Fitch downgrades US Credit Rating due to mounting debt at all levels and declining governance standards over 20 years.
The decision to downgrade US Credit Rating from AAA to AA+ reflects how increasing political polarization and recurrent standoffs in Washington over spending and taxes may eventually burden US taxpayers. Over time, a lower credit rating could lead to higher borrowing costs for the US government.
This is only the second instance in the history where US credit rating has been downgraded. In 2011, the credit rating agency Standard & Poor’s removed the US’s prized AAA rating following a prolonged battle over the government’s borrowing limit.
Despite this, the US has historically enjoyed lower borrowing costs due to its substantial economy and the stable nature of its federal government. During times of economic uncertainty, global investors often turn to US Treasury securities, which helps reduce the interest rate paid by the US government.
Fitch had previously issued a warning on May 24, stating the possibility of removing the government’s triple-A rating as Congress struggled once again to raise the borrowing limit. A week later, a deal was reached that temporarily suspended the limit and cut about $US1.5 trillion from the government deficit over the next decade.
Fitch cited the deteriorating political divisions concerning spending and tax policies as a significant factor behind its decision. The agency observed that US governance has declined in comparison to other highly rated countries and pointed out the recurrent debt limit standoffs and last-minute resolutions as contributing factors.
Row Over US Credit Rating Downgrade – ‘Arbitrary’ Decision Relies on ‘Outdated Data’
The Biden administration officials strongly criticized Fitch’s action, with Treasury Secretary Janet Yellen denouncing it as “arbitrary” and “based on outdated data.”
Yellen emphasized that the US economy had experienced a rapid recovery from the pandemic recession, evidenced by the unemployment rate reaching a nearly half-century low and a solid 2.4 per cent annual economic expansion in the April-June quarter.
Fitch also cited another reason for the downgrade, anticipating the US economy to experience a “mild recession” in the last three months of the current year and early next year. Notably, economists at the Federal Reserve had previously made a similar prediction in the spring but later reversed it in July, suggesting that while growth would slow, a recession would probably be avoided.
US Credit Rating Downgrades: The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.
US Credit Rating downgrades – KEY RATING DRIVERS
US Credit Rating is affected by the Erosion of Governance:
According to Fitch, there has been a consistent decline in governance standards over the past two decades, particularly concerning fiscal and debt matters, despite the bipartisan agreement in June to suspend the debt limit until January 2025. The frequent political standoffs over the debt limit and last-minute resolutions have diminished confidence in fiscal management. Unlike its peers, the government lacks a medium-term fiscal framework and operates with a complex budgeting process.
These factors, along with various economic shocks, tax cuts, and new spending initiatives, have contributed to successive debt increases over the last ten years. Moreover, the country has made only limited progress in addressing medium-term challenges related to the escalating costs of social security and Medicare due to an aging population.
The Increase in General Government Deficits is Another Key Factor in the Downgrade of US Credit Rating
We anticipate the general government (GG) deficit to increase to 6.3% of GDP in 2023, up from 3.7% in 2022. This rise is attributed to weaker federal revenues due to cyclical factors, new spending initiatives, and a higher interest burden. Additionally, state and local governments are projected to incur an overall deficit of 0.6% of GDP this year, contrasting with a small surplus of 0.2% of GDP in 2022.
Despite the Fiscal Responsibility Act’s agreement to reduce non-defense discretionary spending (15% of total federal spending), the medium-term fiscal outlook is expected to improve only modestly. The Congressional Budget Office estimates cumulative savings of USD 1.5 trillion (3.9% of GDP) by 2033 as a result of the Act. In the short term, the Act’s impact is estimated to be USD 70 billion (0.3% of GDP) in 2024 and USD 112 billion (0.4% of GDP) in 2025. Fitch does not anticipate any further significant fiscal consolidation measures before the November 2024 elections.
Fitch’s projections indicate a general government (GG) deficit of 6.6% of GDP in 2024, with further widening to 6.9% of GDP in 2025. These larger deficits will be primarily driven by weak GDP growth in 2024, a higher interest burden, and wider state and local government deficits amounting to 1.2% of GDP in 2024-2025, aligning with the historical 20-year average.
The interest-to-revenue ratio is expected to reach 10% by 2025, significantly higher than the ‘AA’ median (2.8%) and the ‘AAA’ median (1%). This increase is attributed to the elevated debt level and sustained higher interest rates compared to pre-pandemic levels.
The US Credit Rating is Largely Impacted by the Increase in General Government Debt:
Lower deficits and high nominal GDP growth reduced the debt-to-GDP ratio over the last two years from the pandemic high of 122.3% in 2020; however, at 112.9% this year it is still well above the pre-pandemic 2019 level of 100.1%. The GG debt-to-GDP ratio is projected to rise over the forecast period, reaching 118.4% by 2025. The debt ratio is over two-and-a-half times higher than the ‘AAA’ median of 39.3% of GDP and ‘AA’ median of 44.7% of GDP. Fitch’s longer-term projections forecast additional debt/GDP rises, increasing the vulnerability of the U.S. fiscal position to future economic shocks.
Medium-term Fiscal Challenges Are Unaddressed and Denting the US Credit Rating : Over the next decade, higher interest rates and the rising debt stock will increase the interest service burden, while an aging population and rising healthcare costs will raise spending on the elderly absent fiscal policy reforms. The CBO projects that interest costs will double by 2033 to 3.6% of GDP. The CBO also estimates a rise in mandatory spending on Medicare and social security by 1.5% of GDP over the same period.
The CBO projects that the Social Security fund will be depleted by 2033 and the Hospital Insurance Trust Fund (used to pay for benefits under Medicare Part A) will be depleted by 2035 under current laws, posing additional challenges for the fiscal trajectory unless timely corrective measures are implemented.
US Credit Rating row, Economy to Slip into Recession: Tighter credit conditions, weakening business investment, and a slowdown in consumption will push the U.S. economy into a mild recession in 4Q23 and 1Q24, according to Fitch projections. The agency sees U.S. annual real GDP growth slowing to 1.2% this year from 2.1% in 2022 and overall growth of just 0.5% in 2024. Job vacancies remain higher and the labor participation rate is still lower (by 1 pp) than pre-pandemic levels, which could negatively affect medium-term potential growth.
Fed Tightening is really hurting the economy as well as US Credit Rating:
In March, May, and July 2023, the Federal Reserve raised interest rates by 25 basis points each time. Fitch predicts another hike to a range of 5.5% to 5.75% by September. The challenge lies in the economy’s resilience and the strong labor market, making it difficult for the Fed to achieve its goal of bringing inflation back to its 2% target.
Although headline inflation decreased to 3% in June, the core PCE inflation, which is the Fed’s key price index, remains persistently high at 4.1% year-on-year. This is likely to prevent any cuts in the Federal Funds Rate until March 2024. Moreover, the Federal Reserve is actively reducing its holdings of mortgage-backed securities and U.S. Treasuries, leading to tighter financial conditions. Since January, these assets on the Fed’s balance sheet have decreased by over USD 500 billion as of the end of July 2023.
Read More – The Federal Reserve is a Bankrupt Institution
RATING SENSITIVITIES
Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade In US Credit Rating
—Public Finances are the main factor in the downgrade of the US Credit Rating: A marked increase in general government debt, for example due to a failure to address medium-term public spending and revenue challenges;
–Macroeconomic policy, performance and prospects: A decline in the coherence and credibility of policymaking that undermines the reserve currency status of the U.S. dollar, thus, diminishing the government’s financing flexibility essentially leads to erosion of the US Credit Rating
SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)
Fitch’s proprietary SRM has assigned the United States a score corresponding to an ‘AA+’ rating on the Long-Term Foreign-Currency IDR scale.
During the assessment, Fitch’s sovereign rating committee did not make any adjustments to the output from the SRM to determine the final Long-Term Foreign-Currency IDR.
Regarding the macroeconomic factors, Fitch decided to remove the +1 notch that was previously applied due to the deterioration of the GDP volatility variable and a significant spike in inflation following the pandemic and its aftermath. However, as economic volatility and inflation impacts on the SRM have begun to return to historical levels, the previous positive QO notch is no longer deemed necessary.
Fitch’s SRM is a proprietary multiple regression rating model that uses 18 variables, including one year of forecasts, based on three-year centered averages to generate a score representing the Long-Term Foreign-Currency IDR. The agency’s QO is a forward-looking qualitative framework designed to allow adjustments to the SRM output for assigning the final rating, considering factors within its criteria that might not be fully quantifiable or reflected in the SRM.
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