that a small amount of “tax expenditures” are eliminated, raising $55bn.
— We assume a package in which a good deal of the total savings occur in the last few years. … This assumption, combined with other spending cuts and the tax provisions noted above, results in a roughly budget neutral package in 2012 (as compared with current law), rising to savings excluding interest of nearly $300bn by FY2021. Compared with our own forecast, which assumes a payroll tax cut extension and modest spending cuts in 2012, this would increase the structural deficit reduction we assume by 0.2% to 0.3% of GDP.
Bottom line: “The upshot is that against either our projections or the official baseline projection from CBO, the hypothetical $1.7trn agreement we sketch out would meaningfully reduce the debt-to-GDP ratio over the next ten years. The debt reduction would reduce interest expense by more than $300bn, for a total of around $2trn in deficit reduction. Likewise, it would reduce the primary fiscal balance (i.e. the deficit excluding interest expense) by nearly 1.5% of GDP toward the end of the decade.”
Certainly this will only be the first of many deals, with a much bigger one likely in 2013. Hopefully, the credit raters will take that into account. But certainly it seems as if a loss of the AAA ratings is possible even with a debt ceiling deal. And that would be bad. What might happen? We at Reuters have looked at this:
1) When Moody’s Investors Service revised its outlook on Japan’s AAA-rated sovereign debt to negative from stable in 1998 — similar to what S&P did to the United States on Monday — the yen sank to its lowest level in six years and government bond prices fell sharply.
2) If the dollar did weaken, it could boosts export sales of U.S. manufacturers, but also put upward pressure on inflation by making imports more expensive.
3) The greater threat might be higher borrowing costs if investors demand a greater reward to take on more risk from a less credit-worthy nation. The knock-on effect would be felt in sectors sensitive to interest rates such as housing and automobile sales, both of which were floored by the Great Recession of 2007-2009.
4) Skeptics downplay the significance of a potential S&P downgrade. Tom Porcelli, chief economist at RBC Capital Markets, found that sovereign yields on four countries that lost AAA status actually fell six basis points on average 12 months after a downgrade. However, three of those examples — Spain and Ireland in 2009 and Italy in 1991 — hardly compare to the United States, and the fourth, Japan in 1998, has yet to see significant economic growth.
5) Thomas Lawler of Lawler Economic & Housing Consulting is among those who discount S&P’s negative outlook, saying he would look at hard data on jobs and income for guidance. “Who cares what they think? These are the same people who rated (subprime) bonds,” Lawler said. “I don’t view it as a BFD — a big financial deal.”
Oh, and 7,000 U.S. municipal ratings might also be downgraded, says Moody’s
Moody’s Investors Service has placed the Aaa bond rating of the government of the United States on review for possible downgrade given the rising possibility that the statutory debt limit will not be raised on a timely basis, leading to a default on U.S. Treasury debt obligations. On June 2, Moody’s had announced that a rating review would be likely in mid July unless there was meaningful progress in negotiations to raise the debt limit.
In conjunction with this action, Moody’s has placed on review for possible downgrade the Aaa ratings of financial institutions directly linked to the U.S. government: Fannie Mae, Freddie Mac, the Federal Home Loan Banks, and the Federal Farm Credit Banks. We have also placed on review for possible downgrade securities either guaranteed by, backed by collateral securities issued by, or otherwise directly linked to the U.S. government or the affected financial institutions.