Why USA Downgrade............?? Economics

So why was this event so important? What events led to it? What are the implications? We’ll take a

bird’s-eye-view of these pertinent questions.

US Downgrade 

We have lowered our long-term sovereign credit rating on the United States of America to

‘AA+’ from ‘AAA’

This line from the 5th

 of August, 2011 press-release by Standard & Poor’s marked a historic moment

in Financial World as something very significant happened. Something which was unthinkable just a

few months back: United States of America, the world’s safest debt lost its sterling triple-A rating

first time in post-WWII era!

What events led to the downgrade of USA? 

The Debt Ceiling: US  government was having troubles regarding its so-called debt ceiling. As the

name suggests, the debt-ceiling marks the upper limit of how much the government could borrow;

thereby putting a check on government spending. This was set at $14.3tn (which is around the

current US GDP) and can only be increased if a bill to the effect is passed by the government. The

Debt-Ceiling was hit in May-11 and the government needed extraordinary measures to keep

themselves funded till first week of Aug-11, post which they would be exhausted of such measures.

The Democrat-Republican debate:  However, it wasn’t easy to simply increase the debt-limit (or

ceiling) as it would have indicated reckless spending behaviour of the government and thereby

putting risks to its AAA rating. Thus, efforts to reduce budget deficits in the ensuing 10years began.

Beginning Feb-2011, the Republicans and Democrats started discussing the ways to reduce the

deficits. Soon it became evident that they were at loggerheads about increases in taxes as a means.

Democrats wanted it and Republicans vehemently opposed it. What made the situation unique was

that a bill needs to be passed by both houses (the Senate and the House of Representatives) to

become a law and Senate was Democrats-controlled whilst the House was Republican controlled.

The Downgrade Warning: The drop in the rating by one notch to AA-plus was telegraphed as a

possibility back in April-2011. The three main credit agencies, which also include Moody's Investor

Service and Fitch, had warned during the budget fight that if Congress did not cut spending far

enough, the country faced a downgrade. Moody's said it was keeping its AAA rating on the nation's

debt, but that it might still lower it.

S&P had issued a negative outlook (from stable) on US debt in a statement on 18-Apr-11 to the

effect:

"The negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a 1-

in-3 likelihood that we could lower our long-term rating on the U.S. within two years… The outlook

reflects our view of the increased risk that the political negotiations over when and how to address

both the medium- and long-term fiscal challenges will persist until at least after national elections in

2012."

The Law:  After about 7 months of haggling and  intermittent stand-offs, The Democrats and

Republicans hurried onto an agreement of $2.1-2.4bn worth of Budget Deficit cuts in the next 10

years. This was much lesser than the $4tn that S&P indicated will be required for US government to

maintain its coveted triple-A ratings. In addition, the agreement was to be carried out in 3 steps:

  A $900bn worth of first tranche cuts was agreed upon by both parties

  A further $1.5tn was to be agreed upon by a joint-committee by Dec-11 (bring total

reduction in deficit to 0.9+1.5= $2.4tn)

Implications 

So, far the downgrade of USA sovereign debt has had a more adverse impact on S&P itself than the

US debt.  S&P’s Deven Sharma will  be  replaced as president of the ratings agency by Douglas

Peterson, chief operating officer of Citibank effective 12-Sep-11.

Whilst S&P battles political pressures and criticism, US debt remains in high demand. Infact, the 10yr

yields (a standard measure of return on investment) of US Treasury has dropped about 50bps since

the downgrade to around 2%! This effectively means the investors are willing to take 0.5% lesser

yield on the 10yr debt today than on the day of downgrade!!

One reason for the above is  lack of alternatives to the huge US debt. Whilst other AAA-rated

sovereign debts are just a fraction of US outstanding debt, other alternatives like Gold are even

tinier markets.

Another reason is that, investors will not shun a debt unless there are real default fears or the debt

is downgraded by at least two CRAs!

However, what if in future more downgrades happen, especially from either Moody’s or Fitch? This

may happen if these CRAs start using the same glasses that S&P did and US government continue to

be reluctant in implementing the deficit-reducing mechanisms.

It may mean total chaos in financial markets with huge volatility in Treasury prices!

Or

It may mean that the world assumes AA+ is the new AAA!!