Standard and Poor's downgraded the US to AA+ from AAA. The event generated a lot of controversy. However, in practical terms, it turned out to be a non-event. Overall, if anything, the downgrade seems to have strongly affirmed the safe-haven status of US treasuries. Since the downgrade, the yields on US treasuries are not only closely mirroring German bonds, they have also gone down. If S&P's action had altered the risk perception of US sovereign debt, we would have seen a rise in interest rates on US treasuries. The rating downgrade, however, certainly added to the uncertainties and spooked stock markets, wiping out some more wealth for the US consumers.
The reasons for the declining yield on US treasuries are fairly obvious. No other debt market in the world compares with the depth of the US debt market. In an uncertain economic environment, there is a flight to safety and US treasuries still continue to represent that. Investors have diversified into gold and the sovereign debt of some of the better performing European economies, but these markets are hardly a substitute for the $14 trillion US government debt market. Further, the US government debt is not merely held by domestic institutions and public. Other countries hold nearly $4.5 trillion of US treasuries. China and Japan hold nearly $2.1 trillion. Given their export surplus with the US and China's need to maintain a currency peg with the US dollar, it is highly unlikely that these economies would diversify away from dollar-denominated US treasuries in a short span of time.
The response to the debt downgrade is also muted because other rating agencies, such as Moody's and Fitch, have not followed S&P. They have their reasons to do so—looking at the current debt-to-GDP ratio, there is still considerable headroom for the US to accumulate debt before the risk of default becomes a real possibility.
However, what has mostly gone missing in the entire debate is that S&P's decision to downgrade the US from AAA to AA+ never amounted to much in the short term. Looking at the definition of these two ratings, it is clear that the difference is not huge:
AAA: Extremely strong capacity to meet financial commitments—the highest credit rating.
AA: Very strong capacity to meet financial commitments. It differs from AAA only to a small degree. AA+, equivalent to Moody's Aa1, means high quality, with very low credit risk, but susceptibility to long-term risks appears somewhat greater.
The downgrade, therefore, did not amount to much, except a warning that the long-term fiscal health of the US is under question, an assessment that few can argue with, except those who do not want to accept reality. Even after accepting the $2 trillion error by S&P, the debt-to-GDP ratio is expected to reach 85% by 2021. We don't need to take S&P's word for it. The projections by the Congressional Budget Office in the US paint a fairly grim picture of the US fiscal position in the long-term. Going by one of these projections, the US could end up spending its entire revenues in Mandatory spending (social security, pensions etc.) by 2035. In one of the papers, it did not rule out the possibility of a Greek-style sovereign debt crisis. As the CBO states, "There is no way to predict with any confidence whether and when such a crisis might occur in the United States; in particular, there is no identifiable tipping point of debt relative to GDP indicating that a crisis is likely or imminent. But all else being equal, the higher the debt, the greater the risk of such a crisis."[1]
Why then the controversy surrounding the rating downgrade? After all, S&P was not stating that the US is headed towards a default, as has been made out by some. It was merely pointing out that the long-term sustainability of US fiscal situation is an area of minor concern. Ratings are, in any case, meant to be forward looking. So, was S&P and its CEO shot for calling a spade a spade?
While the rating downgrade may not have amounted to much in economic terms, the politics associated with it did reveal a lot. Rating agencies have long been blamed for not being proactive in their risk assessments. However, every time a country is downgraded, it results in a very strong backlash. Greece lashed out strongly at the rating agencies whenever they downgraded its credit rating. The EU has proposed to set up its own rating agencies, voicing no confidence in the US based rating agencies. In the US, three municipalities dropped S&P after the downgrade. There has been some speculation in the media that Deven Sharma may have been forced to quit as the president of S&P, though others speculate that it has nothing to do with the political backlash and Sharma had begun looking for other opportunities due to the impending split of S&P into two—the McGraw-Hill Financial and S&P credit rating services.
The political nature of credit rating, and the clear conflict of interest (in that rating agencies are supposed to be paid by those whom they rate), has been a matter of debate for a long time. It has been a key reason for a lot of heartburn across the world. For instance, closer home, India had a lower rating (BBB- or barely investment grade) than Greece for a long time after the signs of a fiscal crisis in Greece had become apparent. It still continues to have a lower rating than Spain (AA, one grade lower than the US), Italy (A+), and Ireland (BBB+/A-2). Ireland was downgraded to junk status (Ba1) only recently by Moody's. China is rated AA- and Korea A+ by S&P, both lower than Spain. Meanwhile, media reports say that police raided the Milan offices of S&P and Moody's to check whether they "respect regulations as they carry out their work" following the threat that they may downgrade Italy's bond rating.
All of it means that ratings will continue to be looked at with suspicion. The recent episodes with sovereign credit ratings have not done anything to boost confidence in the credit rating system. The system probably requires an overhaul, the primary issue being the need to make credit rating agencies truly independent of their clients. While the US has done a lot to reform the audit system by introducing the SEC, it has not been at the vanguard of reforms so far as the credit rating system is concerned. Given that two of the top three credit rating agencies (S&P and Moody's) are US-based, it will always generate controversy, being often seen as another tool in the hands of the US-based entities to manipulate the global economic environment, as the recent pronouncements from the EU appear to suggest.
[1] Congressional Budget Office, "Federal Debt and the Risk of a Fiscal Crisis", July 27, 2010, < http://www.cbo.gov/ftpdocs/116xx/doc11659/07-27_Debt_FiscalCrisis_Brief.pdf>.
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