US Credit Rating Downgrade- an case study

Recently American credit rating agency, Fitch downgraded the credit rating of United States due to high levels of increase in debt of country in recent years and frequent increase in debt ceiling. This article covers the case study over the issue with knowledge of credit ratings

1. What is credit rating

A credit rating serves as a significant certification that implies financial well-being of a nation or an company. This certificate is given by credit rating agencies, which measure an entity's ability to manage its financials effectively. These agencies play a pivotal role in evaluating and assigning credit ratings, providing valuable insights into their financial health. Essentially, this certification offers an assessment of the financial soundness of a nation-providing a report card for its economic stability.

The process of credit rating involves a comprehensive analysis, and the certification itself is a form of rating mechanism. This mechanism operates on the basis of assigning a numerical or alphabetical grade that reflects the creditworthiness of the subject. Credit ratings are important for countries and companies alike, especially when they intend to secure funds through avenues such as issuing bonds, debentures, or seeking loans from financial institutions.

It is important to note that credit rating are no means to give an investment advice for an instrument, rather it is an amount of risk which investor has while holding that instrument.

 These credit ratings operate on a multi-tiered system, allowing lenders and investors to make informed decisions based on an entity's financial standing. In India, there are 3 main Credit rating agencies- CRISIL, Care Ratings and India ratings. Globally there are 3 most prominent agencies- S&P, Moodys and Fitch.

2. Types of credit rating and outlook

Credit ratings serve as essential indicators of an entity's financial health, and they come in various grades, each conveying distinct messages. At the top of the ladder is the Triple A (AAA) rating, which signifies the best possible creditworthiness. This rating reflects utmost stability and reliability. On the other end, we have the lowest grade, known as the Double D (DD) or Default rating. This indicates a significant risk, implying that the investment may not be safe.

Each rating in between these extremes carries its own significance. For instance, an AA rating suggests a very high credit quality, while a B rating implies a higher risk but still manageable. Additionally, credit rating agencies often include an outlook assessment alongside these ratings. An outlook can be Positive, Stable, or Negative. A Positive outlook indicates a potential improvement in the credit rating in the future, while a Stable outlook suggests that the rating is unlikely to change significantly. Conversely, a Negative outlook implies a possible downgrade if certain conditions are not met.

Understanding these types of ratings and outlooks is crucial for both investors and entities seeking financial resources. A Triple A rating brings a sense of security and trust, making it easier for countries and companies to borrow funds. Conversely, a lower rating or a negative outlook might signal caution to potential investors, urging entities to address their financial weaknesses and work toward improving their rating. While outlooks provide insights into the potential direction of a rating change, the ultimate goal remains achieving and maintaining a favorable credit rating, as it greatly influences an entity's access to financial opportunities and its overall financial well-being.

3. How credit rating is given to countries?

When it comes to countries, credit ratings are assigned based on a thorough examination of various economic factors. These ratings essentially reflect the country's financial health and macroeconomic fundamentals. To put it simply, credit rating agencies look at how well a country's economy is performing. They consider indicators like the Gross Domestic Product (GDP) growth, tax collection, fiscal deficit (which is when a government spends more than it earns), and other economic aspects.

Think of it like a physical check-up for a country's finances. The agencies analyze how the government manages its expenses, whether it's reducing spending, borrowing money, or maintaining strong revenue from taxes. They also consider how much debt the country has accumulated over time and whether it has defaulted on any payments previously. These agencies pay attention to nearby countries too, especially if they've faced default situations. Countries like Sri Lanka and Pakistan have experienced defaults, which makes it important to observe their borrowing patterns.

The credit rating agencies also look at a country's track record – whether it has a history of defaults or has managed to maintain its financial commitments. The agencies not only assess the present situation but also consider future economic outlooks. This includes forecasting the country's economic performance and potential risks.

credit rating agencies give ratings to countries by examining a mix of factors like economic growth, fiscal management, debt levels, past defaults, and future economic outlook. These ratings serve as a guide for investors and lenders to understand the level of risk associated with lending money to a particular country. Just as you might check someone's past behaviour before lending them money, credit rating agencies assess a country's financial behaviour to determine its creditworthiness.

4. Why credit rating is important?

Credit ratings hold significant importance for countries and entities. Imagine countries as individuals in the global financial landscape – just as individuals have CIBIL Score which act as their credit rating, countries have credit ratings. These ratings are crucial because they help countries access funds from other Countries or institutions like the World Bank, IMF, or private companies. When a country wants to borrow money internationally, it needs to assure lenders of its creditworthiness, and that's where credit ratings come in.       

The better a country's credit rating, the more favourable the terms it can secure for borrowing. A higher rating implies lower interest rates, indicating that the country is financially robust, generating good income, and managing its finances well. On the other hand, countries with lower ratings might find it more challenging to borrow money, or they might have to pay higher interest rates due to higher risk.

For instance, let's say two countries, Country A and Country B, both want to issue bonds to raise funds. Country A has a higher credit rating (say, Triple A) compared to Country B (which has a lower rating). Investors are more likely to invest in Country A's bonds because of its strong credit rating. The demand for Country A's bonds would be higher, making it easier for them to raise funds.

Moreover, triple-A-rated bonds are highly liquid, meaning they are easily tradable and have a consistent demand. This attractiveness comes from the confidence investors have in the issuer's financial stability. Investors know that these bonds are relatively safer investments.

In contrast, if a country's credit rating is low, it might face challenges in attracting investments. Investors might be hesitant to invest in bonds from that country due to higher perceived risk. This can lead to limited access to capital, higher borrowing costs, and even difficulties in rolling over existing debt.

In essence, credit ratings offer insight into a country's financial health, helping investors make informed decisions and allowing countries to access funds at favorable terms. They act as a measure of credibility, guiding investment choices and influencing a country's ability to secure loans and investments. Thus, the significance of credit ratings is paramount in the global financial ecosystem.

5. Why United States’ credit rating is downgraded?

 The process of credit rating agencies downgrading the credit rating of the USA can be attributed to several factors. Firstly, the recurring discussion between the ruling and opposition parties creates uncertainty and negatively affects the functioning of the government. The constant power struggle and debates between Democrats and Republicans often lead to government operations being stalled, impeding effective policy-making.

Secondly, the issue of fiscal discipline comes into play. The USA has faced challenges in managing its debt ceiling, which has the potential to disrupt financial markets and investor confidence. The recurring debates and negotiations around raising the debt ceiling raise concerns about the country's ability to control its finances and maintain a balanced budget.

Lastly, economic indicators and financial performance play a role. Fluctuations in key economic metrics like GDP growth and fiscal deficits have an impact on a country's creditworthiness. If these indicators deviate from projected levels, it can signal potential economic instability and influence credit rating decisions.

Furthermore, the recent statements from credit rating agencies suggest that the prevailing conditions may lead to a potential increase in interest rates, possibly towards the end of 2023 or the beginning of 2024. This forecast is grounded in the assessment that the current economic situation might warrant such adjustments.

the downgrading of the USA's credit rating can be attributed to a combination of factors, including political instability, fiscal challenges, and economic performance. These factors collectively contribute to the evaluation of the country's creditworthiness by credit rating agencies, leading to adjustments in its credit rating.

6. What is debt ceiling?

The debt ceiling is a crucial fiscal policy concept that defines the maximum amount of debt that a government can legally borrow. It represents an upper limit on the total amount of money that a government is authorized to owe its creditors, which can include other governments, institutions, and individuals. In essence, the debt ceiling sets a cap on how much the government can borrow to finance its operations, initiatives, and obligations.

When a government reaches the established debt ceiling, it cannot issue additional Treasury securities or borrow further funds without specific legislative approval. This limit is intended to ensure that the government's borrowing remains within reasonable bounds and that it doesn't accumulate excessive debt.

The debt ceiling is a key component of fiscal discipline and responsibility. It forces governments to carefully manage their finances, control spending, and make informed decisions about budget allocation. It also plays a role in maintaining the country's creditworthiness and preventing excessive reliance on borrowed funds.

When debates over raising the debt ceiling arise, they often become politically contentious. The decision to increase the debt ceiling requires approval from the legislative body, and these discussions can lead to political negotiations and potential government shutdowns if an agreement is not reached in a timely manner.

In the United States, for example, the debt ceiling has been a recurring issue, and debates around it can have far-reaching implications for government operations, financial markets, and the overall economy. It's important for governments to carefully manage their debt ceiling and borrowing practices to ensure fiscal stability and responsible financial management.

7. Impact of downgrading the rating for USA

Downgrading the credit rating of any country meant that the financial position of country is not good compared earlier. Now if we take look of financial institutions who purchase American security bonds as they are mandated to only purchase bonds of AAA rating, they would no longer invest in these bonds and try to sell the bonds which they were having previously, which could shook the debt market for America as whole.

The main impact would be on the financial credibility of United states. US bonds, for long time was the safest instrument for invest among investors all over the world, because of high liquidity, safest rating and easy availability. Now with this downgrade, it could hurt the trust of investors who invested in bonds just because of these reasons, trust which was built by investors over the years. With this, investors can search for alternate investments in different countries which have AAA rating, like Canada and Australia, which could decrease the inflows of these investors to US.

Now for the government of US, they have to either improve their rating in future, or should increase the interest rate on the government bonds, as for investors, higher degree of risk means higher degree of return. The higher rate would also attribute to higher cost of borrowings for government.

8. Is downgrade by fitch justified?

The reason fitch representative gave for downgrade is the problem of debt ceiling in United states, increase in debt in recent years and political indiscipline in USA. However Most of the people give an political outlook on the situation, as fitch hurriedly downgraded without updating beforehand, such as giving negative outlook on AAA rating before downgrading further to AA+. Also it is not the time where the situation in USA is very much adverse. There is reporting of strong GDP numbers of country, unemployment rate, one of the most important aspect is lowest in 3 years. Companies are reporting best numbers in past years

Also the rating agency did not downgraded the rating during financial crisis of 2008, and the situation today is far better that that time, so downgrading in today’s scenario did not look much promising. 

It looks like the step to downgrade the rating has much reason of politics rather than the fundamental outlook of the country.

9. Reaction on US market on previous downgrade on 2011

Previously, S&P downgraded the rating of US  bonds in year 2011, and at that time S&P 500 Index fell 5.5% on single day. There were very much fear among the investors regarding this measure, thinking of adverse effect it would have on world, as if USA’s economy is not strong then what would happen to world.

But surprisingly, after that correction, index rose to 4.5% after 1 month, 13% in 3 months, 19% in 6 months and 22% after one year, which suggests that investors soon adapted to the rating and it had an short term impact on the market, inspite of having any long term consequence.

10. Reaction on Indian markets on downgrade of 2011

Reaction of Indian markets on this news were very much mixed. On first day, nifty fell around 1.75%, after three months index rose to 3.5%, in 6 months 5%, after one year 4% and after 2 years the return was 9%. The Indian markets did not perform well during that period of time compared to US markets. However there could many factors for this change.

This suggests that the rating downgrade impacted the US markets and there were not much similar impact on Indian markets or the economy.

11. Impact in today’s scenario

Indian markets has an negative impact on this news and BSE SENSEX dropped 1.83% in 2 days, slamming an brake on the bull run the indices had on pas 3-4 months. However according to me, the impact would be short lived and Indian markets would not have much impact on it, as for much of the year, the market does not followed any correlation with US markets. Also there are positive news by Morgen Stanley of upgrading rating to “overweight” for Indian markets, and downgrading china markets, which has an impact on markets and indices recovered 0.74% following that news, meaning there is positive look for Indian markets by foreign institutions.

However the impact of dollar index is seen on the news, and It impacted the currency markets. Indian rupee fell 3 days straight after the news. We could see some fall in Indian rupee in upcoming days.

There is tendency of gold to increase after negative news come in, so we could see increase in gold price in upcoming days.

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