US Sovereign-Rating Downgrade Exposes Significant Debt, Fiscal and Governance Vulnerabilities

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By Alexander Jones, International Banker

Having first placed it on review for downgrade on May 24, Fitch Ratings proceeded on August 1 to cut the United States’ Long-Term Foreign-Currency Issuer Default Rating to “AA+” from “AAA”. It is only the second time that one of the “Big Three” private rating companies has taken such action against the sovereign rating of the world’s biggest economy (by nominal gross domestic product, or GDP)—the first being in 2011 by Standard & Poor’s (S&P). As was the case then, an erosion of confidence in US fiscal governance—as reflected by often frenzied, last-minute debt-ceiling negotiations—and a deterioration of long-term debt dynamics, among other factors, were pivotal in triggering this downgrade. As such, US governance standards, debt-management credentials and future economic prospects are being scrutinised perhaps more intensely today than ever before.

In its report published on August 1, Fitch attributed the downgrade to “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”. This clearly refers to the frequent debt-ceiling negotiations that have come down to the wire, denting confidence in the government’s ability to pay its bills. The rating agency also predicted that the general US government debt-to-GDP ratio will continue to rise from 112.9 percent this year to 118.4 percent by 2025. “The debt ratio is over two-and-a-half times higher than the ‘AAA’ median of 39.3 percent of GDP and ‘AA’ median of 44.7 percent 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 also did not mince words when describing the “steady deterioration” in US governance standards over the last 20 years, including on fiscal and debt matters, notwithstanding 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. In addition, the government lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process,” Fitch noted. “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 aging population.”

Reports have also suggested that the January 6, 2021, riot, which saw hundreds of protestors storm the U.S. Capitol Building in what many view as an attempted insurrection following the defeat of former President Donald Trump in the 2020 presidential election, was also a key contributory factor to the downgrade. Although not mentioned in Fitch’s final report, the infamous incident was reportedly raised in a meeting between Fitch representatives and officials of President Joe Biden’s administration.

Fitch is not the first major credit-rating agency to downgrade America’s sovereign debt, however. That title belongs to S&P Global Ratings, which first pulled the US’ top rating of “AAA” down to “AA+” in 2011. And although it did not join Fitch this year in taking further negative action against Washington, it did confirm in March 2023 that it could well enact a further downgrade over the next two to three years “if unexpected negative political developments weigh on the strength of American institutions and the effectiveness of long-term policymaking or jeopardize the dollar’s status as the world’s leading reserve currency.”

As such, Moody’s (Moody’s Investors Service) is the only one of the Big Three rating firms to have maintained the US’ top credit rating. That said, it seems likely that it would have succumbed to negative action had the federal government shut down—a scenario that was narrowly avoided late on September 30 after Congress passed a stopgap funding bill ahead of the critical midnight deadline prior to the start of the country’s new fiscal year in October. While “debt service payments would not be impacted and a short-lived shutdown would be unlikely to disrupt the economy, it would underscore the weakness of US institutional and governance strength relative to other Aaa-rated sovereigns,” Moody’s analysts led by William Foster noted on September 25. “A government shutdown would demonstrate the significant constraints that intensifying political polarization continue[s] to put on US fiscal policymaking during a period of declining fiscal strength, driven by persistent fiscal deficits and deteriorating debt affordability.”

But while the shutdown was ultimately averted, this has done little to restore confidence in the US in the eyes of rating firms. John Chambers, S&P’s chairman of the Sovereign Rating Committee in 2011 when it first downgraded the US, recently contended that the US fiscal position is even worse today than 12 years ago. Back then, the agency defended its action because the government’s “fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.” And once again, the rating agency’s main concern involves the spiralling US debt position. “Right now, the deficit of the general government—which is the federal and the local governments combined—is over 7 percent of GDP, and the government debt is 120 percent of GDP,” Chambers told CNBC on September 27. “At the time, we forecasted that it might get to 100 percent of GDP, and the government ridiculed us for being too scaremongering.”

Will this downgrade have significant long-term implications for financial markets? Some analysts believe so. For one, the government’s rising debt burden will likely prompt investors to demand higher premia as compensation for holding long-term government debt that’s now deemed a riskier prospect. “We see that causing DM [developed market] bond yield curves to steepen over time as long-term yields rise, underpinning our long-held strategic underweight,” according to BlackRock. “We stay tactically underweight [on] broad DM equities but are overweight on a long horizon—alongside inflation-linked bonds, credit and beneficiaries of structural mega forces.”

Others have downplayed any sustained long-term damage. “The ratings action points to a deteriorating fiscal situation, which will take longer to play out. But as the US dollar remains the number one reserve currency, foreign demand for Treasuries will remain, and we are unlikely to see a dramatic rise in yields in the near term,” Amundi Asset Management noted on August 8. However, the €2-trillion French asset-management firm did suggest that the US dollar’s position as the main global reserve currency could be weakened over the long term.

As for the US government itself, there have been strong objections to the downgrade from the Biden Administration. “I strongly disagree with Fitch Ratings’ decision,” Secretary of the Treasury Janet Yellen stated. “The change by Fitch Ratings announced today is arbitrary and based on outdated data.” White House Press Secretary Karine Jean-Pierre, meanwhile, added that “we strongly disagree with this decision” and expressed concern over the proficiency of Fitch’s modelling systems.

Those criticisms aside, Fitch now expects the US economy to fall into a “mild” recession in the fourth quarter and the first quarter of 2024, citing tighter credit conditions, weakening business investments and slowdowns in consumption. “The agency sees US 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,” Fitch noted, adding that higher interest rates and the rising debt stock over the coming decade will raise the cost of debt servicing. An aging American population and rising healthcare costs will also result in more being spent on the elderly in the absence of fiscal-policy reforms, the agency added.

From an international perspective, meanwhile, some are perceiving this downgrade as a hugely significant sign of the US’ waning geo-economic influence over the world. Because of the US dollar’s systemic global dominance, for instance, “the negative effect of US monetary policy on the world economy is very significant…some countries have been badly hurt by the US monetary tightening, but there is nothing they could really do,” Lian Ping, chief economist and head of the Zhixin Investment Research Institute, told Chinese news outlet Global Times shortly after the downgrade, noting that some vulnerable economies even faced potential collapse due to last year’s exceptionally strong US dollar. But Lian Ping also noted that US-dollar hegemony is weakening and that Fitch’s downgrade “may also be a part of the gradual decline of the US dollar system”.