Fitch Downgrades U.S. Credit Rating to AA+ from AAA

Key Takeaways:

• Fitch downgraded the US credit rating from AAA to AA+ due to fiscal deterioration, growing debt burden, and erosion of governance
• Political showdowns and a complex budgeting process have contributed to increased debt over the past decade
• The US general government deficit is projected to rise to 6.3% of GDP in 2023, and the debt-to-GDP ratio is expected to reach 118.4% by 2025
• Despite the downgrade, the US has economic resilience, a stable political environment, global reserve currency status, and deep financial markets

Fitch, one of the "Big Three" credit rating agencies alongside Moody's and Standard & Poor's, early this month downgraded the United States of America's Long-Term Foreign-Currency Issuer Default Rating (IDR) to 'AA+' from 'AAA' basing their decision on a combination of factors, including expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance.

The rating system's two prominent categories are AAA and AA, indicating the highest degree of creditworthiness:

Why did Fitch Downgrade the USA?

Erosion of Governance

The frequent political showdowns over the debt limit and last-minute solutions have diminished trust in fiscal administration. Furthermore, unlike its counterparts, the government needs a foreseeable fiscal framework and follows a convoluted budgeting procedure. These elements, coupled with various economic shocks, tax reductions, and fresh spending initiatives, have contributed to consecutive increases in debt over the previous ten years. 

Rising General Government Deficits

Anticipated trends indicate that the deficit for the general government (GG) is projected to increase to 6.3% of the Gross Domestic Product (GDP) in 2023, a rise from 3.7% in 2022. This shift can be attributed to a combination of factors, such as a decrease in federal revenues due to a weaker economic cycle, the introduction of new spending initiatives, and a higher burden of interest payments. Furthermore, state and local governments are predicted to experience a deficit equal to 0.6% of the GDP this year after recording a slight surplus of 0.2% in the preceding year, 2022.

According to the Fiscal Responsibility Act, adjustments have been made to non-defense discretionary spending, constituting 15% of the total federal expenditure. These changes are expected to enhance the medium-term fiscal projection moderately, resulting in cumulative savings of $1.5 trillion (equivalent to 3.9% of the GDP) by the year 2033, as estimated by the Congressional Budget Office estimated. The immediate impact of this Act is foreseen to amount to $70 billion (0.3% of the GDP) in 2024, followed by $112 billion (0.4% of the GDP) in the subsequent year, 2025. It is outside Fitch's expectations that any significant measures aimed at fiscal consolidation will be undertaken before the November 2024 elections.

General Government Debt to Rise

In the past couple of years, a combination of reduced deficits and strong growth in the nominal GDP has led to a decrease in the debt-to-GDP ratio from its peak of 122.3% in 2020 due to the pandemic. However, despite this improvement, the ratio remains relatively high at 112.9% this year, still significantly above the pre-pandemic level of 100.1% in 2019. Projections indicate that the debt-to-GDP ratio for GG. is expected to climb further, reaching 118.4% by 2025. This ratio is over two and a half times greater than the median debt ratios of 'AAA' countries at 39.3% and 'AA' countries at 44.7% of GDP. Fitch's long-term forecasts suggest that the debt-to-GDP balance will continue to rise, making the U.S. fiscal position more susceptible to future economic shocks.

Impact of the Downgrade on the U.S.'s Ability to Repay its Debt

Fitch's decision to downgrade America's credit rating raised concerns about the impact on the U.S.'s ability to repay its debt and overall financial standing. Despite the downgrade, the United States has a strong capacity to meet its financial commitments. This assertion is backed by several factors that contribute to the country's continued ability to service its debt obligations:

1. Economic Resilience: The United States has a diverse and robust economy that has demonstrated resilience in various challenges. Its GDP remains substantial, and its ability to generate tax revenue is a testament to its economic strength
2. Global Reserve Currency: The U.S. dollar remains the world's primary reserve currency. This affords the U.S. a unique advantage, as demand for its currency and assets remains high, allowing the government to access capital from international investors quickly
3. Deep and Liquid Financial Markets: The U.S. boasts deep and highly liquid financial markets that attract global investors seeking safe-haven assets. This demand provides a consistent funding source for the government's debt obligations

The impact of a downgrade on the U.S.'s ability to repay its debt is a topic of debate among investors:

•    Some investors argue that a downgrade from AAA to AA+ undermines America's credibility and trustworthiness.
•    They believe it leads to higher borrowing costs as investors demand higher yields for the increased risk.
•    They suggest that the downgrade could have a cascading effect on the overall economy.
•    It may make it harder for the U.S. government to service its debt and potentially erode its ability to repay.

o    On the other hand, some investors believe that the difference between AAA and AA+ is merely a matter of perception.
o    They argue that it does not significantly impair the government's ability to meet its obligations.
o    These investors emphasize the U.S. economy's underlying strength, robust cash flows, and the reserve currency status of the U.S. dollar.
o    They believe these factors provide a solid foundation for debt repayment, even with a slight downgrade.

What should be Noted?

When discussing the noteworthy aspects of Fitch's downgrading the U.S. credit rating from AAA to AA+, examining both the market reaction and the impact on interest rates is essential. This downgrade signifies a shift in investor sentiment, potentially leading to increased market volatility. Following such news, stock markets often experience fluctuations as investors reassess their investment portfolios and adjust their risk appetites accordingly.

In terms of interest rates, a credit rating downgrade can weaken the overall creditworthiness of the nation, leading to an increase in borrowing costs for the government. Consequently, this may ripple effect throughout the economy, influencing interest rates for mortgages, loans, and other financial products. It is imperative to closely monitor how these parameters fluctuate in response to Fitch's decision, as they can have far-reaching implications on the financial landscape domestically and globally.

In conclusion, while this downgrade may initially shake investor confidence and potentially have negative implications for borrowing costs, it should serve as a wake-up call for policymakers to take immediate action. The downgrade underscores the urgent need for the U.S. government to implement comprehensive and responsible fiscal policies that prioritize reducing the deficit, stimulating economic growth, and ensuring long-term sustainability.

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