In a significant move, Fitch Ratings has downgraded the United States’ Long-Term Foreign-Currency Issuer Default Rating (IDR) from ‘AAA’ to ‘AA+’. This action, announced on August 1, 2023, is the reflection of concerns regarding the nation’s fiscal health, governance standards, and debt management, thereby signalling to investors and the global markets about the increased risk of lending to the United States. With markets currently in the red, the immediate impact of this downgrade is still unfolding.
Decoding the Downgrade
Credit ratings are an integral part of the financial system, acting as a barometer for assessing the creditworthiness of a nation. Essentially, they help investors worldwide to navigate the investment landscape by offering a risk-assessment tool. Therefore, a downgrade can significantly impact the inflow of investment, leading to fluctuations in market stability.
The primary reasons for this downgrade revolve around anticipated fiscal deterioration, a high and growing general government debt burden, and the erosion of governance standards over the last two decades. Repeated debt limit standoffs, last-minute resolutions, and a lack of a medium-term fiscal framework are among the critical issues flagged by Fitch. The agency also highlighted challenges related to rising social security and Medicare costs due to an ageing population, which are yet to be effectively addressed.
Furthermore, the decision underlines the challenges that the U.S. faces as it deals with the aftermath of several economic shocks and policy decisions, including tax cuts and new spending initiatives, which have contributed to the escalating debt over the last decade.
Understanding the Implications
Credit ratings serve as a reflection of a country’s economic stability and its ability to repay debts. An ‘AAA’ rating, the highest rating offered by agencies like Fitch, indicates the lowest possible risk of default. On the other hand, a downgrade to ‘AA+’ suggests a slightly higher risk.
In an interconnected global economy, investors use these ratings to guide their investment decisions. Therefore, the downgrade of the U.S. credit rating could potentially rattle investor confidence, affecting the flow of investments into the country. Investors, particularly foreign ones, may perceive the U.S. as a riskier destination for their capital and might choose to invest elsewhere, where they deem the risk-reward ratio more favourable.
A decrease in investments can slow down economic growth, as investments are a critical driver of job creation, innovation, and development in various sectors. Furthermore, this could also impact the valuation of the U.S. dollar and lead to fluctuations in the currency exchange market.
Credit ratings also significantly impact the interest rates at which countries can borrow money on international markets. Higher ratings often correlate with lower borrowing costs because lenders believe the risk of default is minimal. Conversely, a lower rating means higher perceived risk and therefore, higher interest rates or yields.
With this downgrade, the U.S. might face higher borrowing costs in the future. These elevated costs can have a chain reaction within the economy. The government may need to allocate a larger portion of its budget to service its debts, leaving fewer resources for public spending in areas like infrastructure, education, and healthcare.
Higher borrowing costs can also trickle down to businesses and consumers. If the government borrows at higher rates, banks and other lending institutions often raise their interest rates as well. Consequently, businesses might find it more expensive to finance their operations or expansion plans, and consumers may face higher rates on mortgages, credit cards, and loans. This can slow down domestic consumption and economic activity.
The U.S. plays a pivotal role in the global financial system. As the issuer of the world’s preeminent reserve currency, the U.S. dollar, its credit rating can have substantial implications for global financial stability.
A downgrade can lead to a decrease in the value of the U.S. dollar against other currencies. This shift could affect international trade, as many global transactions are conducted in U.S. dollars. Furthermore, many countries hold U.S. government bonds as part of their foreign exchange reserves. A downgrade, and the subsequent potential decrease in bond values, could impact the value of these reserves.
Moreover, due to the interconnectedness of today’s global financial system, a decline in investor confidence in the U.S. or a sharp adjustment in U.S. asset prices could cause significant financial market volatility worldwide.
In essence, the U.S. credit rating downgrade is not just an internal issue but has far-reaching consequences that could reverberate throughout the global financial system, impacting nations far beyond the U.S. borders.
As we publish this article, the markets are in the red. The downgrade has undoubtedly added a layer of uncertainty in an already volatile environment. It’s important to note that the other major rating agencies have not downgraded the U.S. credit rating and this is not the first time such a thing has happened. The 2011 Standard & Poor’s downgrade did affect markets negatively, but was quickly shaken off. Whether this is the case now remains to be seen.
Ivailo Chaushev
Chief Market Analyst at Deltastock
Risk warning:
This article is for information purposes only. It does not post a buy or sell recommendation for any of the financial instruments herein analysed.
Deltastock AD assumes no responsibility for errors, inaccuracies or omissions in these materials, nor shall it be liable for damages arising out of any person’s reliance upon the information on this page.
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