The lowering of rating of the US by Moody’s has passed off as a non-event. S&P and Fitch had done the same quite a while back. S&P did so in 2011, post-Lehman crisis, and Fitch followed a little over a decade later in 2023. The state of the economy is well-known. The US has a fiscal deficit ratio of 7.6% and evidently spends more than it earns. The debt-to-GDP ratio is 124%, one of the highest in the world. The current account deficit was at 3.9% as of December. All these indicators should have raised a red flag from the point of view of credit rating companies. But this is taken to be a normal given that it is the US. Therefore, downgrading a notch does not really mean much.
The present downgrade has been driven a lot by what the new regime could end up doing. Higher tariffs will necessarily increase inflation which in turn will put pressure on the Fed on rates, which can lead to a slowdown in economic growth. Some also say that the phenomenon of stagflation cannot be ruled out where inflation remains high and GDP growth slows down, if not turn negative.
How then does the US manage this situation with ease? The answer is that for all practical purposes the dollar is the anchor or reserve currency in the world. Dollars are used primarily for all global transactions. The euro, pound, yen, and Swiss franc follow but the dollar is supreme. If that is the case with transactions, there is dependence on the US for the supply of dollars. Only when the US runs high deficit will there be more treasuries that are issued, which central banks all over the world can invest in. Otherwise, this investment option will get diluted.
There was a brief period following the Ukraine war when Russia’s dollar assets were frozen and the nation was pushed out of the SWIFT (Society for Worldwide Interbank Financial Telecommunication) system of payments. This was when there was a cry for de-dollarisation. While there has been talk, central banks or nations have made no significant move as such when it comes to dealing with forex assets. The dollar is still strong and used for trade settlements, while central banks have not really changed their composition of assets. Some central banks have opted for gold, but given the physical supply constraints such a move has limitations.
In this context it would be interesting to see the credit default swap (CDS) rates on sovereign bonds to gauge the market flavour. These are notional rates provided by worldgovernmentbonds.com. The CDS is, in a way, the insurance cost that has to be paid against any default on the bond. For AAA rated countries like Switzerland, Sweden, and Finland, the five-year CDS was in the region of 8-13 basis points (bps). In case of AA rated countries, it would be around 20 bps which will be 30 bps for A rated sovereigns. For the US it is in the region of 45-50 bps with AA+ rating. It is higher than that of other similarly rated sovereigns because of the recent developments in economic policies.
Therefore, two points emerge. The first is that this will not really have a bearing on how countries look at the dollar which is still the most preferred asset. In fact, the US President had warned countries which move away from the dollar for settlement of payments that higher tariffs could be imposed on them. The second is that while a downgrade is normally associated with a reputation risk, in case of the US it would not really make a difference. This is because two other agencies had done so earlier, which did not quite move the needle. In fact, American companies have not quite had any issue in raising funds in overseas markets due to the sovereign rating being less than AAA.
A broader issue is the methodology used by rating agencies. There seems to be a stickiness in assigning ratings at both the upper and lower scales. India, for example, would definitely be in the A+ category given a spectacular economic record. Consistently labelled as the fastest-growing economy even during global economic turbulence, there has been a strong regulatory framework on both the fiscal and monetary sides. While consistently recording low current account deficits and attracting high foreign direct investment inflows, the rupee has also been one of the best-performing currencies in the last three years. There has also been a strong improvement in job creation as well as removing people from poverty, a significant achievement over the years.
Besides, government debt is in rupees and the fiscal deficit has been following a glide path downwards. In fact, three global bond indices have included/will be including Indian securities in their basket. This is a strong vindication of the quality of government debt. Under these conditions, there would be a strong case for a rating upgrade. Looking at the implied CDS rates for India, it is 85 bps for a BBB (minus) rating. China with A+ has a CDS of 54 bps while Israel with A rating has a CDS of 100 bps (which can be due to the ongoing war).
There is definitely a need for the credit rating agencies to revisit their approach to sovereign ratings and align them with the changing economic developments to be more realistic. While the argument of anchor currency is pertinent, there must be limits. In fact, if this strong assumption is relaxed, there can be more discipline brought in terms of US policies on budget and the way in which it maintains relations with the rest of the world. Moreover, growth — where India has done very well — is a strong argument to consider when it comes to sovereign rating. Developed countries which fall below the average mark for successive years need to be reexamined. Moreover, the view of the market which is represented by investors cannot be ignored as this entity has skin in the game and is putting money on the table and investing in the emerging markets.
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