The IMF projected global growth to decelerate from 3.4 % in 2022 to 2.8 % in 2023 with risks heavily skewed to the downside and high chances of a hard landing. Growth could remain at 3% in 2024-28.
Anaemic growth in 2023 stems from aggressive monetary policy to curb inflation, the impact of deteriorating financial conditions, Russia Ukraine war, and growing economic fragmentation.
Renewed thrust on growth, productivity, financial inclusion, and inequalities in income and wealth is needed. The BIS Annual Report (2023) cogently argued to use all instruments to meet the twin challenges of high inflation and financial fault lines. Fiscal and prudential policies must move in tandem to help stabilise the economy and financial sector.
Why has Fitch downgraded U.S. long-term credit rating
Against this backdrop, Fitch downgraded U.S. long-term credit rating on August 2, 2023, from AAA (i.e., the highest rating that an agency gives to a country, locality or company concerning its ability to repay its debts) to AA+ for the first time since 2011 because of an erosion of governance resulting in multiple gridlocks over the debt ceiling. Fitch said, ‘The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management’.
Considered in a proper historical and comparative perspective, Standard and Poor (S&P) downgraded US debt for the first time in 2011 in the wake of a tense debt ceiling standoff.
Fitch expects Government deficits to rise from 3.7% in 2022 to 6.3% of GDP in 2023. Things do not seem to improve anytime soon because as Fitch said ‘cuts to non-defense discretionary spending (15% of total federal spending) as agreed in the Fiscal Responsibility Act offer only a modest improvement to the medium-term fiscal outlook’.
There are also real and worrisome concerns of a further rise in general government debt reflected in debt-to-GDP ratios.
The storms have been gathering for quite some time with the US debt crossing the Lakshman Rekha, i.e., the borrowing cap of $ 31.381 trillion on Jan. 19, 2023.
With US unable to pay its bills, including interest and other payments, US government would have been unable to issue new debt triggering a financial crisis and necessitated swift changes.
Accordingly, President Joe Biden signed the debt ceiling bill on June 2, 2023, perilously close to the ‘X-date’ on June 5. The precarious debt situation had induced Fitch to place the USA’s AAA rating on negative watch in May 2023 and this debt constraint was once again reiterated in the downgrade announced on August 2, 2023.
In the damning words of Fitch, ‘There has been a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters, notwithstanding the June bipartisan agreement to suspend the debt limit until January 2025’. While the US has more debts outstanding, its currency continues to be strong and resilient.
There are also the issues of unresolved medium-term fiscal challenges. Rising rates are resulting in an increase in interest costs and tax cuts set in 2017 are set to expire in 2025. These and other factors (e.g., one more rate hike by September) are likely to exacerbate the political pressure and result in deterioration in the domestic macroeconomic setting.
Fitch also raised the specter of a ‘mild’ recession in Q4 of 2023 and Q1 of 2024 because of the triple whammy of tightening credit conditions, weakening business investment and a slowdown in consumption. The cookie crumbles because of Fitch’s prognostically alarming view that the failure to address governmental spending issues and macroeconomic policy could lead to more negative revisions.
Future ramifications and repercussions
Where do we go from here? While this move would dent the credibility of the US to a limited extent, it could lead to heightened risk aversion with the US Treasuries and the USD (also gold) emerging as a safe haven.
This implies that despite some short-term volatility triggered by the downgrade, the investors would continue to stay invested in Treasuries despite higher political risk because demand for US bonds is likely to remain strong as there are few markets that are large and safe enough to rank as an alternative and the dollar’s initial weakness is likely to be transient.
This point of view can be substantiated by the fact that after the move by Fitch, there was greater, not diminished, demand for the 10-year Treasury.
There are, however, differing schools of thought. Treasury Secretary Janet Yellen strongly reacted to this downgrade. She maintained it ‘does not change what Americans, investors, and people all around the world already know: that Treasury securities remain the world’s preeminent safe and liquid asset and that the American economy is fundamentally strong’.
Contextually macroeconomic setting and the drivers for the current downgrade differ markedly from the rating cut of 2011 by S&P because stock markets then were already in a sell-off mode and interest-rate were falling. But with rising interest rates, higher growth outlook and rising stock indices, it is justifiably believed that any correction in equities will be short and shallow.
Given the overarching global and domestic environments, this move is unlikely to severely impact risk assets, including emerging market economies (EMEs) in terms of flows.
In our assessment, bond market investors are unlikely to be unduly worried about an impaired debt servicing ability of the US government. Indian investors, however, took a beating of Rs 3.5 lakh crore as foreign portfolio investors (FPIs) sold shares to meet redemption pressures and accordingly, benchmark indices Nifty and Sensex ended 1% lower each at 19,526.55 and 65,782.78 on the day when Fitch announced downgrade.
