Analysis: After US credit downgrade, who's next?

A joke making its rounds in Washington: What is the difference between the United States and Belgium? Belgium has a government without a cabinet. The US has a cabinet without a government.

As of Friday, what is more notable is what the two countries have in common: both are now rated AA+ by the rating agency Standard & Poor’s.

America’s loss of the S&P’s top AAA rating was felt in the most tangible way today with Wall Street plunging 635 points -- its sixth worst drop in history. See market action.

Apart from the immediate market reaction, Washington is deeply embarrassed. The US has never had a rating lower than AAA since S&P began publishing it in 1941.

The nation’s status as the world’s safest borrower has been so deeply ingrained that federal law governing bank collateral does not even contemplate the possibility that Treasury bonds could be anything other than AAA-rated – it is simply accepted as a given.

Of course, at one time it was also said that “nuclear powers don’t default” – until Russia did just that in 1998. Even earlier, in 1976, the UK had to go cap in hand to the IMF for a bailout. And now, the world’s largest economy is considered – at least by the S&P – to be a more risky borrower than Luxembourg. Bottom line: there are no certainties.

Dysfunctional politics
That the US political system has shown itself to be truly dysfunctional in the weeks leading up to the S&P downgrade is beyond doubt – hence the comparison to Belgium, which (in)famously hasn’t been able to name a new cabinet since April 2010. The fact that it took until the very last possible day – August 2 – to raise the federal debt ceiling was bad enough.

What made it even worse is that, in their compromise agreement, Congress and the Obama administration continued to kick the proverbial can down the road by deferring the tough decisions on fiscal reform until late in the year.

While the immediate cause of the S&P decision was Washington’s persistent gridlock and lack of seriousness on the budget deficit, it is what the agency calls the “medium-term debt dynamics” that are more troubling for the markets. The US ratio of federal debt to GDP is approximately 74% in 2011, and the S&P projects an increase to 79% in 2015.

This forecast may actually be generous, because the S&P assumes GDP growth of 3% per year, something that seems highly optimistic after growth of 1.3% and 0.4%, respectively, over the past two quarters.

The S&P downgrade will, of course, be debated. Critics will point out, not unfairly, that S&P and the other major agencies (Fitch and Moody’s) were placing AAA ratings on mortgage-backed securities until shortly before their implosion amid the subprime crisis of 2007-2008. In this case, the S&P may be trying to be “ahead of the curve” by downgrading the US before either of its two competitors.

Other downgrades likely
What’s perhaps most interesting about the downgrade of the US is that it logically opens the door to analogous downgrades of many other leading economies. Among the G-7 countries, two have long been seen as weaker credit risks: Japan (AA-), which has the world’s highest debt-to-GDP ratio at over 200%; and Italy (A+), the bond market’s latest headache, with yields on Italian debt surging in recent weeks.

That leaves four others still holding the AAA rating: Germany, France, UK, and Canada. How long will it be before one or more of these countries lose the AAA?

The UK, for example, is estimated to have a debt-to-GDP ratio of 80% this year – 6% above US levels. While David Cameron’s government is pursuing an aggressive austerity programme, the UK is also facing a period of frustratingly slow growth.

Germany’s balance sheet is relatively stronger, though also deteriorating. France is stuck in the grey area between the healthy economies of northern Europe (Germany, Austria, Finland, Norway) and the peripheral Mediterranean PIGS (Portugal, Italy, Greece, Spain). Canada, with a debt-to-GDP ratio of only 30%, is the only G-7 country with truly sustainable public finances.

Currency concerns
The US (and UK, and Canada) have one important advantage over the eurozone economies. Unlike the eurozone’s individual members, Washington controls its own currency.

One of the structural reasons for Europe’s current crisis is that the monetary decisions of the European Central Bank have been, and inherently must be, a “one size fits all” policy. Over the previous decade, this meant interest rates that were too low for the profligate PIGS countries and too high for the rest. In short, the ECB  lacks the wherewithal – unlike the US Federal Reserve – to adequately deal with the current crisis.

What the global markets are now trying to figure out is which of the two – the US or the eurozone – is in worse shape.

In recent weeks, the US dollar’s rally against the euro would seem to indicate that the US is looking relatively better. Of course, this does not obscure the fact that the US dollar has been in freefall against such commodity-leveraged currencies as the Canadian and Australian dollars and the Brazilian réal.

If the trend continues, perhaps in a few years’ time it will be Brazil that surpasses the US in the S&P ratings – only six more notches to go.

Pavel Molchanov is a financial analyst in Texas. Email: pavel@alumni.duke.edu


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