July 30, 2011
Scenario Implications - US Sovereign Ratings
On July 14th 2011, Standard & Poor's had placed the 'AAA' long-term and 'A-1+' short-term sovereign credit ratings on the United States of America on CreditWatch with negative implications. Over the last fortnight, the ongoing debate between the opposing camps has not resulted in any resolution of the deadlock.
Background: Two separate Issues Driving the Decision
The CreditWatch action reflects S&Ps view of two separate but related issues. The first issue is the continuing failure to raise the U.S. government debt ceiling so as to ensure that the government will be able to continue to make scheduled payments on its debt obligations. The second pertains to the current view of the likelihood that Congress and the Administration will agree upon a credible, medium-term fiscal consolidation plan in the foreseeable future.
(1) Raising the debt Ceiling
S&P may lower the long-term rating on the U.S. to the 'AA' category if they conclude that Congress and the Administration have not achieved a credible solution to the rising U.S. government debt burden and are not likely to achieve one in the foreseeable future. However, Standard & Poor's still anticipates that lawmakers will raise the debt ceiling by the end of July to avoid those outcomes. However, if the government is forced to undergo a sudden, unplanned fiscal contraction--as a result of Treasury efforts to conserve cash and avoid default absent an agreement to raise the debt ceiling- the effect on consumer sentiment, market confidence, and, thus, economic growth will likely be detrimental and long lasting. If the government misses a scheduled debt payment, we believe the effect would be even more significant and, under our criteria, would result in Standard & Poor's lowering the long-term and short-term ratings on the U.S. to 'Selective Default' until the payment default was cured.
(2) Long Term Fiscal Consolidation
S&P may also lower the long-term rating on the U.S. to the 'AA' category in the next three months, if they conclude that Congress and the Administration have not achieved a credible solution to the rising U.S. government debt burden and are not likely to achieve one in the foreseeable future.
Congress and the Administration are debating various fiscal consolidation proposals. Under S&P’s baseline macroeconomic scenario, net general government debt would reach 84% of GDP by 2013 from the current level of 75%. Such a percentage indicates a relatively weak government debt trajectory compared with those of the U.S.' closest 'AAA' rated peers (France, Germany, the U.K., and Canada).
They expect the debt trajectory to continue increasing in the medium term if a medium-term fiscal consolidation plan of $4 trillion is not agreed upon.
Therefore, as the deadline of August 2nd looms nearby, the possibility of the unthinkable credit event is inching higher. If such an event were to really happen, what are the likely scenarios? S&P has provided three scenarios: Scenario 1: (best case), Scenario 2: (base case) and Scenario 3: (worst case)
Hypothetical Scenario 1--Agreement to Raise the Debt Ceiling and Reduce Debt - Best case
If both the Congress and the Administration were agree to raise the debt ceiling before the deadline and come to terms on a long-term debt-reduction plan, Standard & Poor's would likely affirm the U.S. ratings and remove them from CreditWatch.
Reduction of debt would lead to significant slowing of government spending which would have generally negative implications for the economy broadly. This would especially be the case for the corporate and government entities that most depend on federal spending.
Yet even under this relatively positive scenario, the resulting fiscal contraction may weigh for many years on an economy already expected to show below-trend GDP growth due to the after effects of the financial crisis.
Moreover, even if Washington does avoid a default, investor confidence in the dollar, Treasury securities, and U.S. institutions may suffer lingering effects.
Hypothetical Scenario 2--Agreement to Raise the Debt Ceiling but no Credible Agreement to Reduce Debt - Base case
Agreement on raising the debt ceiling without making any tough budget decisions would be materially less optimal than hypothetical scenario 1. Such a partial solution would essentially push the debt reduction issue to the 2012 election debate. Meanwhile, debt would continue to mount and the results of the election might not, in any event, resolve the issue.
Under this scenario, the U.S. sovereign rating could be lowered to 'AA+/A-1+' with a negative outlook as early as August. There is a possibility of a moderate rise in long-term interest rates (25-50 basis points). Economic growth could also slow down (25-50 basis points on GDP growth) due to an ebbing of market confidence, as well as an increase in consumer and business caution.
This scenario could also lead to the review /downgrade of all government related entities. However, it wouldn't affect the ratings of the four U.S.-based corporate borrowers rated 'AAA'.
Hypothetical Scenario 3--No Agreement to Raise the Debt Ceiling, Increasing the possibility Of Default Worst case
A failure to raise the debt ceiling and agree on deficit-reduction measures would lead to significant turmoil--and could prove severe if such a situation lingered long enough. Under this hypothetical scenario, financial market conditions would worsen considerably in a matter of days. Failure to pay off maturing debt or missing interest payments (approximately $32 billion of interest is payable on Aug. 15) would constitute a selective default and Standard & Poor's expects it would lower the sovereign rating to 'SD'.
Even if the Fed and other central banks managed to keep the financial system functioning, we expect that markets around the world would be severely damaged. In such a hypothetical scenario, equity markets would plunge, borrowing costs and interbank lending rates would soar, and corporate credit
Conclusion
The equity, sukuk and foreign exchange markets are likely to turn volatile till the time the issues get sorted out. This is likely to be the case even in the Middle Eastern markets. Caution is advised and all investment decisions can be delayed till the time the issues are played out in the global financial markets.
Source: S&P website analysis
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