Explained: Six key reasons why Fitch Ratings downgraded US
US Treasury Secretary Janet Yellen issued a statement declaring the downgrade as “arbitrary and based on outdated data”, a Reuters report said.
“This is a bizarre and baseless decision for Fitch to make now. It simply defies common sense to take this downgrade as a result of what was really a mess caused by the last administration and reckless actions by congressional Republicans,” Reuters reported a senior Biden administration saying so.
Fitch is being criticised by the Biden administration but the rating agency has explained why it downgraded the United States of America’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to ‘AA+’ from ‘AAA’.
It highlighted the expected fiscal deterioration in the US over the next three years along with a high and growing general government debt burden. Besides, Fitch pointed out that the erosion of governance over the last two decades has manifested in repeated debt limit standoffs and last-minute resolutions.
What is a credit rating downgrade?
In simple terms, a credit rating downgrade means getting a lower grade on one’s financial scorecard. Companies and governments get ratings that show how likely they are to pay back their debts. If a company or government’s rating gets downgraded, it means their financial situation has worsened, and they are seen as riskier to lend money to.
Credit rating agencies assess the creditworthiness and risk of default associated with the companies and governments (borrower or issuer of debt instruments) and assign ratings based on their evaluation. Different rating agencies follow different practices for assigning ratings. As per experts, for Fitch Ratings, ‘AAA’ rating is the best and ‘AA+’ is high-quality.
The US rating has just come down to ‘AA+’ from ‘AAA’ and the outlook is ‘stable’ so the creditworthiness of the US still remains strong.
Why did Fitch Ratings downgrade the US?
Fitch Ratings enlisted six key rating drivers in its statement. Take a look:
Erosion of Governance: Fitch believes there has been a steady deterioration in standards of governance in the US over the last 20 years, including on fiscal and debt matters, in spite of the June bipartisan agreement to suspend the debt limit until January 2025.
“The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management,” Fitch pointed out.
Besides, the rating agency observed that the US government lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process.
“These factors, along with several economic shocks as well as tax cuts and new spending initiatives, have contributed to successive debt increases over the last decade. Additionally, there has been only limited progress in tackling medium-term challenges related to rising social security and Medicare costs due to an ageing population,” Fitch observed.
Rising General Government Deficits: Fitch expects the general government (GG) deficit to rise to 6.3 per cent of GDP in 2023, from 3.7 per cent in 2022, reflecting cyclically weaker federal revenues, new spending initiatives and a higher interest burden.
Fitch forecasts a GG deficit of 6.6 per cent of GDP in 2024 and a further widening to 6.9 per cent of GDP in 2025.
“The larger deficits will be driven by weak 2024 GDP growth, a higher interest burden and wider state and local government deficits of 1.2 per cent of GDP in 2024-2025 (in line with the historical 20-year average). The interest-to-revenue ratio is expected to reach 10 per cent by 2025 (compared to 2.8 per cent for the ‘AA’ median and 1 per cent for the ‘AAA’ median) due to the higher debt level as well as sustained higher interest rates compared with pre-pandemic levels,” said Fitch.
Read more: Fitch Ratings downgrade: Could a cut in US rating mean higher inflows to India, other EMs?
General Government Debt to Rise: Fitch pointed out that 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 per cent in 2020. However, the rating agency underscored that at 112.9 per cent this year, it is still well above the pre-pandemic 2019 level of 100.1 per cent.
“The GG debt-to-GDP ratio is projected to rise over the forecast period, reaching 118.4 per cent by 2025. The debt ratio is over two-and-a-half times higher than the ‘AAA’ median of 39.3 per cent of GDP and ‘AA’ median of 44.7 per cent of GDP. Fitch’s longer-term projections forecast additional debt/GDP rises, increasing the vulnerability of the US fiscal position to future economic shocks,” Fitch said.
Unaddressed Medium-term Fiscal Challenges: Fitch pointed out that the medium-term fiscal challenges, including higher interest rates, rising debt stock and rising healthcare costs remain unaddressed.
“Over the next decade, higher interest rates and the rising debt stock will increase the interest service burden, while an ageing population and rising healthcare costs will raise spending on the elderly absent fiscal policy reforms,” said Fitch.
“Additionally, the 2017 tax cuts are set to expire in 2025, but there is likely to be political pressure to make these permanent as has been the case in the past, resulting in higher deficit projections,” Fitch said.
US Economy Likely To Slip into Recession: According to Fitch projections, tighter credit conditions, weakening business investment, and a slowdown in consumption will push the US economy into a mild recession in 4Q23 and 1Q24.
“The agency sees US annual real GDP growth slowing to 1.2 per cent this year from 2.1 per cent in 2022 and overall growth of just 0.5 per cent in 2024. Job vacancies remain higher and the labour participation rate is still lower (by 1 pp) than pre-pandemic levels, which could negatively affect medium-term potential growth,” Fitch pointed out.
Fed Tightening: Fitch expects one further hike to 5.5 per cent to 5.75 per cent by September. The rating agency said the resilience of the economy and the labour market are complicating the Fed’s goal of bringing inflation towards its 2 per cent target.
“While headline inflation fell to 3 per cent in June, core PCE inflation, the Fed’s key price index, remained stubbornly high at 4.1 per cent year-on-year. This will likely preclude cuts in the Federal Funds Rate until March 2024. Additionally, the Fed is continuing to reduce its holdings of mortgage-backed securities and US Treasuries, which is further tightening financial conditions. Since January, these assets on the Fed balance sheet have fallen by over $500 billion as of end-July 2023,” said Fitch.
Read more: Fitch downgrades US credit rating: Here’s what market experts, economists make of it
Disclaimer: This article is based on Fitch Ratings’ statement on US credit downgrade. The views and recommendations above, if any, are those of individual analysts and broking companies, not of Mint. We advise investors to check with certified experts before taking any investment decisions.
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Updated: 02 Aug 2023, 12:03 PM IST
