What Does the U.S. Credit Rating Downgrade Really Mean?
In August 2011, the United States’ credit rating was downgraded by the credit rating agency Standard & Poor’s (S&P) from AAA to AA+, or down one level. Because this is the first time in American history that the U.S. credit rating has been downgraded, the long-term economic impact remains uncertain. Here is a brief explanation of the S&P downgrade decision, some background on credit ratings, and possible implications of the downgrade.
Reasons for the downgrade in the U.S. credit rating
Standard & Poor’s believed that the rising level of government debt and lack of effective policymaking weakened U.S. creditworthiness to a level no longer commensurate with an AAA sovereign credit rating. S&P pointed to a debt trajectory where U.S. net general government debt of $11.4 trillion (74% of GDP) this year (2011) is projected to increase to $14.5 trillion (79% of GDP) by 2015.
In addition, S&P was troubled by the U.S. political climate, observing that the stability, predictability, and effectiveness of the nation’s policymaking has weakened, as demonstrated in the recent debate around the debt ceiling. S&P criticized the nation’s lawmakers for failing to cut spending and raise revenue to reduce record budget deficits.
How governments like the U.S. get a credit rating
A sovereign credit rating is the credit rating of a sovereign entity, namely a national government. The credit rating is an evaluation of the likelihood of default and credit-worthiness of an issuer of debt, like the U.S. government. Credit ratings are determined by credit ratings agencies, the most influential being Standard & Poor’s (S&P), Moody’s, and Fitch Ratings. These agencies determine credit ratings for both sovereign entities, like national governments, and private corporations.
Credit ratings are based on qualitative and quantitative information for a government, the judgment and experience of the rating agency’s analysts, and their evaluation of public and private information, including a nation’s history and long-term economic prospects. S&P also publishes a more detailed explanation of credit ratings. The following chart shows the various sovereign credit ratings given by each of the major credit rating agencies.
|AAA||Aaa||AAA||Highest rating - extremely strong capacity to meet financial commitments|
|AA||Aa2||AA||Very strong capacity|
|A||A2||A||Strong capacity but somewhat susceptible to adverse economic conditions and changes in circumstances|
|BBB-||Baa3||BBB-||Lowest investment grade|
|BB+||Ba1||BB+||Highest speculative grade|
|BB||Ba2||BB||Less vulnerable in near-term but faces major ongoing uncertainties to adverse business, financial, and economic conditions|
|B||B2||B||More vulnerable but currently has capacity to meet financial commitments|
|CCC||Caa||CCC||Currently vulnerable and dependent on favorable economic conditions|
|CC||Ca||CC||Currently highly vulnerable|
|C||C||Currently highly vulnerable, bankruptcy petition filed or similar action|
Credit ratings should not be confused with credit scores. Credit scores are based on mathematical formulas that assign numerical values to information in a person’s credit report regarding financial history, current assets and outstanding liabilities. Banks and other financial services companies use the credit score to estimate the probability that the individual will pay back a loan or credit card.
A credit score does not take into account future prospects or changed circumstances. In short, a sovereign credit rating is a forward-looking estimate of a national government’s probability of default while a credit score is an estimate of an individual’s potential for default based on past performance.
S&P gives 18 sovereign entities its top ranking, including Australia, Hong Kong, and the United Kingdom. New Zealand is the only country other than the U.S. that has an AA+ rating from S&P and an Aaa grade from Moody’s. Belgium has an equivalent AA+ grade from S&P, Moody’s and Fitch.
The negative economic impacts of the U.S. credit rating downgrade
Some economists and financial experts believe S&P’s downgrade will have significant negative impacts to the U.S. and world financial markets that ripple through the U.S. and global economy in both the short term and long-term. They argue the downgrade will have the following effects.
Increases the possibility of a double-dip recession and a larger fiscal deficit.
Degrades the confidence of investors, making the fragile financial market even worse. Provokes panic selling in global stock markets.
Intensifies emerging trend of investors avoiding U.S. treasury securities and increases market turbulence.
Increases the global risk premium level by making the global market more sensitive to the European debt crisis and making the bad-credit economies of the European Union more fragile.
Diminishes global economic recovery by dampening people’s optimism for U.S. economic growth, increasing U.S. costs to issue treasury securities, and negating economic development through large scale debt funding and printing more U.S. currency. In this scenario, the U.S. falls into a vicious cycle where borrowing money becomes harder, economic development is encumbered and credit worsens.
Exposes U.S. citizens to higher borrowing costs and lower purchasing power thus reducing U.S. consumer demand and exposing countries relying on U.S. import orders to significant losses and economic slow down.
Damages the interests of U.S. debt holders such as China, Japan and Russia as U.S. treasury bonds loose their superior international status and the U.S. dollar depreciates.
Why the downgrade in the U.S. credit rating doesn’t matter
Other economic experts note that the downgrade of the U.S. credit rating may have little effect and point to the following reasons.
The U.S. still has AAA ratings from two rating agencies, Moody’s and Fitch.
The debt limit agreement reached by Congress in August 2011 showed U.S. politicians can reach political solutions to address the nation’s debt problems.
The U.S. credit rating is underpinned by the flexible, diversified and wealthy economy that provides the country’s revenue base.
U.S. monetary and exchange rate flexibility enhance the capacity of the economy to absorb and adjust to shocks.
Most U.S. debt is held by big institutions like pension funds and central banks that do their own research on sovereign debt and aren’t heavily influenced by rating agencies, and Treasury yields may experience little impact as a result.
Nearly all financial-industry regulations and internal policies at financial institutions treat the AA+ rating the same as an AAA rating, so forced selling is unlikely.
The effect on other countries that were downgraded was minimal in most cases. For example, Canada’s interest rates went up briefly in 1994 when it was downgraded, but rebounded within two months and Canada later regained the AAA rating it holds today.