Hung Tran
On August 1, 2023, Fitch Ratings announced its decision to downgrade the US long-term credit ratings to AA+ from AAA, but maintained the country credit ceiling at AAA (meaning other borrowers in the US can still receive AAA ratings). The reaction was swift but varied. Officials, including Treasury Secretary Janet Yellen as well as several well-known economists, criticized the downgrading decision. They argued it was “unwarranted” since the near-term prospects of the US economy look better than many of its peers, and “oddly timed” because the US government has just managed to suspend the debt ceiling at the last minute to avoid a default.
Market participants, on the other hand, largely viewed the downgrading as not adding any new information to the body of facts markets have already incorporated in asset prices. In their view, the impact of the rating move was negligible. With a touch of complacency, many observers also claimed that the rating decision’s effects would be limited because the rest of the world simply does not have many alternatives to US Treasury securities as high-quality liquid assets to satisfy their reserves, collateral, and investment needs.
Missing the bigger picture
Both reactions miss the bigger picture. The downgrading decision is another warning sign, and the only question is why it took twelve years for Fitch to follow the move by S&P to remove the AAA rating on US long-term debt. Neither the complacency of markets nor the forced optimism of officials reflects the seriousness of the rating agencies’ concerns.
Both agencies basically used similar reasoning to support their rating decisions: the US fiscal decision-making process has become increasingly dysfunctional as the Republican Party has been willing to use the debt ceiling as a political tool, holding the US sovereign credit quality hostage in order to realize its agenda, instead of following well-established Congressional procedures. The fact that the two parties have managed time and again to reach compromises at the last minute to diffuse artificial government debt crises, after forcing the Treasury to resort to “extraordinary measures” to avoid default, does not mean that the US has re-established a normal and predictable process of managing its fiscal affairs. Until recently, the question of a possible technical default even for a few days by the US had never been raised. The repeated use of debt ceiling stalemates and threats of default have turned such a dysfunctional and irresponsible governance practice into a “new normal”—not consistent with the prudent conduct expected of a AAA sovereign borrower. In fact, another budget wrangling and potential government shutdown is looming: Republicans are looking to use similar debt-limit tactics to get their way as Congress has to pass twelve annual appropriation bills for the government to function in the new fiscal year starting October 1.
Moreover, the important problem of high public debt—cited by both agencies—has worsened noticeably over the past decade. The debt/GDP ratio has increased by 25 percentage points, from 93 percent in 2011 to 118 percent in 2023. And with interest rates at decades-highs, the government’s interest payments have ballooned to almost $1 trillion in 2023 from a bit more than $400 billion in 2011. And they are starting to crowd out other important spending, including for physical and social infrastructures as well as national defense.
What is needed from Congress is not brinkmanship over the debt ceiling, but a credible medium-term fiscal framework to bring the US budget trajectory down to a sustainable level.
Downgrading the banks
Following on the heel of the Fitch’s decision, on August 7 Moody’s downgraded ten US regional banks, put six other lenders including some large banks on notice that they are under review and could be downgraded, and assigned a negative outlook for eleven other banks. The bank downgrading has clearly upset a revived sense of comfort by investors. They’d seemed relieved that the spring’s regional banking turmoil was over, bank deposit outflow had subsided, and 23 large banks had passed stress tests and been certified by the Fed as “having sufficient capital to absorb more than $540 billion in losses and continue to lend to households and businesses under stressful conditions.” Moody’s action has re-focused market attention to the fact that even though deposit outflow has stopped, there are other causes for concern:The mix of deposits has changed, with less interest-free deposits and more interest-paying deposits and funding, pinching banks’ income streams.More credit losses are a possibility, especially in the commercial real estate sector.Loan demands by households and businesses remain lackluster and could decline if the US gets into a recession later this year/early next year as many still expect.
Financial markets have reacted more negatively to the bank downgrading news, with shares of regional banks suffering the most.
The downgrading will raise funding costs of many regional banks, possibly leading them to be more cautious in extending credit, thus adding to the headwinds against the still tentative US recovery.
More important than the near-term credit outlook for banks is the seriously intractable problem of a steady deterioration of the credit quality of all US borrowers from the government to banks and non-financial corporations—as their debt has increased to very high levels. Indeed, there are only two US corporate borrowers left with a AAA rating (Microsoft and Johnson&Johnson) amid a sustained migration of corporate ratings from the A-AAA ranges to BBB+ and below. In particular, 29 percent of corporate borrowers are rated B- or below—in other words junk bonds with high risk of default!
Deteriorating credit quality increases fragility
As the credit quality of US borrowers continues to deteriorate, their fragility has increased—meaning they will find it more difficult to withstand and deal with adversities including high interest rates, slow growth with or without recessions, and a variety of global shocks such as pandemics and geopolitical events. Under the circumstances, they and the US economy in general increasingly rely on the Fed as the rescuer-of-last resort when—not if—the next major financial crisis occurs. However, a repeat of the post-global financial crisis dose of zero interest rates and quantitative easing may be less potent and create worse aftereffects than the last time around—as the US economy will have been burdened with much higher debt levels.
In short, the two downgrading actions by Fitch and Moody’s should be viewed as much-needed warnings for the US public and private sectors to put their fiscal houses in order so as to better navigate the stormy weather ahead. Unfortunately, political polarization will likely hamper efforts to do what is needed.
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