When rating agency Fitch downgraded US government debt from Triple A to AA+ earlier this month, it was only the second time in history that Uncle Sam got a slap on the wrist.
The first time this happened, when S&P downgraded it in August 2011, the markets barely reacted, and the downgrade was largely ignored.
Will it be any different this time?
Before we answer that, it is worth noting why Fitch downgraded Uncle Sam’s long-term debt ratings.
Fitch said that the downgrade reflects the drop in US fiscal governance standards, where political brinkmanship between the Republicans and Democrats over the debt ceiling has repeatedly threatened a government shutdown.
However, Fitch is worried not just by this political arm-wrestling, but the unlikely prospect of the US ever getting down to a serious fiscal reform timetable.
Here is what the Fitch downgrade :
“In Fitch's view, 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…. The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management. In addition, the government lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process. These factors, along with several economic shocks as well as tax cuts and new spending initiatives, have contributed to successive debt increases over the last decade. Additionally, there has been only limited progress in tackling medium-term challenges related to rising social security and Medicare costs due to an aging population.”
In 2011, when S&P did its downgrade,
“We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process.”
The issue is simple: the markets have forgiven the US's much higher levels of fiscal mismanagement than other countries. And the real question is whether this can continue forever.
Fitch notes that even though robust growth has brought down the general government debt-GDP ratio to nearly 113 per cent, it will worsen to 118.4 per cent by 2025.
“The debt ratio is over two-and-a-half times higher than the 'AAA' median of 39.3 percent of GDP and 'AA' median of 44.7 percent of GDP.”
In short, even at its downgraded level of AA+, the US rating soars far above what the markets would tolerate in peers.
As the only country in the world whose currency is accepted as payment in almost any transaction, the US has unique advantages. The dollar is still the only game in town as a safe haven currency.
But things are changing, and this time the downgrade heralds a change in perceptions that may do more damage than the S&P downgrade in 2011. Here are three of the most important reasons why.
First, post-Covid, supply chains have broken down, and there is now a tendency to not put all eggs in the China basket. This means rising costs for the whole world, and the US too.
Plus, there is inflation, fed by relentless printing of dollar notes. In the last three years, annually.
This overhang will make inflation stickier, and interest rates may remain high longer than anticipated earlier. This means the world is sooner or later looking at a US slowdown, if not a full recession.
Second, the illegal freezing of nearly $300 billion of Russia’s dollar holdings after the Ukraine war began has forced all countries with huge dollar reserves to shift surpluses to other assets beyond the dollar.
In 2022, . This trend is continuing in 2023. The US dollar is no longer seen as a safe haven by many countries.
They worry that any issue — human rights or other local wars — could be weaponised against them financially. Countries are seeking alternatives to both dollar and US military dependence, and this will impact Uncle Sam’s ability to manage its fisc at some point in the future.
Third, geopolitical power is moving towards new organisations that are not US dominated.
For example, there is a rush to join and the only thing holding back faster growth in BRICS numbers is the China-India standoff.
Saudi Arabia, Argentina and Egypt are among the countries keen to join this non-western institution. If China and India can move towards greater mutual trust after their border issues are at least partly resolved, the sky is the limit for BRICS.
In other words, it is China’s bullying tactics in the region that are preventing it from countering western influence in much of Asia, Africa and Latin America. The US will be impacted by a consequent decline in its political and economic clout.
Fourth, there is no sign that the Ukraine war is ending anytime soon in the way the US hoped it would — with a defeat for Russia.
Russia may not win, and its economic and political clout is surely declining, but the war is now entering stalemate zone where neither Europe nor America have anything to gain from it.
Voters will surely ask Joe Biden what America gets from this endless bankrolling of the war in Ukraine.
It is worth recalling that every time the US faced an economic or geopolitical crisis, it could buy itself out of trouble. This happened during the dotcom bubble, the post-9/11 war on terror, the 2008 Lehman crisis, and — most recently — the Covid economic crisis.
The assumption that the US can endlessly print money to get out of economic trouble is sure to be questioned as the world looks for new geopolitical anchors in Asia and becomes less and less willing to hold assets in dollars.
Nobody should be writing off the US as yet, but the smoke signals are clearly showing that a slow underlying shift in global economic power is happening that could ultimately undermine the dollar world.
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